Industrial Alliance is the latest Canadian life insurer to struggle with the burden of stringent capital requirements.
Faced with rock bottom interest rates and shaky equity markets, life insurers here have long been forced to store huge amounts of capital to ensure they can pay out future obligations. During an investor session on Tuesday, Industrial Alliance revealed that its capital requirements are increasing faster than its earnings.
The root of the problem is a regulatory requirement to store what National Bank Financial analyst Peter Routledge calls an "exceptional amount" of additional reserves andcapital. Canadian rules dictate that life insurers must assume that current interest rates will stay low for the foreseeable future.
That means that while their American counterparts can assume a regression to historical averages, Canadian insurers must input current rates into their long-term models.
Although putting extra money aside is a nice safety measure, Mr. Routledge noted that "this, of course, has come at the expense of common shareholders, either via lower earnings, dilutive common equity issuances or increased leverage."
Since the third quarter of 2011, Industrial Alliance has issued almost $200-million in common shares, $250-million in subordinated debt and $150-million in preferred shares. Should the current rate environment persist, Mr. Routledge expects the insurer to take on more debt in order to store it as capital, which could ultimately lower its debt rating by one notch.
Industrial Alliance in particular faces an uphill battle because its main source of revenue is long-term life insurance, which make the firm especially sensitive to interest rates. And because its exposure to rates was so high, the firm recently boosted its equity allocation that back long-term assets.
At Industrial Alliance, a 25 per cent drop in equity markets would now push its minimum continuing capital and surplus requirements ratio down by 27 per cent, compared to drop of 21 per cent at Manulife and a 6 per cent hit at Sun Life, according to National Bank Financial. A 50 basis point drop in interest rates would push this ratio down 7 per cent, versus 5 and 3 per cent at Manulife and Sun Life, respectively.
However, Industrial Alliance can't be singled out because the entire industry has been hit. Required capital as a percentage of total life and health premiums in Canada is now above 65 per cent, its highest point over the past decade, during which the low was about 44 per cent in 2004.