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Manulife Financial Corp. headquarters is seen in Toronto. (KEVIN FRAYER/Canadian Press)
Manulife Financial Corp. headquarters is seen in Toronto. (KEVIN FRAYER/Canadian Press)

Hot markets won't make insurance valuations any more accurate Add to ...

Manulife Financial Corp.'s earnings exposed the damage that Canada’s stringent accounting rules have inflicted on life insurers.

Had Manulife reported its latest quarterly earnings south of the border, the company would have booked a $2.2-billion profit, rather than a $1.28-billion loss, because U.S. rules allow insurers to assume that interest rates will eventually revert to their historical average.

Though the loss hurts the company, it may comfort you to think that investors (and regulators) at least have a clear picture of how much trouble Manulife will be in if interest rates stay this low. And the demise of a firm like MF Global, even if it isn't an insurer, may buttress your support of stringent rules on this side of the border.

No doubt we need tough standards, but the insurance model is particularly askew. The core problem: Canada's life insurers must assume current interest rates will last into perpetuity.

Technically, these companies can assume two different rates in their actuarial models -- one for the next 20 years, and another for anything beyond that -- but the main assumption is that the current low rates will persist for a long, long time. That's enraged insurers, because they argue it is very unlikely to happen.

But that's only half the story. When the markets eventually rise, you probably won't hear a peep from these companies because they'll be recording massive profits. Yet investors won't be any safer -- and that's the scary part.

Here's how it all works. Because rates are so low, and because insurers like Sun Life Financial and Industrial Alliance invest most of the money they collect from customer premiums in bonds, their return is practically nil these days. Yet the accounting rules dictate that this minuscule return must be assumed for years and years.

At these rates, insurers can't expect to cover their claims, so they must all set aside money to backstop their expected shortfalls -- hence their quarterly losses.

You could argue that is a good thing. What we really need is an accurate picture of where the company stands, because rates may never go up. But while that's theoretically true, historical trends prove they are bound to climb higher at some point.

Yet the big problem is that even when they do, the current valuation model won't be any more accurate.

Say interest rates climb quickly once the economy gets into full swing. The insurers will be able to assume that they last into perpetuity, enabling the companies to record handsome profits as they move money out of their reserves. That will paint a picture of confidence, and also lower the capital cushions, even though the economy could unexpectedly turn sour once again. In other words, the model is over-reactive.

However it is fixed is up to the regulators. But for the time being, investors must remember their risk won't be any lower once they start seeing a string of profits.

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