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Insurers can handle Japan-light. Can investors?

Canada's life insurers could survive a period where North America's financial markets look like Japan's lost decades, but you sure wouldn't want to own their stocks if that comes to pass.

The insurers, with their balance sheets bolstered by new equity, could muddle through a further period of low rates and falling equities and policy holders will still get paid, according to a new report from National Bank Financial analyst Peter Routledge. However, that scenario would mean further corrections in their stock prices.

The analyst took a look at how Canada's life insurers would fare in a "Japan-light" scenario that envisioned further drops in stocks over the next two years and more declines in bond yields.

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Investors have been asking what if North America starts to look more like Japan, where years of deflation, stocks stuck at low valuations and miniscule interest rates crippled the insurance industry. Seven insurers in that country went bankrupt as they had made promises to policy holders in good years that they couldn't fund in the new low-return environment.

For North America, Mr. Routledge believes a "Japan-light" scenario is more likely than "Japan-like." Central banks are actively fighting against deflation, and Canada's insurers are in a better place than Japanese insurers were to endure low rates and weak equities. One reason Canada's insurers are better situated is because of the demands that regulators put on them to raise capital, in part due to accounting rules that force tough decisions earlier.

He looked at the outcome for Manulife Financial, Sun Life, and Industrial-Alliance if long-term interest rates in Canada decline slightly over the next few years, and more in the U.S. He also assumed a 30-per-cent drop in equity prices over the next two years.

"Were the Japan-light scenario to arrive, we believe Canadian life insurers would muddle through with poor profitability and intermittent capital raises," Mr. Routledge found.

Of the three insurers he looked at -- Manulife Financial, Sun Life and Industrial-Alliance -- the most vulnerable in a Japan-light scenario is Sun Life and the one with the least downside is Manulife .

Manulife's current stock price is closest to its intrinsic value in a Japan-light scenario, which he estimates at $10.90. Sun Life has the most room to fall to its intrinsic value in that scenario, which he puts at $18.20. Industrial-Alliance is not far behind Sun Life, with considerable distance between its current share price and an intrinsic value of $23.96 in a Japan-light environment.

In Mr. Routledge's analysis, Sun Life wouldn't require a capital raise to support its Canadian holding company, but might have to raise $500-million for its U.S. operations, with some of that in the form of equity. The company would also have to cut its quarterly dividend to 24 cents a share from 36 cents in 2013.

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Industrial Alliance would need to raise $550-million, some by selling stock, the analyst reckons, but could maintain its dividend.

Manulife, because of its exposure to stock prices, would require $2.5-billion in new capital under Mr. Routledge's assumptions. About $1.5-billion would come from equity. Shareholders would also "have to endure a short period of very low dividends" with the quarterly payout cut to a nickel a share by the end of 2013.

Canada's mark-to-market rules for insurers mean that the companies are in some ways set up to endure a Japan-light scenario, Mr. Routledge says. In response to the mark-to-market rules, which force the insurers to run their balance sheets as if today's market environment will persist, the companies have raised equity, worked to reprice products and hedged. The rules also probably prevented the companies from selling even more aggressively priced products, he argues.

So the insurers can survive.

Can they thrive again? That will depend on people like Federal Reserve Chairman Ben Bernanke and Bank of Canada Governor Mark Carney as much as the people who run the insurance companies.

"Investing in life insurers, regardless of geography, is a bet that a Japan-like scenario (or "Japan-light") will not come to pass; that ultimately, central banks will be successful in fending off deflation and that long-term interest rates will bounce off their historic lows," Mr. Routledge wrote.

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"If investors believe a Japan-light outcome is likely to occur, then they would be well-advised to reduce their exposure to Canadian life insurers," he said.

And if he's wrong, and the resemblence to Japan is more than passing, and North America endures a lost decade on the markets? What if it's more Japan-llike than Japan-light?

That would be a "near-disaster for common shareholders," the analyst wrote.

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