Interest Rates Hold Steady: Is This Bad News for Sun Life Financial Inc.?

The Bank of Canada is holding interest rates at a low 0.75%. What does this mean for Sun Life Financial Inc.? (TSX:SLF)(NYSE:SLF)

| More on:
The Motley Fool

The financial sector received some bad, albeit not entirely unexpected, news this week—the Bank of Canada is holding overnight interest rates at a historically low 0.75%.

The Bank of Canada estimates that the Canadian economy saw zero growth during the first quarter due to weak oil prices, and although GDP growth is expected to resume later in the year as non-energy exports increase, bolstered by a weak Canadian dollar, many are now predicting Canada will not see a 2015 interest rate hike—even if the U.S. moves to increase them this year as anticipated.

Insurance companies like Sun Life Financial Inc. (TSX:SLF)(NYSE:SLF) are extremely sensitive to interest rates due to their large exposure to fixed-income investments. Assets, liabilities, and earnings can be all adversely affected by a period of interest rate weakness.

Is Sun Life prepared for a continued period of interest rate weakness? To find out, let’s look at how interest rates affect insurance companies, and then at how Sun Life is exposed to these effects.

How insurance companies are affected by interest rates

Insurance companies largely have three sources of revenue– premiums, investment income, and fees. Insurance companies collect premiums in exchange for adopting various degrees of risk, and since claims on these premiums occur on an uncertain timetable, the companies will often invest the money in the interim in something known as the general fund.

This fund, in turn, generates income from interest and dividends, and this income is used in conjunction with premiums to generate an insurance company’s earnings. The two often work together, and in times of high interest rates, insurance companies often decrease premiums, sometimes even pricing policies at an underwriting loss with the expectation that strong investment income will more than offset the loss.

The opposite is true for periods of low interest rates, but since companies are often limited to the degree in which they can raise premiums, low interest rates can have a serious impact on earnings.

In addition, insurance companies also have exposure to variable annuity and segregated funds products, which provide various income and benefits guarantees to policyholders over the course of the policies life, which can often be 20-30 years.

These policies are risky, since interest rates can fluctuate wildly over these time frames. And because insurance companies often invest the premiums for these policies in interest-bearing assets, low interest rates can make it difficult for insurance companies to pay guarantees, which weighs on capital and reserves.

Sun Life has made moves to protect against these risks

Fortunately, Sun Life has some of the best risk management practices in the Canadian insurance business. First, the company has been in the midst of a steady move away from the “spread-based” businesses (where earnings are dependent on interest rates) towards more stable, fee-based businesses by expanding its asset management segment.

In 2014 Sun Life earned $4.4 billion in fee income, up from $3.7 billion in 2013, and this increase is largely from Sun Life’s MFS investment management firm, which represents the company’s global asset management business, and is responsible for managing assets for investors through mutual funds. Fees from this area now represent 19% of earnings, providing solid diversification in revenue.

Total assets under management for Sun Life’s asset management business were $511 billion in 2014, up 15% from 2013, and these assets collectively represent 69% of Sun Life’s total assets. This is compared with only 23% for Manulife Financial’s asset management segment, which demonstrates that Sun Life’s risk profile is lower because most of its assets are devoted to the less volatile, and less interest rate-sensitive asset management business.

Sun Life also made the recent move to sell its $1.35 billion U.S. annuity business, which significantly reduces Sun Life’s interest rate risk and frees the company from the type of risky guarantees to policyholders that can severely deplete capital, reserves, and earnings in weak capital market conditions.

The result? Sun Life now estimates a 0.5% decrease in interest rates (which would be extremely unlikely) would decrease net income by only 5%.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Mancini has no position in any stocks mentioned.

More on Investing

investment research
Dividend Stocks

Best Stock to Buy Right Now: TD Bank vs Manulife Financial?

TD and Manulife can both be interesting stock picks for today, depending on your investment style.

Read more »

A worker gives a business presentation.
Dividend Stocks

2 Dividend Stocks to Double Up on Right Now

These stocks are out of favour but could deliver nice returns over the coming years.

Read more »

Man holds Canadian dollars in differing amounts
Dividend Stocks

This 5.5 Percent Dividend Stock Pays Cash Every Month

This defensive retail REIT could be your ticket to high monthly income.

Read more »

Confused person shrugging
Dividend Stocks

Passive Income: How Much Do You Need to Invest to Make $600 Per Month?

Do you want passive income coming in every single month? Here's how to make it and a top dividend ETF…

Read more »

Canadian Dollars bills
Dividend Stocks

3 Monthly-Paying Dividend Stocks to Boost Your Passive Income

Given their healthy cash flows and high yields, these three monthly-paying dividend stocks could boost your passive income.

Read more »

ways to boost income
Investing

Are Telus and BCE Stocks a Smart Buy for Canadian Investors?

Telus (TSX:T) and BCE (TSX:BCE) have massive dividend yields, but their shares have been quite sluggish!

Read more »

investment research
Tech Stocks

Is OpenText Stock a Buy, Sell, or Hold for 2025?

Is OpenText stock poised for a 2025 comeback? AI ambitions, a 3.8% yield, and cash flow power make it a…

Read more »

Make a choice, path to success, sign
Dividend Stocks

The TFSA Blueprint to Generate $3,695.48 in Yearly Passive Income

The blueprint to generate yearly passive income in a TFSA is to maximize the contribution limits.

Read more »