Monday, November 10, 2008

Manulife IncomePlus Default Risk

Recent stock market declines forced Manulife Financial to borrow $3 billion from the Canadian banks. This brings to mind one of the risks of buying any type of annuity including IncomePlus: default by the insurance company.

The main drawback of IncomePlus is the high fees and the likelihood of not keeping up with inflation. On the positive side is the protection from a prolonged decline in stock prices. If stocks perform poorly for a long time, customers of IncomePlus will get a steady income eroded by inflation, but at least it wouldn’t drop in absolute terms.

But if this doomsday scenario for stocks plays out, all IncomePlus customers will be leaning on the insurance guarantee all at once. What happens if Manulife runs out of money? Existing regulations require Manulife and other insurance companies to maintain certain financial reserves, and this was the reason for the $3 billion loan.

If stock prices really do decline for a long time, creditors will eventually stop lending Manulife more money. I don’t know how deep the decline would have to be to cause Manulife to default on its promises, but this is something that potential customers should know before handing over their life’s savings.

This doesn’t apply only to Manulife. Any person who considers buying any type of annuity should understand exactly what entities are backing it, and whether they are strong enough financially to make good on their promises.


  1. Annuities certainly are a trade off of risks. Compared to government bonds, annuities can eliminate longevity risk but expose you to default risk if the insurer goes under. I suppose default risk is mitigated somewhat through regulations requiring these insurance companies, among others things, to maintain a certain capital ratio.

    Can someone explain what a capital ratio is and how it pertains to insurers in Canada?

    I read this in the Financial Post which stated that insurers in Canada must maintain a 150% capital ratio, but I don't really understand it.

    "Pre-released third quarter results from Manulife and Sun Life Financial Inc. showed that both had capital ratios – at 183% and 202%, respectively – that exceed the regulatory minimum of 150%. However, since equity markets have declined further since the beginning of the fourth quarter, these capital ratios will face additional pressure “as capital required for equity-linked guarantees is set to rise again.”

  2. Blitzer68: There is a seemingly useful definition of Risk-Based Capital Ratio here. The denominator of the ratio is a sum of potential liabilities multiplied by a probability weighting. The numerator is the insurance company's capital. A ratio of 100% would mean that the insurance company was exactly enough capital to pay for the expected liabilities. Anything more than that is a buffer. However, IncomePlus liabilities are strongly correlated. What happens if the payout on IncomePlus turns out to be more than 10 times the amount calculated as the probability-weighted liability?

  3. These guys seem to give some protection against company failure.

    Manulife is a member of this organization,So I assume IncomePlus would be included in the coverage.
    Is this not correct?

  4. Hazy: Assuris is essentially government backing for life insurance policies. However, IncomePlus is not life insurance. In fact, it's more the opposite: you get paid more if you live longer.

  5. According to the Assuris website,coverage goes beyond life insurance.
    Several insurance products are listed,including annuities.
    Isn't IncomePlus basically just a variable annuity?

    Regardless,If a big dog like Manulife
    went down the tubes,things would get a little scary.

  6. Hazy: The Assuris site does mention annuities. I can't tell whether IncomePlus would be covered or not. However, if Manulife were to be even more successful at attracting customers for IncomePlus, the potential liability if stock prices were to drop drastically for a long time would be enormous. If Manulife couldn't make the payments, then either their customers are out of luck, or the government would have to back the annuities.

    Back in my post, I said "any person who considers buying any type of annuity should understand exactly what entities are backing it." The answer may very well be that the ultimate backer is the government. I wouldn't buy any type of annuity until I knew for certain, though.

  7. I agree that you need to understand the risks, including the risk of default risk.

    Here's that Financial Post article link (the correct one):

    The article says that it is estimated that a 10% drop in the stock market would lead to a 5% drop in Manulife's capital ratio. I'm not sure what Manulife's capital is invested in, but if it were 50% stock and 50% long bonds matched to liabilities then I can see how the estimate makes sense.

    So let's see what happens if the market goes up. Well, then Manulife owes more on variable annuities like IncomePlus, but this additional liability is covered by their assumed 50% capital investment in the stock market.

    What happens if there is a depression era crash in the stock market, say stocks down 90%. Well, then they don't have to pay anything extra to annuants who hold variable annuities, like IncomePlus. The capital ratio drops from over 150% to over 100%, which still allows Manulife to cover their liabilities.

    I think where it gets tricky, as usual, is in the details. Has Manulife properly correlated their capital to their liabilities? And even if the answer is yes today, can you be sure that Manulife will continue to do so long after you've bought an annuity from them? Can you rely on the government to keep insurers solvent in bad times through proper regulation, now and in the future? Can you rely on the government to bail out insurers if things don't work out as planned?

    In this current financial crisis, it looks like the insurers in Canada didn't sink themselves like AIG. But can you be sure they will be so prudent or lucky in the future?

    I think annuities, especially inflation adjusted annuities, can have a place in a portfolio for some investors, especially later in life when you're not as sharp as you used to be and you just want certainty. But we need to understand the risks.

  8. Blitzer68: Thanks for the pointer to the Financial Post article. I think the 10% stock market drop leading to a 5% drop in capital ratio was for Sun Life rather than Manulife. The article also said that a further 10% stock market drop would be more painful. Presumably, if Canadians continue to pour money into IncomePlus, the effect of stock market drops on Manulife would be magnified.

    I still don't know whether IncomePlus customers are covered by Assuris, but a minor point is that Assuris only covers 85% of annuities that are over about $2350 per month. I also don't know whether Assuris has limited funds or whether it is fully backed by the government.

    I should point out that I don't actually believe that a disaster scenario for stocks is likely. But, customers of IncomePlus are paying very high fees to protect against a disaster scenario. They should at least determine whether they will truly get paid if stocks drop significantly further and stay low for a long time.