DBRS' review of Canada's top insurance companies has concluded that Sun Life Financial and Industrial Alliance face the biggest profit challenges amid a tough operating environment and low interest rates.
The ratings service placed Sun Life's debt and preferred share ratings under review with negative implications and confirmed Industrial Alliance's rating with a negative trend.
The ratings of Canadian insurance companies Manulife Financial Corp. and Great-West Life were unchanged as stable with DBRS giving top marks to Great-West.
"The rating actions reflect our view of the changing dynamics for the Canadian life insurance industry, combined with the impacts of turbulent economic conditions," DBRS managing director Brenda Lum said Friday during a conference call
DBRS said that the change for Sun Life Financial Inc. (TSX:SLF) reflected the company's weak profitability and earnings volatility associated with outside market forces.
It concluded that Sun Life's exposures are "out of alignment" with its recent earnings and those of its peers.
DBRS said its action also reflected uncertainty associated with the company's strategic plan to restore profitability and earnings stability by pursuing more profitable products with fewer embedded risks and lower capital requirements.
It said Sun Life faces a string of challenges, including the continuing weak economic and interest rate environment aggravated by evolving regulatory measures.
Despite smaller relative exposure to market risks since the outset of the financial crisis, it has experienced earnings volatility, increased leverage and a slippage of its core coverage ratios.
"From an optical perspective, it just doesn't seem right not to indicate to the market that we are mindful that a company of Sun Life's quality against Great-West Life with superior metrics just kind of stubs the eye a little bit," added senior vice-president David Hughes.
Sun Life is targeting $2 billion of earnings in 2015 with a return on equity of between 12 and 14 per cent.
DBRS said Sun Life's rating review hinges on the "imminent return to reasonable profitability."
Sun Life is ranked first in Canada in several product categories, including group benefits and group retirement savings products. The Canadian operations account for nearly half of its net income.
The Asian operations continue to grow and represent a good source of future earnings growth.
DBRS said Sun Life's strategic decision to exit the U.S. individual life and variable annuity lines of business was prudent given its competitive disadvantage, noting the shift to products requiring lower capital and more predictable earnings such as mutual funds, and group benefits.
But the move cuts into its franchise value as it adopts a niche strategy in the world's largest insurance market, the agency added.
Industrial Alliance Insurance and Financial Services Inc's (TSX:IAG) rating reflects its reduced financial flexibility to shore up regulatory capital ratios through the issuance of additional preferred shares.
DBRS said Industrial Alliance's rating can be addressed to some degree with a return to a more sustainable interest rate environment that would remove pressure on earnings.
While it acknowledged "significant efforts" to mitigate low interest rates, DBRS said there are limits to what it can do in the longer term with an uncertain global economy.
"Should earnings start to be negatively affected over the next 12 months by low interest rates or by deterioration in top-line growth following recent strategic decisions, DBRS would likely convert its negative trend into a downgrade," it warned.
Meanwhile, the ratings for Great-West Lifeco Inc. (TSX:GWO) and Manulife Financial Corp. (TSX:MFC) were maintained.
DBRS said Manulife's rating trend, which is downgraded two years ago, is stable reflecting its strong position in Canada, Asia and in the U.S., where it offers the John Hancock brand. It is also well-diversified by customer, distribution channel, and product line.
The ratings for Great-West and its subsidiaries Canada Life and London Life reflect its strong financial performance and absence of earnings volatility.
"I regard Great-West as the benchmark for a well-run, a well-capitalized, highly rated Canadian life insurance company," Hughes added.
On the TSX, Sun Life's shares closed up 13 cents at $23.24, Industrial Alliance was up 47 cents to $28.12, Great-West gained 26 cents at $22.09, while Manulife rose 25 cents top $11.75 in Friday trading.