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Signage is seen on Manulife Financial Corp.'s office tower in Toronto, on Feb. 11, 2020.Cole Burston/The Canadian Press

A product that troubled Canadian life insurers during the last financial crisis a decade ago has come back to bite some industry players again.

Empire Life took a large hit in the turbulent first quarter this year on a type of annuity product that guarantees income for life, while other insurers have also worked to minimize exposure from legacy products still on their books.

The contracts provide “guaranteed minimum withdrawal benefits” (GMWBs) and are tied to the stock market, allowing the holders to share in gains as markets rise – and, in many cases, lock in higher benefits. When markets fall, however, insurers can be on the hook for large unfunded liabilities to cover the cost of protecting investors against losses.

GMWBs badly wounded Manulife Financial Corp. over a decade ago and damaged Sun Life Financial Inc. Since then, insurers have re-engineered them to make them less lucrative and, when possible, tried to buy out customers or sold off the original contracts to other institutions to get them off the books. They’ve also engaged in hedging and other forms of financial protection to minimize large potential losses.

Today, Canadian insurers’ so-called “segregated funds” business – the catch-all term that includes these annuity products – is less risky than before. Segregated funds look similar to mutual funds in that they are invested in stock and bond markets, but typically guarantee 75 per cent to 100 per cent of an investor’s principal at the end of the contract – usually 10 years or longer – or upon death. The insurer must keep the money in the funds separate from its other types of business.

Canada’s three biggest life insurers – Manulife, Sun Life and Great-West Lifeco Inc. and its subsidiaries – have limited their exposure to the GMWBs since the financial crisis. But some smaller providers still sell the products, and had a painful experience early this year as markets fell.

Empire Life took a pre-tax $131-million hit in the first quarter as it made a special provision to shore up its segregated funds business. The company didn’t disclose how much was related to GMWBs. In a statement to The Globe and Mail, chief financial officer Edward Gibson said GMWBs represent about 43 per cent of its segregated fund business. Given that GMWBs are risky, well over half of the liability increase was likely related to them.

The cost of the provision was hefty for a mid-sized company – three times its profit in the same quarter last year, and led to a net loss of $32-million in the first quarter.

Great-West Lifeco said its profits in the first quarter were dampened by $149-million in market-related losses, including $68-million from its legacy segregated funds business. Great-West has about $3-billion of GMWBs in force worldwide and hedges to manage investment risks, but said “hedging ineffectiveness” contributed to the loss.

Manulife and Sun Life also reported – deep inside their financial statements – that the first quarter was difficult for their segregated funds business. But the two companies used hedging and tools such as reinsurance to blunt the impact. A stock market rebound in the second quarter also reversed some damage.

Manulife said it had $55.5-billion of GMWB guarantees in effect at March 31, but the funds backing the guarantee were worth just over $43-billion. That meant the “amount at risk” – the excess of guarantees over fund values – was almost $12.5-billion, double the total on Dec. 31. By June 30, as markets partially recovered, the amount at risk was just under $8.9-billion on $53.1-billion of guarantees.

Sun Life does not break out GMWBs in its disclosures, but said its entire segregated funds business had an “amount at risk” of just over $2-billion on $14.4-billion of guarantees at March 31 – more than double the $781-million at risk on Dec. 31. Sun Life’s at-risk number also declined by June 30, to $1.2-billion.

In their disclosures, both companies emphasize the amounts at risk are not currently payable to customers. Insurers only have to cough up in certain situations, such as customer deaths or the maturity of segregated fund contracts. The numbers also portray the situation before risk-minimization programs, such as hedging, come into play.

When GMWBs first hit the market in the early 2000s, they seemed too good to be true. Policyholders were given a guarantee on a portion of their principal investment. They put their money in a portfolio of underlying mutual funds. If the mutual funds gained in value, GMWB holders could periodically reset their principal higher and boost their guaranteed income for life. Guaranteed payments would start at a specified age – typically 65.

In Canada, Manulife introduced GMWBs in 2006, and brought in more than $2-billion in assets within 10 months. Investors were drawn to the opportunity to protect their savings against market volatility yet still withdraw a set amount every year during retirement. Insurers liked them because the underlying funds typically had higher management fees than traditional mutual funds – often 3 per cent to 4 per cent.

Other financial institutions quickly followed and several GMWB products were launched in 2007 and 2008. Competitors raced to offer lower management fees and shorter reset periods until investors could lock in earnings – sometimes as often as twice a year. Manulife set the bar for payouts, guaranteeing 5 per cent a year for life. Desjardins Insurance then increased its guarantee to 7 per cent.

But there was a downside for the insurers: Even if the underlying funds declined, the guarantees remained. And it took just two years before there was a big problem. As stock markets crashed in 2008-09, share prices of Canada’s Big Three life insurers plunged by more than half. The strain on their capital reserves raised alarm bells with regulators, and analysts even suggested that Manulife’s guarantees to customers might result in the company being put up for sale.

(Regulators now require insurance companies to take into account the risk of loss arising from guarantees to certain products when setting minimum capital requirements.)

Since 2008, Manulife has beefed up its hedging to protect against losses from market declines. It also changed the contract terms for GMWBs to make them less generous to the customers, effectively discontinuing sales of its legacy products.

Chief executive officer Roy Gori says Manulife took “significant action” over the past decade to de-risk and reduce its sensitivity to market swings. At the end of 2019, the company had freed up about $5-billion in capital – three years ahead of a 2022 target.

In 2018 and 2019, Manulife took further steps to de-risk by offering clients invested in legacy GMWBs the option to transfer the market value of their contract to a newer fund version – with a bonus to do so. The company has not disclosed how many clients accepted the buyout.

“Manulife today is very different to the Manulife in 2008,” Mr. Gori said in a interview with The Globe. “Our sensitivity to interest rates today is about one-tenth of what it was a decade ago and our sensitivity to equity markets is about half of what it was.”

To a lesser extent, Sun Life was also swept into the selling frenzy of GMWBs before the financial crisis. Compared with some competitors, CEO Dean Connor says Sun Life had a “relatively good experience,” in that its hedging program “worked the way it was supposed to.”

“We had enough assets and capital to support obligations,” Mr. Connor said in an interview.

The insurer also sold off its U.S. variable annuity business, which created similar risks, in 2013. Mr. Connor said “it was very capital-heavy” – it required a lot to support each year of sales. The company also shut down sales of its “original” GMWB products and launched new funds with “less generous” guarantees.

“We have been pivoting the company to products that are less capital-intensive and create less risk for investors,” he said.

In total, there were $27.1-billion in assets in GMWBs as of April, 2020, making up about 24 per cent of the Canadian segregated fund market, according to data by Investor Economics, an ISS market research company. In recent years, many insurers reduced the equity exposure in the funds – which sometimes was as much as 100 per cent. Higher fees and reduced guarantees also made the products more sustainable, but much less attractive to clients.

Empire Life took a different route and continued to sell GMWBs similar to the original contracts of 2008 – although without the 100-per-cent equity exposure. The product makes up about 40 per cent of the $7-billion in assets the company manages.

Mr. Gibson, Empire’s CFO, said despite having to raise fees by 75 to 100 basis points and decrease some guarantees, market demands and demographics continue to drive sales. The products maintain equity exposure and allow clients to reset their principal every three years.

“We’ve never been the company that’s been trying to get out there and win on pricing or being the most aggressive,” said Mr. Gibson. “We’ve always come up with product designs that at times were viewed as being a bit too conservative, but have allowed us to remain resilient.

“We are continuing to offer a product that actually meets the needs for Canadians in terms of being able to meet some of their guaranteed retirement income needs, but also still give them the ability to participate in [up] markets. Because those are the two things that customers consistently ask for.”

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