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Morningstar | Manulife Posts Strong 3Q, Discusses Legal Issues

Manulife's third-quarter results were strong, and recent results suggest management's actions to improve operations might be bearing some fruit. The annualized return on equity of 15% for the quarter was impressive and marks three straight quarters of returns exceeding our estimate of the firm's cost of equity. While our valuation anticipates a material improvement in returns over time, we believe that the competitive dynamics of the space, and Manulife's lack of a moat, likely put a cap on the level of returns that the company can ultimately sustain. We will maintain our CAD 23 and $17.50 fair value estimates for the shares.

With the exception of Canada, Manulife saw solid year-over-year increases in core earnings across all of its operating segments, with core earnings declining in Canada due in a large part to a favorable tax event in that market in the year-ago period. Net flows in the global wealth and asset management segment were CAD 400 million, an improvement over last quarter but well below the multi-billion-dollar rate that Manulife has seen previously. The shortfall was concentrated in Canada, which recorded net outflows of CAD 1.5 billion, due primarily to a couple of large fixed-income redemptions. Although we think the asset management industry is structurally much more attractive than the life insurance business, and we view Manulife's ongoing shift toward the asset management side of the business as a positive, third-quarter results were a little disappointing.

Recently, Manulife has been in the spotlight for legal reasons. Hedge fund Mosten Investment asserted in a lawsuit filed in late 2016 that it has found a flaw in the structure of certain Manulife policies (sold more than two decades ago) that it believes requires the life insurer to allow Mosten to park unlimited funds with the insurer with a rate of return that would now be highly disadvantageous to Manulife, given the historically low interest rate environment the past several years. Manulife rejects the premise of the case, and the issue is currently being fought in the courts. In our view, regulators are likely to take a dim view of Mosten's claims--that it should be allowed to park capital for as long as it wants (for a guaranteed interest rate of 4%) as opposed to being a temporary arrangement until funds could be reinvested in the main policies; allowing Mosten's view to prevail would weaken insurers and potentially place other policyholders at risk.

Recently, Saskatchewan regulators issued a ruling that investments of this sort must be limited, and while this goes some way to confirming a favorable regulatory stance for Manulife and other life insurers, we don’t believe it fully resolves the issue at hand. On the company's third-quarter conference call, management discussed this issue and described Mosten's argument as "commercially absurd." While we would agree that Mosten's stance is well out of line with the intent of these policies, we think that the outcome (as with any legal issue) is difficult to predict with certainty and could ultimately come down to a technicality. At this point, we have not factored the implications of a favorable ruling for Mosten into our valuation and reiterate our high uncertainty rating on Manulife's shares.