EUR 850.00 For Business Accounts Only

Morningstar | Great-West Continues to Make Great Capital Decisions; 4Q Results Put Glare on Market Exposure

No-moat Great-West’s fourth-quarter results were about in line with our expectations. Though earnings volatility resulting from market challenges had significant effects on surface numbers, this has little impact on the core business. The company continued to create value by posting an adjusted ROE of 14.3%, a year-over-year improvement of 1.1%, excluding effects of tax reform, and we highlight our positive view of Great-West’s decision to sell its U.S. life and annuity business. We’re maintaining our CAD 36 fair value estimate.

Looking at the top-line numbers, revenue came in below our expectations, with the biggest decline coming on the investment front. Overall declines were mostly explained by market challenges. However, on balance, the bottom line was relatively unaffected, as mark-to-market investments were netted out by declines in liabilities. For the year, Great-West had healthy premium growth of about 5% and benefits as a percentage of net premiums were lower. Net income was up CAD 700 million for the year, comparing well with our initial forecast. While insurers can use accounting tools to smooth profitability, we view existing assumptions as reasonable and continue to believe Great-West is an adept underwriter.

It's worth highlighting that capital allocation decisions over the year reinforced our view that Great-West deserves an exemplary stewardship rating. Great-West realized CAD 209 million of expense reductions, exceeding its internal target by CAD 9 million. While this is perhaps an example of an "under-promise and over-deliver" strategy, it does show that management can effectively set achievable goals. In addition, the sale via reinsurance of Great-West’s U.S. life and annuity business will give management capital flexibility. We view this sale as a net positive because of the no-moat nature of life insurance and competitiveness of the U.S. market.

Year-over-year, most segments showed net income gains, with the exceptions being Canada Group and Putnam, Great-West’s U.S. asset management arm. The earnings variability in the Canada Group segment can be explained by significant differences in market returns between 2017 and 2018, with markets posing challenges over the past year. Excluding market impacts, the segment had a few bright spots, with higher fee income and lower expenses compared with fourth quarter 2017. Putnam continues to be unprofitable and experienced a steep loss of CAD 48 million in the fourth quarter, concluding a full year of quarterly losses. The fourth quarter loss was caused by negative earnings on surplus comprising investment income and mark-to-market real estate. Despite the ongoing losses, there was evidence of a potential turnaround, with fund inflows of $2.4 billion, compared with 2017 net outflows of $2.4 billion. Even still, Putnam remains a drag on Great West’s profitability.

One item that stood out to us in fourth-quarter results was the elevated level of expenses, specifically the 15% year-over-year increase in expenses in Canada. On the call, management explained that recurring expense growth was only 7%, as the remaining 8% was due to one-off legal matters and the tail-end of the Guggenheim integration. Nonetheless, we will continue to monitor expenses in the coming quarters, as we view year-over-year expense growth of 8% as unsustainably high. Although higher expenses can potentially be beneficial in the long run, no convincing specific reasons were given for the higher spending, and quarterly expense growth in Canada of over 10% strikes us as being incredibly high.

We also take note of ongoing litigation between Mosten Investment and Manulife, one of Great-West’s primary competitors. Mosten filed a lawsuit against Manulife, claiming that a flaw in the structure of certain legacy policies requires the insurer to allow Mosten to park unlimited funds with a guaranteed high rate of return (over 4%). In our view, regulators are likely to take a dim view of Mosten's claims. Recently, Saskatchewan regulators issued a ruling that investments of this sort must be limited, and while this goes some way to improving the likelihood of a favorable outcome for Manulife, we don’t believe it fully resolves the issue at hand. Though this lawsuit doesn’t directly affect Great-West, if the lawsuit ultimately goes against Manulife--again, an outcome we view as improbable--there will be considerable structural risks to all Canadian life insurers, including Great-West.