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Manulife Financial Corporation (NYSE:MFC)

Q3 2009 Earnings Call Transcript

November 5, 2009 2:00 pm ET

Executives

Amir Gorgi – IR

Donald Guloien – President and CEO

Mike Bell – Senior EVP and CFO

John DesPrez – COO, Manulife Financial Corporation; Chairman & CEO, John Hancock Financial Services

Bev Margolian – EVP and Chief Risk Officer

Simon Curtis – EVP and Chief Actuary

Hugh McHaffie – EVP, John Hancock Wealth Management

Analysts

Tom MacKinnon – Scotia Capital

Jim Bantis – Credit Suisse

Steve Theriault – Bank of America-Merrill Lynch

John Reucassel – BMO Capital Markets

Michael Goldberg – Desjardins Securities

Eric Berg – Barclays Capital

Darko Mihelic – CIBC

Doug Young – TD Newcrest

Mario Mendonca – Genuity Capital Markets

Operator

Please be advised that this conference call is being recorded. Good afternoon and welcome to the Manulife Financial Q3 2009 financial results conference call for November 5, 2009. Your host for today will be Mr. Amir Gorgi. Mr. Gorgi, please go ahead.

Amir Gorgi

Thank you and good afternoon. I would like to welcome everyone to Manulife Financial's earnings conference call to discuss our third quarter 2009 financial and operating results. If anyone has not yet received our earnings announcement, statistical package, and slides for this conference call and webcast these are available in the Investor Relations section of our Web site at manulife.com.

As in prior quarters our executives will be making some introductory comments. We will then follow with a question-and-answer session. The speakers who follow may make forward-looking statements within the meaning of Securities legislation. Certain material factors or assumptions are applied in making forward-looking statements, and actual results may differ materially from those expressed or implied in these statements.

For additional information about material factors or assumptions apply and about the material factors that may cause actual results to differ please consult the slide presentation for this conference call and webcast available on our Web site as well as the Securities filings referred to in the slide entitled “Caution Regarding Forward-Looking Statements.”'

When we reach the question-and-answer portion of our conference call we would ask each participant to adhere to a limit of one or two questions. If you have additional questions, please re-queue as we will do our best to respond to all questions.

With that I would like to turn the call over to Donald Guloien, our President and Chief Executive Officer. Donald?

Donald Guloien

Thank you, Amir, and good afternoon, ladies and gentlemen. Thank you for joining us on the call. If you turn your attention to slide #4 in your deck, I will start with an overview of the third quarter results before turning it over to our Chief Financial Officer, Mike Bell, and our Chief Operating Officer, John DesPrez. I will also have a few wrap up comments at the end before we take questions.

Manulife's underlying earnings, business performance, and asset quality remained strong, but our results for the quarter were impacted by reserve strengthening for lower corporate bond rates and changes in actuarial assumptions.

Mike Bell will address the financial results in much more detail in just a moment.

We continue to grow and strengthen our company this quarter. As promised, we took actions to increase margins through higher pricing, adjustments to compensation, and more favorable reinsurance terms.

We recorded higher sales across almost all of our product lines with the exception of variable annuity products where we’re consciously trying to rebalance our product mix, reduce risk, and improve profitability.

We improved our equity risk profile through a variety of product and asset mix changes, took advantage of rising equity markets to opportunistically hedge a further 3.8 billion of our in-force variable annuity business.

We now have approximately 30% of our book either hedged or reinsured. With rising markets, more hedging, and currency changes our net amount at risk dropped by over 50% since the end of the first quarter of 2009.

John and Michael speak to these actions and our performance across our operations.

Despite challenging markets, Manulife's credit experience continues to be excellent and our asset quality and our diversified portfolio remain a competitive strength.

We announced two acquisitions that expand our Canadian business; AIC retail mutual funds and Pottruff & Smith Travel Insurance. These will grow our existing market positions in Canada and help to balance our overall business mix.

We continued to see an unprecedented number of opportunities for acquisitions across a variety of markets, and I expect that these opportunities will continue. As I have said before, the flow, one way or another, from the financial crisis, I am confident there will be a steady supply of acquisition opportunities over the coming years in addition to the coming months.

Manulife is well positioned with the ability to grow both organically and through strategic acquisitions. We have also remained highly focused on building fortress levels of capital over time to cushion Manulife against the most potential challenging scenarios and help fund growth, including future strategic opportunities.

Our MCCSR was strong this quarter at 229%. We expect to retain additional earnings of approximately 1 billion per year as a result of our dividend reduction and dividend reinvestment program.

Looking ahead, we plan to continue to build our scale and strengths, which includes superior asset quality, well-recognized brands, leading products and distribution, excellence in investment management, and strong positioning in key growth markets.

With that I would ask Mike to take us through the financial results. Mike?

Mike Bell

Thanks, Donald. Hello, everybody. Today we reported a third quarter shareholder loss of CAD172 million and a fully diluted loss of CAD0.12 a share. This quarter's results benefited from the increase in North American equity markets. However, this impact was more than offset by the impact of lower corporate bond rates and reserve strengthening to reflect our annual review of actuarial assumptions.

On slide #7 we provide a summary breakdown of the notable items that impacted this quarter's earnings. As noted on the slide, the strong North American equity markets in the quarter resulted in gains of approximately CAD1.2 billion after-tax. The negative impact of interest rate changes in the third quarter also amounted to approximately CAD1.2 billion, essentially offsetting the equity impact.

In the third quarter, we completed our annual review of all of our actuarial assumptions. And this resulted in a charge to earnings of CAD783 million after-tax. CAD469 million of the impact was due to changes in assumptions on policyholder behavior for our variable annuity products and this was consistent with our previously communicated expectations of less than CAD500 million after-tax.

The remainder of the charge is due to assumption changes primarily related to other policyholder behavior and morbidity. And this was partially offset by favorable assumption changes related to mortality, expenses, and investment-related items.

I will provide some additional detail in a few minutes. In addition, our investment portfolio continued to perform very well in the quarter relative to overall market conditions. Provisions for credit impairments and reserve strengthening for downgrades were CAD36 million in the quarter.

Our equity-related impairments were CAD75 million and were comprised of CAD32 million of other than temporary impairments on equity positions in the corporate and other segment and CAD43 million of OTTI on private equity investments.

The unfavorable impact of the strengthening Canadian dollar from June 30 levels was approximately CAD27 million in the third quarter. Other items resulted in a charge of CAD33 million for the quarter and were primarily comprised of charges for the reduced value of real estate appraisals, which were partially offset by the favorable impact of tax items, the gains related to the recapture of reinsurance treaties, and a small amount of policyholder experience gains.

So collectively the notable items on this slide totaled CAD975 million of unfavorable earnings impact. And excluding these items our adjusted earnings from operations for the third quarter were CAD803 million after-tax.

Now I will go to slide #8 which details the impact of equity markets on our results in the third quarter. The S&P TSX and the S&P 500 increased by 10% to 15%, respectively for the quarter.

Now it's important to note that our earnings benefit of the strong U.S. equity market performance was dampened somewhat by the strengthening Canadian dollar.

Of the CAD1.2 billion of net gains related to equity markets, more than CAD1 billion related to the after-tax impact of the release of reserves for segregated fund guarantees. And a portion of these earnings were subject to lower average tax rates consistent with our recent past. You can see the impact of this in our overall effective tax rate for our consolidated results in the quarter.

Moving now to slide #9. As noted on slide #9, the decline in long maturity corporate bond rates and spreads resulted in a CAD1.2 billion non-cash charge to earnings. Corporate spreads narrowed by as much as 84 basis points during the quarter. Decreases in interest rates impact the actuarial valuation of our in-force block by reducing the future returns assumed on the investment of net future cash flows.

I would also point out that our interest rate sensitivity has increased since year-end and the increase is due in part to lower interest rates as well as lower long-term lapse assumptions for several of our products.

As shown on the slide, a parallel decrease in interest rates of 100 basis points would have an estimated one-time charge of approximately CAD2 billion at September 30. And this is an increase in sensitivity relative to year-end 2008.

On slide #10 we illustrate the historical movements in various interest rates. And as noted in the chart, during the quarter, long-maturity corporate bond rates continue to decline. In addition, spreads continued to narrow and have moved closer towards longer term averages.

On slide #11 we’ve provided a summary of changes in actuarial assumptions from our annual review completed in the third quarter. The net change in mortality and morbidity assumptions resulted in a CAD260 million after-tax charge to shareholder income. This charge was primarily due to the impact from higher projected net long-term care claim costs in excess of projected prices.

Favorable mortality changes in Japan and the Reinsurance division partially offset the long-term care change. Lapses in other policyholder behavior assumption changes resulted in an after-tax charge of CAD829 million affecting shareholder net income.

Over half of this increase, specifically CAD469 million after-tax, was attributed to updated lapse assumptions for variable annuities in the U.S. and Japan. And this charge was within our previously communicated expectations of less than CAD500 million after-tax.

The balance is due to strengthening of policy liabilities for lower lapse rates for a number of long duration protection businesses, most notably, life insurance in Japan, U.S., and Canada, and the U.S. group long-term care business.

Now partially offsetting these impacts were net favorable assumption changes to expenses, investment returns, and other refinements. An additional detail around the annual review is provided in our in MD&A.

So in aggregate, changes in actuarial assumptions resulted in reserve strengthening of over CAD1 billion and a negative after-tax impact to earnings of CAD783 million.

Turning to slide #12, after-tax charges for credit impairments and credit downgrades were limited to CAD36 million in the quarter. This was comprised of CAD30 million for net credit impairments and CAD6 million for credit downgrades.

And we continue to be satisfied with the current credit performance of our investment portfolio in these challenging market conditions, and we view our asset quality as a competitive advantage.

We are also pleased that in the third quarter our below investment grade bond holdings declined modestly as maturities and prepayments exceeded net downgrades.

Now on slide #13 we’ve highlighted equity-related impairments for the quarter. As I mentioned, in aggregate, these impairments totaled a CAD75 million charge to earnings.

Turning now to our source of earnings, which is on slide #14, you can see that expected profit on in-force and earnings on surplus funds together contributed over CAD1 billion to earnings. This result was more than offset by the impact from assumption changes and experience losses that I previously discussed.

Expected profit on in-force increased over the prior year due to favorable currency movements and growth in our in-force business. The impact of new business was higher than the prior year primarily as a result of a lower interest rate environment which particularly impacted our U.S. life insurance business. The net experienced loss reflects the pretax impacts of declining interest rates, which I discussed earlier, which more than offset the equity market-related gains.

Management actions and changes in assumptions primarily resulted from our annual basis changes previously detailed and are shown here on a pretax basis. Earnings on surplus funds resulted in income of CAD156 million and include higher realized gains in the quarter.

The income tax benefit reflected investment related gains, primarily the equity related ones being reported in more favorable tax jurisdictions than the investment-related losses.

Now on slide #15 provided summary metrics for our reserves and capital in relation to segregated fund guarantees. With a significant rally in North American equity markets in the third quarter reported amount at risk has decreased from CAD21 billion at the second quarter to less than CAD15 billion as of September 30.

As a result, the expected net gain from guarantees is measured by projected revenue from guarantee fees less projected claims increased from a pretax profit of CAD980 million in the second quarter to a projected pretax profit of approximately CAD1.6 billion measured at September 30.

At quarter end CAD19.5 billion of guaranteed value was being hedged, up from CAD14.5 billion in the prior quarter. We now have approximately 30% of our gross guaranteed value either reinsured or hedged, and this is an increase from 20% at year-end 2008.

Now slide #16 provides an updated estimate of earnings and capital sensitivities going forward. From a consolidated earnings perspective we estimate that a one-time equity market correction of 10% followed by normal market growth at assumed levels would now reduce reported earnings by approximately CAD1.3 billion after-tax. We observed decreasing sensitivity is largely due to the lower in-the-moneyness of these exposures.

In terms of regulatory capital, MLI's reported MCCSR was 229% at quarter-end. We estimate that a 10% equity market correction could result in a decline of approximately 15 points in this ratio as of September 30.

As summarized on slide #17 our investment portfolio continues to be high-quality and well-diversified. Our portfolio is performing relatively well in the current downturn with 94% of our bonds being investment grade and highly diversified by geography and sector.

We have also provided on slide #18 an update on gross unrealized losses on our fixed income securities. You can see the progression over the last three quarters illustrates continued, significant improvement.

At September 30th we had a net unrealized gain on our CAD107 billion fixed income portfolio. And due to general spread narrowing gross unrealized losses declined over 50% sequentially to CAD2.5 billion and represents a relatively modest 2.4% of our total fixed income portfolio.

In addition, unrealized losses for our fixed income portfolio trading at less than 80% of costs for over six months declined by 33% since the second quarter to CAD1.4 billion. This favorable change is primarily due to market improvement and also the appreciation in the Canadian dollar. Now we’ve the ability to hold these securities until maturity and have provided for expected levels of defaults in our actuarial reserves.

Based upon our performance to-date and our lower level of gross unrealized losses, we believe that our asset quality represents a significant competitive advantage

Slide #19 provides a summary of our expectations of adjusted earnings from operations for the remainder of 2009 and 2010. Our expectations are based upon our book of business and currency levels as of June 30, 2009 and include approximately 2% per quarter equity market appreciation and no unusual interest rate movements. On this basis last quarter we estimated normalized earnings of CAD750 million to CAD850 million after-tax per quarter for the remainder of 2009 and 2010.

Now to be clear we’re not providing earnings guidance, particularly since no one can predict near-term market conditions with confidence, and adjusted earnings are not the same as GAAP net income. Our current estimates would imply an adjusted ROE of approximately 12% with our longer-term objective being a higher ROE over time.

As noted on slide 20, there are a number of items excluded from our definition of adjusted income from operations, which may positively or negatively impact net income. These may include such items as underlying business growth, including potentially increasing fee income from asset growth.

Potential policy related experience gains and losses, such as mortality, morbidity, and lapse experience; investment and market-related gains and losses. And these can arise from investment management performance, moves in equity markets, and changes in interest rates. And in the current challenging economic environment credit losses and impairments could be higher than our long-term assumptions.

Other items include higher or lower prices and margins in the future on insurance and wealth management products; new business mix changes; lower or higher operating expenses; the potential for accretive acquisitions; and favorable or unfavorable currency movements.

So, for example, the weakening of the U.S. dollar reduced third quarter earnings by CAD27 million relative to our June 30 assumptions for normalized earnings. If the current exchange rate continues into the future, we would expect this impact to persist.

Now turning to discussion to capital on slide #21. As we’ve previously described, our goal is to have the financial flexibility to weather many, but not all, potential adverse scenarios without being forced to raise common equity under stress conditions.

We also want to have more flexibility to respond to both risks and opportunities from a continued position of strength. We continue to believe that companies with strong financial strength ratings and capital ratios will benefit from a flight to quality.

Now on slide #22 you will note that MLI's third quarter consolidated MCCSR was 229%. We view this as strong and it’s up significantly over the prior year. The sequential decrease in the MCCSR primarily reflects the impact of lower corporate bond rates and our annual review of actuarial assumptions, which more than offset the impact from improved North American equity markets.

Our current MCCSR position provides us with a significant buffer relative to the regulatory target of 150%. In addition, it's important to note that we currently have CAD1 billion of contingent capital at the holding company level, which can be downstreamed if required.

Slide #23 provides an update on our process of reorganizing our U.S. subsidiary structure. As we’ve previously communicated this involves the merger of our John Hancock Life Insurance and our John Hancock Variable Life Insurance subsidiaries, which currently reside under our MFC holding company into our John Hancock U.S.A subsidiary, which resides under our MLI subsidiary

Pending regulatory approvals, we anticipate that the reorganization will be completed by December 31st of this year. Now there are a variety of benefits associated with this reorganization as outlined on slide #24. Most notably, once the reorganization is completed we will have a more efficient capital structure, a more diversified risk portfolio, more stable capital ratios, and reduced administrative costs.

We expect that the pro forma MLI MCCSR ratio will decline upon the merger by approximately 15 points. But importantly we will maintain a comparable equity market correction buffer relative to the regulatory target of 150%. Now in the future our overall MCCSR sensitivity to equity markets will be lower after the legal entity merger.

In addition, on a post-merger basis we estimate that our pro forma RBC ratio would be in excess of 300%. So, overall, our underlying earnings for the quarter were strong. However, as anticipated net income was impacted by lower corporate bond rates and spreads as well as the charges associated with our annual end-to-end review of actuarial assumptions. These items more than offset the impact strong equity market performance in North America. Moving forward we’re well-positioned to profitably grow our underlying businesses.

And with that I would like to pass over to John who will provide an update. John?

John DesPrez

Thank you, Mike, and good afternoon. Main topics that I will cover today include our strong operating results, our continued progress on reducing equity risk exposure and recently announced acquisitions.

Overall, sales of non-variable annuity products have been strong despite the weak economy. We believe this is evidence of the strength of our brand and a growing flight to quality in the market.

On slide #26 insurance sales have experienced sequential increases over the prior two quarters. across most business segments and ended the quarter 2% higher than prior year levels on a constant currency basis with solid advances in Asia and Canada being offset by a decline in the United States.

Overall, U.S. sales improved by 18% over the prior quarter, but were down 6% over the prior year with both life and long-term care experiencing significant improvements over the prior two quarters, but falling short of prior-year levels by 4% and 13% respectively.

Despite general economic trends, life sales topped CAD200 million in the quarter and long-term care sales were robust compared to strong prior year comparables. Since the end of the first quarter, life has introduced stronger pricing on its term and universal life offerings, while long-term care has increased pricing on its group segment.

In Canada, overall sales increased by 6% from prior year levels. Group benefit sales experienced robust growth of 12% as a result of impressive large case sales, which were partially offset by a 2% decline in individual insurance sales.

Asia experienced record sales during the quarter with overall sales exceeding the prior year by 16% on a constant currency basis. Japan sales were up 22% or 7% on a local currency basis. Hong Kong sales increased by 29% with strong sales momentum bolstered by new product offerings and distribution initiatives.

In addition, substantial advances in market share in 2009 were reported by Japan and Indonesia reflecting consumer flight to quality. China sales also continued to grow, up 18% in the quarter reflecting contributions from new offices opened in the prior year as well as recent marketing efforts.

During the quarter Manulife continued to expand operations in China, receiving an additional license in the province of Tianjin, bringing the total number of licenses up to 38, among the most of any foreign life insurance company in China.

Turning to slide #27, wealth sales excluding variable annuity products increased by 4% over prior year levels on a constant currency basis driven by fixed return product sales in the United States and Canada, which continued to outpace prior year levels resulting from consumers seeking stable investment returns.

In the United States, wealth sales, excluding variable annuity products, improved by 21% over the prior quarter and were in line with prior year levels. All non-variable annuity segments experienced double-digit growth over the previous quarter with fixed return product sales up 16%, pension sales up 30%, and mutual fund sales up 18% over the second quarter of 2009. In comparison to the prior year, fixed return product sales were up by 37%, retirement plan sales were flat, and mutual fund and other sales were down 12%.

In Canada, wealth sales, excluding variable annuity products increased by 5% over prior year levels, bolstered by impressive growth in fixed products and group retirement, which more than offset declines in Manulife bank loan volumes.

Fixed product sales increased by 51% over the prior year while group retirement sales more than quadrupled prior year levels driven by record sales of group annuities. Year-to-date group retirement sales exceeded CAD1 billion, reflecting strong results in the defined contribution market.

In Asia, wealth sales excluding variable annuity products increased by 59% versus the prior year, driven by strong growth in Indonesia. Indonesia fund sales more than tripled benefiting from the equity market recovery. Variable annuity sales were less than half of prior year as a result of ongoing risk management initiatives across all geographies.

Turning to slide #28, premiums and deposits, excluding variable annuity products we’re CAD14.3 billion for the quarter, a decrease of 2% over the prior year on a constant currency basis. Growth of in-force insurance business and higher sales of fixed return wealth products were offset by lower new mandates in the institutional advisory business.

Variable annuity and segregated fund deposits of CAD1.9 billion declined by CAD2.1 billion as a result of our ongoing risk management initiatives across all geographies.

On slide #29 new business embedded value, excluding variable annuities was CAD588 million during the quarter, up 4% over the prior year. Insurance new business embedded value was 17% higher than prior year levels driven by growth across all geographies, while wealth new business embedded value was down 48%, reflecting lower variable annuity sales, hedging costs, and other product mix changes.

As shown on slide #30, total funds under management as at September 30, 2009, were CAD437 billion, an increase of 13% over the prior year as a result of net positive policyholder cash flows of CAD20 billion and favorable currency movements.

Over the last four quarters investment returns have contributed approximately CAD19 billion to the increase. The growth in funds under management also includes CAD3.8 billion from the acquisition of AIC Limited’s retail investment fund business.

Moving to our efforts on further reducing our equity risk exposure, slide #31 summarizes our strong progress in this regard. During the third quarter we opportunistically hedged CAD3.8 billion of Canadian in-force business, in addition to the new business written in the quarter.

Substantially, all new business in the United States and Canada continues to be hedged on an ongoing basis. In total CAD19.5 billion of guaranteed value is currently being hedged with a corresponding CAD1.6 billion of net amount at risk.

We also continued to implement changes to our product offerings by altering product features, increasing margins on new products to ensure profitable business after hedging costs.

In Canada, we introduced a new segregated fund platform and closed legacy products providing a more streamlined suite of products with reduced product features, lower equity content, more index funds to improve hedging effectiveness and higher fees.

As noted on slide #32, our risk exposure on equity guarantees has decreased significantly due to increased hedging and recovery in global equity markets. At quarter-end our net amount at risk was CAD13.3 billion, down significantly from year-end 2008. In all we’re now hedging or reinsuring 30% of the gross guaranteed value as at September 30, 2009, up from 20% at December 31, 2008.

Turning to slide #33 we’ve continued to capitalize our strategic acquisition opportunities. During the quarter we announced and completed the acquisition of AIC's Canadian retail investment fund business. This transaction added approximately CAD3.8 billion of assets under management and increased our scale by approximately 40%, bolstering our presence in the retail investment fund markets.

Subsequent to the quarter-end we also announced the acquisition of Pottruff & Smith Travel Insurance Brokers Inc., one of the largest travel insurance brokers and third-party administrators in Canada. This acquisition solidifies Manulife's position as one of Canada's largest providers of travel insurance with a stronger platform for long-term growth. We continue to be presented with a wide range of acquisition opportunities, which are currently being investigated.

With that, I will turn it back to Donald who has some closing remarks.

Donald Guloien

Thank you, John. If you turn your attention to slide $34, we got a wrap up; like to wrap up a few comments before we open up to your questions. Our actions this quarter are consistent with the priorities you have heard us outlined before. We are growing our businesses with a priority on the highest return products and geographies and diversification of risk.

We are taking advantage of a flight to quality. We are reducing our equity sensitivity, the derisking of products, through structure, and through hedging. We are taking steps to increase margins, charging more for taking risk and offering quality that consumers value.

We are growing sales by extending our product offerings and leveraging our skills, particularly in all elements of savings and investment management. We are seeing unprecedented opportunities for acquisition, geographic expansion, and we remain highly disciplined as we move on some of these.

We are leveraging our skills and building upon our scale and strengths, which include strong asset quality, excellence in investment management, well-recognized brands, leading products, and excellent positioning in key growth markets

And finally, we remain focused on building toward fortress capital levels that will help to cushion us against potential challenging scenarios and fund growth including future strategic opportunities. Overall, we remain on track and I remain very optimistic about Manulife's future.

Operator, that slide was going to conclude our remarks. However, we just became aware that a newswire has been issued by Standard & Poor's. Rather than lose our audience to their Blackberries and computer terminals I would like to ask Mike Bell to address the Standard & Poor's announcement.

Mike Bell

Thanks, Donald. Again, we were just informed that S&P did issue an announcement on Manulife. Admittedly, I do not actually have the actual release right in front of me, but I want to make some comments based on a draft that I had seen earlier this morning on the assumption that it did not change materially. There are really three points in the S&P release that are worth highlighting.

First and most importantly, we’re really pleased that the operating company ratings for our company are unchanged at the AA+ level. Now, we’re really proud of the AA+ rating. It's a competitive advantage for us against all of our main benchmark competitors. It's really important to us because it supports our brand out in the marketplace. It helps promote our brand of having financial strength out in the marketplace, which is very helpful. So that to us is the most important piece.

Now, second, it’s also noted in the release that S&P has changed the operating company outlook from stable to negative. And given that rating agencies have been reasonably pessimistic on the life insurance industry and particularly pessimistic as it relates to equity market exposure, given that we’ve got some of that and obviously are in the life insurance industry, I think that's the primary driver of the change to a negative outlook.

The third item that was referenced in the release is the holding company. Currently, we’ve AA- rating for our holding company, and my understanding is that has been changed to credit watch negative.

I would point out that S&P has a standard notching protocol of having three notched differences between the holding company and the operating companies. Manulife obviously has enjoyed and appreciated being a positive outlier and having only a two notch difference between the hold co and the operating companies; AA- versus AA+.

If, in fact, the holding company does ultimately get downgraded and we would be back to the standard notching. So we believe that would be a manageable outcome if it happens, although obviously I am disappointed in it. And I do believe that the comments around the legal entity merger are inconsistent with our own views. Our own view is that the legal entity merger in the U.S. actually strengthens our capital position.

So that in a nutshell is the S&P release. Again, overall, most importantly, we remain AA+ at the operating company level. And that's a competitive advantage for us and, in fact, very important. At this point I think we’re opening it up to Q&A.

Question-and-Answer Session

Operator

(Operator instructions) First question is from Tom MacKinnon of Scotia Capital. Please go ahead.

Tom MacKinnon – Scotia Capital

Yes, thanks very much; couple questions. First, with respect to the interest rate hits that we’ve seen, is the fact that some of these loan yields sort of picked up right now that interest rates sort of picked up a little bit since the end of the quarter. Could we actually say that maybe we’re at the end of the road in terms of interest rate hits going forward in terms of reserve development there?

And then I have a question with respect to the hedging. The CAD3.8 billion that was hedged in the quarter, what was the cost of that, if that can be disclosed and what was sort of the cost in terms of actually all the hedging that you have done so far this year? Thanks.

Mike Bell

Great. Hi, Tom, It's Mike. I will start with the first question. Your question on interest rates, obviously, it's useful to have interest rates rise. We're obviously pleased that the long bond rates have increased since September 30. Whether this is the end of the road of drops in interest rates and compression on spreads, I think is anybody's guess. But, certainly that movement since September 30th is useful and would certainly help us in the future. But, again, one month not necessarily a future make, but certainly a positive trend.

Tom MacKinnon – Scotia Capital

Now when you set the reserves do you use the rates that were in effect at the valuation date? Is that correct or what kind of leeway do you have?

Mike Bell

Tom, that is correct that we use the rates as of the valuation date. Now again there's based on the Canadian actuarial practices, we also over time use an ultimate reinvestment rate. But the major driver is the rates and spreads as of September 30th for the valuation.

Tom MacKinnon – Scotia Capital

Okay. And then with respect to hedging?

Donald Guloien

Bev Margolian to answer that, Tom.

Bev Margolian

Thanks. When we hedged the business we’re hedging it using a dynamic hedging strategy, so we don't know the locked in cost upfront. It's important to know that. So when we estimate based on what we assume to be realized volatility going forward that we will be able to have hedged this business to maintain a healthy profit margin after the cost of hedging and –.

Donald Guloien

So we look to make approximately 50 basis points from issue on the business, Tom. That's we look to, and I got a lot of advice when I assumed the helm to hedge the whole business out and put it behind us and we didn't do that. We wait for equity markets to go up on each cohort of business when we can lock in something like a 50 basis point profit from issue, we hedge it from there.

Tom MacKinnon – Scotia Capital

But there wasn't any kind of one-time charge that you have been able to determine as a result of putting in-force hedge on in the quarter?

Bev Margolian

No, there is no one-time charge. We basically execute or execute some futures and put on some lengthening interest rate swaps and neither of them incur charges upfront. It really just depends on the settlement costs based on the interest rate movements and the equity market movements going forward.

Tom MacKinnon – Scotia Capital

Okay, thanks a lot.

Donald Guloien

So, Tom, there would be some modestly lower earnings expected going forward, because again, the margins post-hedging would be somewhat lower than pre-hedging on an expected basis. Obviously, the reduction in the equity sensitivity though is very useful and hence why we took the action.

Tom MacKinnon – Scotia Capital

And the reduction in the sensitivity to both equity markets and capital, is that a function of hedging or is that a function of increased equity markets?

Donald Guloien

It's a function of increased equity markets, Tom. It's a function of hedging; it's also a function of currency frankly.

Mike Bell

But certainly, primarily –

Tom MacKinnon – Scotia Capital

How would you rank them?

Mike Bell

Essentially, in that order. Again, because of the convexity of the liability curve with equity markets having improved, that reduces our sensitivity.

Tom MacKinnon – Scotia Capital

Okay, thanks.

Operator

The next question is from Jim Bantis of Credit Suisse. Please go ahead.

Jim Bantis – Credit Suisse

Hi, good afternoon. Two questions. I'm looking at your slide #11. You've shown some disclosure with respect to the policyholder behavior coming in at roughly 130 million. Could you give us some color in the context of what type of change in lapse rates you've forecasted or made changes in assumptions, just so we can get a sense is this issue by and large behind us now?

Donald Guloien

Jim, I'm going to turn that over to Simon Curtis.

Simon Curtis

Jim, it’s Simon speaking. As Michael mentioned, about half of the increase was on our variable annuity businesses that we had talked about at the second quarter call. In those products what we were not changing was the long-term lapse rates, but more the speed with which lapse experience adjusts to how sort of perceived contracts are to be in the money. So I can't actually give you any sort of hard statistic on that, but basically the adjustments on the variable annuities was really assuming that lapse rates would go down more quickly, as contracts became more in the money, the guarantees were perceived to be more valuable.

The other half of the basis change increase was really on insurance businesses, and it was in four business groups, geographically split and basically different product lines. So four businesses had between CAD100 million to CAD200 million increase each. In Canada, there was an increase on some of our par lines where we took our lapse rates down below 2% long-term.

In the U.S. the lapse adjustment was primarily on long duration universal life contracts, where we reduced the ultimate lapse rate so that now they are actually basically between 0% and 1%. We had an adjustment in our group LCC business in the United States, which took the lapse rates there down to – actually I don't have that one right in front of me, but I believe it would be down in the 1% range there as well.

And then, finally, in Japan we had some adjustments on our universal life business, which were sort of mid duration lapses to reflect the experience there. No adjustments to the long-term lapse rates. So as we mentioned at previous calls where we’re seeing sort of changes in policyholder experience it's not confined to one geography or one product line. It's just a systemic change in (inaudible) behavior that we’re viewing over time. And each year when we update the basis changes is when we sort of see that coming through in a capitalized way.

Jim Bantis – Credit Suisse

Got it. Thank you, Simon, for that detailed response. It sounds like from some of the lapse rates you quoted that would be highly unusual to see the lapse rates falling much further? Are you requiring substantial adjustments to these reserves?

Simon Curtis

Yes, I think one comment I can make is we’re very proactive in trying to update for where lapses are and as a result we’ve taken our lapse rates to low levels. We can't sit here and say, we would never see adjustments again, but we’re pretty confident that we’re very on top of and proactive in capturing the lapse experience.

Donald Guloien

This is Don Guloien here. I just wanted to interject. These are uncomfortable changes to make, but it's the strength of the Canadian accounting process that forces people to confront these things in a very dynamic way. And we've obviously strengthened our reserve basis for these. Only time will tell whether they are necessary, but the approach requires us to confront them as we see them coming.

Jim Bantis – Credit Suisse

Don, along those lines when you talk about the conservative nature of the assumptions and then earlier were comments about the asset quality, do you view these two issues to be some of the challenges that potential acquisitions will have going forward? Like when you think of the potential targets that you are looking for, will these be the kind of catalysts that we’ve all been waiting for, for these companies to have to embrace at some point?

Donald Guloien

Well, as I said before, Jim, there is a lot of companies that are in fairly tough shape and that is shaking loose a lot of opportunities. And we intend to be there to receive them. That's the goal of the company, plain and simple. We have done very well on that type of activity in the past and I think quite frankly, the opportunities have never been better than they are today.

Jim Bantis – Credit Suisse

Just a last question for John DesPrez; 771 million of VA sales is still a sizable run rate even though coming off of substantial highs in the previous year. John, when we think of the ROE that's being expected from this new VA sales, what should we be thinking about is? Are you pricing it at a 15% rate?

John DesPrez

Let me let Hugh McHaffie, who is directly responsible for the VA business, respond to that.

Hugh McHaffie

In regards to pricing targets, Donald had already mentioned that our goal is to hit a 50 basis point spread of managed assets after hedging. And through the fourth quarter, we're, on a long-term basis, relatively hitting that and those numbers are hitting our pricing and targets in terms of ROE. We’re very comfortable with the 700 and some odd, CAD0.75 billion of sales in regards to profitability. The changes we’ve made for derisking the product of we’ve taken some fairly substantial changes to push down the bonus deferrals, change expenses, change asset mix. That's all come together and a very comfortable block of business.

Jim Bantis – Credit Suisse

Hugh, so I am just trying to kind of capture this from an ROE perspective. Maybe it sounds like it's difficult to do so, but you're quoting the 50 basis points. Maybe you can give me a sense of what the spread was pre-crisis?

Hugh McHaffie

In the first quarter, clearly, the cost of hedging being higher, it would have been much lower than that, and that facilitated the change in the product. In terms on an ROE basis, it's north of a 15% return on equity on those products.

Jim Bantis – Credit Suisse

Thanks very much. I will re-queue.

Operator

The next question is from Steve Theriault of Bank of America-Merrill Lynch. Please go ahead.

Steve Theriault – Bank of America-Merrill Lynch

Thank you. Two questions. Firstly, a new item or what I think is a new item in the notes that I noticed that references goodwill testing and mentions the repositioning of your VA business. So how much goodwill is backing the VA business and would you be prepared to comment on the likelihood, timing or magnitude of any potential impairment going forward?

And secondly, just a follow-up on Tom MacKinnon's question on hedging. If you're trying to lock in a targeted margin, does that mean that additional hedging becomes is unlikely if equity markets stay roughly where they were at the end of the third quarter? Thanks.

Mike Bell

Okay, I will start on the goodwill question. First of all, we view it as a very good financial disclosure to add that to the quarterly disclosure, so I would suggest that you not overweight the importance of the point. But to answer your question, we’ve CAD1.9 billion of goodwill today, backing our U.S. wealth management business. And we simply wanted to note that since we’re obviously repositioning the VA business, repositioning our VA sales for the future, we’re cognizant of the fact that, that could have some impact on goodwill.

We do a very thorough goodwill review each year. We would do that as scheduled in the fourth quarter and as we wrap up our 2010 business plan that would get factored in to the goodwill testing as well. So at this point I wouldn't try to predict where that's going to come out, but to me, it was good disclosure to at least highlight it as something on the radar screen here for the fourth quarter.

On the hedging piece, I will start and I will see Donald or Bev want to add. Again, at this point, we’re evaluating a wide range of potential hedging scenarios. I think it's fair to say that we would be more inclined to expand the hedging program as markets go up. But again, at this point, we’re still reviewing that and wouldn't try to add more specificity at this point.

Steve Theriault – Bank of America-Merrill Lynch

Okay, thank you.

Operator

The next question is from John Reucassel of BMO Capital Markets. Please go ahead.

John Reucassel – BMO Capital Markets

Thank you. Just a quick question, back to slide #11 and I am just a little confused. You have a positive contribution from basis change on investment returns, yet, we talk about how low rates are and everything else. Can you explain to me exactly what is that valuation basis changes that you are expecting higher investment returns on?

Donald Guloien

I will let Simon respond to that one.

Simon Curtis

Sure. Yes, that investment return category captures a number of things, John. As in all these categories there are offsetting items since we’re reviewing all of our assumptions and methods. The first thing that generated strengthening were the review we reviewed our stochastic parameters for our variable annuity reserving. And as you could expect there was some increase from our assumption review there, because we were reflecting some update to return and volatilities. There was a modest increase as well from updating the ultimate reinvestment rates under the Canadian standards, but they got offset.

And we have a net release when we started also updating our models for a sort of fundamental review we’ve been doing all year on our modeling of reinvestment strategies under Canadian GAAP to make sure they align with what we actually have in our investment policies and such. We're required to make sure that the investment strategies and valuation reflect what we actually plan to do in executing those strategies, and that actually led to a release from that I know which overall drove the valuation release. But, we did have some strengthening as you would expect and I think is what you were getting at related to long-term interest rates and stochastic parameters.

Mike Bell

John, it's Mike. The only piece I would add is that last item that Simon mentioned relates to our long-term care business and I would just add that on a net-net basis we did strengthen reserves for long-term care.

John Reucassel – BMO Capital Markets

Okay. I might have to come back on that, but, thank you. The other question I had is just trying to understand this interest rate risk. I understand on equity market risk you can go out and it maybe expensive or what not to hedge that risk, but you can't hedge interest rate risk, can you? I mean, this is fundamental to the business model so if rates go lower it's just a tough environment to grow earnings. Is that a fair statement or is there a way to offset that?

Mike Bell

Well, John, you are essentially right. What we hope to do is these are liabilities with a selection, diversified selection of corporate A bonds on average, right, with some other investments. And you can hedge treasury rates, but you can't hedge corporate rates going (inaudible) years. So the issue we’ve is a valuation issue. We make assumptions about how much we’re going to earn on a premium that comes in year 20. And yes, we could hedge forward on the underlying treasuries, but we can't hedge the spread that we expect to earn unless we’re going to do some wild and crazy credit derivatives and you can imagine our attitude towards that.

So in the meantime, we take a big valuation hit on the underlying assumption that rates will stay as low as they are for a very long period of time, both the underlying treasury yield and the corporate spread. If you believe that North America is going the direction of Japan that's probably not conservative enough. If you belief like most of us in the room do and I suspect the people on the call do, that interest rates will go up, both the treasury rates for a whole bunch of reasons and spreads, we will have quarters in the future, where the outcome will have a very positive sign associated with it.

John Reucassel – BMO Capital Markets

Okay, great. And then just last, just to be clear on the new merged MCCSR at MLI, the new consolidated, right now the equity market movements on 10% plus or minuses, plus or minus 15 points. So on the new merged MLI in Q4 '09 what would the sensitivity be there? Is it half that or is it a little less than that? Could you give us some sense?

Mike Bell

Sure, John. Not to sound overly precise. It's approximately 11.5 points. So it's 3.5 points less than the 15 based on the current pro formas. Now, again, the actual number we got to get through the year end to complete the legal entity merger itself. It may move around a little bit, but at this point the pro forma number is 3.5 points less.

John Reucassel – BMO Capital Markets

Thank you.

Operator

The next question is from Michael Goldberg of Desjardins Securities.

Please go ahead.

Michael Goldberg – Desjardins Securities

Thanks. Okay, I was going to ask about the interest sensitivity, but I think that, that's covered. So I am going to go to slide #29 and your new business embedded value where I think that you said that on excluding variable annuities it was CAD588 million this quarter, which implies that just on variable annuities alone CAD68 million seems to look something like about a 3.6% margin on VA sales. So what I would like to know is, is this a reasonable way to look at it? And as you restructure and reprice your variable annuity product, would you expect that, that margin is going to go up, down, or sideways?

Simon Curtis

It's Simon here, Michael. I think what you're doing is you're sort of taking that new business embedded value that we come up with and trying to take a ratio of that to sort of what we’ve reported as the premium. I think that it’s a useful metric. I can't actually vouch for your math because I haven't actually done the calculation myself, but I think it would be one way to look at the profitability. Obviously, that new business embedded value if you are writing the higher margins it should go up as a proportion of your premiums and down, if you are writing at a lower margin. In terms of the profit outlook on VAs going forward, I don't know, John or Hugh?

Hugh McHaffie

Embedded in that new business embedded value calculation is the cost of hedging, so it will depend upon the variability of hedging costs over time. So I think you will just see that move around as the cost of hedging moves around on the new business. I haven't done the math either so, Simon, I can't vouch really your specific math.

John DesPrez

But, Michael, I think where you are going is the new business embedded value on the VA business before it was a lot higher when it was on an unhedged basis. Obviously, we don't find that a good way to continue so we’re hedging the new business, that reduces it on a unit basis enormously. I think the broader question you're asking is the business sufficiently profitable to justify the capital allocation. And we think it is, but I've said it before we should all in the industry be charging more for this. We're taking a leadership position with some of our product designs and changing prices, but I guess this stuff on the U.S. statutory basis throws up profits and issue I think.

And a lot of companies are enamored with writing more and more of it, so there is still a little bit more price competition going on than I think is perhaps appropriate in the market. But that's what markets are for, and everybody taking a different view. We are trying to balance the sales of it and trying to ensure that what we’re selling is profitable with a high balance of probability in favor of our shareholder.

Michael Goldberg – Desjardins Securities

And on another topic, it looks like given OSFI's comments recently that we’re safe in retaining comp at least until we get to phase two of the implementation of IFRS. And my question is, are you doing anything, can you do anything to ensure or to get more allies on the side of retaining comp? Because it seems to me like if comp disappears, either the way you manage investments changes or all hell breaks loose.

Donald Guloien

Michael, we couldn't agree with you more. The Canadian accounting regime, as I said earlier, forced companies to deal with problems earlier than they would otherwise do. And is a very intelligent regime that promotes matching of assets and liabilities very effectively and penalizes people for not doing that where it's unable to do that. The historical direction of IFRS was sort of disassociate the two and could result in some difficult outcomes. I think we’re getting more and more allies around the world on that, not just the Canadian basis. There has been discussion in our industry and I think our regulator understands the issue.

But, more importantly, perhaps is on a foreign basis a number of countries and companies in various places in Europe are starting to recognize that some of the proposals inherent in IFRS aren't necessarily that sensible. And I think there is going to be some rethinking of it from its original premise.

Michael Goldberg – Desjardins Securities

Can you give me some examples?

Donald Guloien

Well, they have had proposals about discounting all reserves at the risk free rate for instance. That would not be a very bright thing to do. The consequence of that would mean that people around the world nobody would be able to buy any products with any long-term guarantees at all. So when you've got people everywhere in the world worried about how they're going to live with pension plans, both government and company-sponsored declining, I mean I can't imagine it would be good government policy to take away the last bastion that people can go to, which is life insurance companies, offering things like life annuities and pension buyouts, that, that would be an intelligent thing to do from a public policy standpoint.

But if everybody discounted everything at the risk free rate you could imagine what that would do to pension plans around the world. So that's one proposal it's easy to attack, and there are already signs that they are moving at a very positive and intelligent direction there. But, it's not our company; or our country, it's a number of companies around the world, very large and sophisticated companies. And it's also some governments that are saying we’ve to intervene on this stuff to make sure it lands in a sensible place.

Michael Goldberg – Desjardins Securities

Thank you.

Operator

The next question is from Eric Berg of Barclays Capital. Please go ahead.

Eric Berg – Barclays Capital

Thanks very much. Good afternoon, Don, and to your team. Don, I am looking at the S&P news release and to me at least the agency seems to make very clear why they will very likely downgrade Manulife. I quote. “Manulife's risk tolerance remains high and the majority of its equity-linked liabilities remain unhedged.” I can't get into their head, for sure, but they seem to be saying that they don't like your threshold decision not to hedge the entire book all at once. I know you've been through it, but can you remind the audience?

Given that the cost of hedging is more than it was before the crisis, but down dramatically from where it was at the peak and given too the extreme upheaval that Manulife went through, why have you made the decision that you have made, not to put this issue behind Manulife and buy hedges for everything now?

Donald Guloien

Well, Eric, that's a great question. I think it would not be in the shareholders interest. I've said this before in the public eye and I will say it now, it would be in Don Guloien's interest. I mean, I can look like a hero of a huge one-time charge and say, we put it behind us. And I think that would mollify rating agencies and other people who are concerned about the downside risk. If we'd done that back in March and compared with where we’re today we’ve made billions of dollars by not doing that. And you can see that as markets moved up we opportunistically moved in and hedged for a very significant gain for the shareholder. I happen to believe that the shareholders, who've suffered a great deal by seeing the unhedged positions cost in terms of the market downdraft have a right to earn that back in the market updraft.

And I'm not prepared to put their interest behind me, because rating agency has a view on the unhedged position. I mean I think their view is fair that it exposes us to risk, but we’ve tried to be very open about the amount of risk that we’ve. And we think the majority of shareholders will commend us. If the market were to go down to 650 in the next couple of weeks, I think people would say that was a very dumb decision. But if the market goes up and down as it want to do and slowly recovers over a period of years or a period of months, whatever, I think people will commend the decision. So far it's served us very well to take a cautious approach and we intend to follow that approach going forward.

Eric Berg – Barclays Capital

Okay, that's responsive and I appreciate it. My second of three questions; I will try to go quickly so that others can have a chance too behind me. Turning to slide #19, I'd like to get a sense from you folks this is essentially what you told us at the end of the June quarter. So by placing this slide here now at the end of the September quarter are you essentially affirming the guidance – not guidance, but I know you were careful, I know Mike Bell was careful not to refer to it as guidance. But in reprinting a slide for information that you provided at the end of the June quarter what should we infer from that?

Mike Bell

Eric, it's Mike. I think you should infer that we remain committed to the comments that we made at second quarter and that we reaffirmed today. And that is that we do expect the normalized earnings, as we’ve defined it, to be in that range. Now as I said in my prepared remarks, there are all sorts of pluses and minuses, not contemplated in our definition of normalized earnings. A couple that I highlighted. Credit conditions. While our credit results have been a real competitive strength, credit conditions generally have been negative and also just a clear area of uncertainty. So the point is the normalized earnings are based on long-term expectations.

Near-term, that would be an area where I'd be expecting to have some pressure. I don't think there is a way to quantify it, but there is clearly pressure, same thing with currency, obviously the weakening of the U.S. dollar versus June 30th since the normalized earnings are based on the CAD1.16 exchange rate as of June 30, the weakening of the U.S. dollar also is a headwind in terms of the normalized earnings. But again, given that all that stuff is out of the definition of normalized earnings we continue to believe that for the remainder of 2009 and 2010, that's an appropriate expectation.

Eric Berg – Barclays Capital

Last question to Mike and I think this will be fairly easy for you, Mike. Page #7 of the slides references a CAD1.2 billion hit related to interest rates, and then on slide #11 you are enjoying a benefit of CAD314 million related to interest rates. I know you were discussing this earlier, maybe you could build on your earlier response. What is the difference between those two numbers, not arithmetically but in concept wise? They are obviously dealing with different topics. And could you just go over – you just went a little bit too quickly for me – why is one number going in one direct – have a negative sign associated with it, it was a hit to earnings, and one is a benefit to earnings? Thank you.

Mike Bell

Sure, Eric. First, in terms of the CAD1.2 billion hit to earnings from interest rates. As we’ve talked about in the past, there are a lot of different factors that impact that, but most importantly, as Donald reaffirmed here today, the drop in corporate bond rates and the further compression in spreads hurts our earnings, and that's really a normal phenomenon for most life insurance companies these days. I can't give you a specific formula or a specific single interest rate to look at, but the phenomenon here is that CGAAP accounting rules require us to present value all future premiums and all future claims.

So, again, as we’ve to make a modeling assumption around what interest rate are we going to invest a premium that we’re going to get 20 years from now. And so, given that we had to do all of that in the present value formula, when we’re in a situation like we’re in now where corporate bond rates drop, the assumed interest rate on what we’re going to invest that 20th year premium in also drops. So we’ve got that phenomenon.

The other piece that impacts our earnings is spreads. Again, we’ve reduced our interest rate sensitivity for several of our products by entering into swap arrangements that synthetically lengthen our assets. And again, that's helpful and that it reduces our interest rate sensitivity. Unfortunately, we’re not able to achieve the traditional corporate spreads when we enter into those swaps. So we’re also susceptible to corporate bond rates coming down. The bottom line here is that corporate bond rates as well as spreads moved against us in the quarter, and that was worth approximately CAD1.2 billion.

On slide #11, this is really a very different item here on slide 11. Slide 11 was the annual review, Eric, of all of our actuarial assumptions across our entire portfolio of products in all of our geographies. As Simon pointed out a minute ago, there were a number of pluses and minuses in the quarter. For example, we strengthened our volatility reserve assumption for equity markets and so that was part of the reserve strengthening in that line item. We also lowered the reinvestment rate assumed in the valuation model. That was a reserve strengthening. Going the other way was for long-term care. We did an update, really better modeling of how we actually manage the investment portfolio that supports long-term care. That indicated a reserve release. So it's really the sum total of those items that led to the favorable reserve release that's outlined on slide #11.

Eric Berg – Barclays Capital

Thank you. Very comprehensive. And thank you, Donald.

Donald Guloien

Thank you, Eric.

Operator

The next question is from Darko Mihelic, CIBC. Please go ahead.

Darko Mihelic – CIBC

Couple of questions. First, on slide #7, the notable items that had up to about CAD975 million. If I am thinking about this correctly, do most of those go through assumption changes and the rest of them go through experience gains? I don't need exact numbers. I just need to have a ballpark figure of how much is going through assumption changes and how much is going through experience gains?

Simon Curtis

It's Simon. The only one on that slide that goes through the assumption changes is the CAD783 million impact of the annual valuation basis change. Most of those other items would effectively go through the experience gains and losses in the source of earnings.

Darko Mihelic – CIBC

Okay, thank you. That's helpful and then it leads me to the next question, which is, as I am to understand it, your view of normalized earnings include an earnings on surplus. And since none of these items actually affected earnings on surplus, could I look at the number that happened this quarter and think of that as basically part of an underpinning of that CAD750 million to CAD850 million of earnings?

Mike Bell

Darko, it's Mike. The short answer is, yes. Now, again, in fairness, the interest on surplus in the quarter benefited from some realized capital gains that we had on the sale of equity, so that contributed to the CAD803 million. Just in full disclosure, the CAD803 million though was depressed by the higher than expected levels or higher than normal levels of a new business strength. But the short answer is IOS is a key component of what's in the adjusted earnings from operations.

Darko Mihelic – CIBC

Would it also be fair to think of the CAD803 million that was also have been helped by some tax recoveries?

Mike Bell

Yes, that is fair.

Darko Mihelic – CIBC

Okay. Another question then looking at slide, I think it's #21 here where we talk about capital.

Mike Bell

21, Darko.

Darko Mihelic – CIBC

Yes. Sorry, 22; I apologize.

Mike Bell

22. Yes.

Darko Mihelic – CIBC

The last bullet there, the CAD1 billion of contingent capital in the hold co, how are we to think of this if we go to hold co MCCSR sort of approach with OSFI? Is that something you could actually downstream if we were to actually think about these things on a consolidated basis?

Donald Guloien

Well, a couple things there. First, I think, Darko, it’s way too early to speculate on what OSFI might be doing in the future around hold cos. So I don't think I'd try to speculate at this point. I think what's most important about the CAD1 billion that we’ve today sloshing around the hold co is that it could be downstream today into MLI to strengthen the MCCSR. I think that's the most important point. Now, again, also in full disclosure, we do expect to use that CAD1 billion in the future to repay our CAD1 billion outstanding on our bank loan. But it is fair to say that today it’s a contingent source of capital if we were in a pinch.

.

Darko Mihelic – CIBC

Okay. And thanks very much for that. Maybe just my last question and this relates to slides #23 and 324. You outlined the reorganization and you outlined the benefits. I guess the question that comes to mind is why wasn't this done before? There must have been a reason for not having it consolidated or reorg this way?

John DesPrez

Well, this is an embarrassing one to answer. It took a huge amount of activity. I mean it's a massive. You would not believe what an administrative undertaking is it's something we’ve been working on for a couple of years. The second thing is we had to get regulatory approval, and you can imagine around year-end last year regulators were sort of focusing on the highest priority items and they certainly didn't want to focus on this one.

We need approval of Michigan, Massachusetts, and New York in order to effect this reorganization. The good news is that the work has essentially been done. I'm looking at Jim Boyle here and the massive project is well on its way to completion, and it looks like we’re getting regulatory approval. So, we think this is a very positive move for our company.

John DesPrez

And by the way, it will reduce operating costs very significantly. First of which we won't have the cost of the project ongoing and the second is we won't be administering two different subs, essentially managing very similar business. So, ongoing this will produce very significant expense benefits, which is not a trivial part of the equation.

Darko Mihelic – CIBC

Okay, thanks very much.

Operator

The next question is from Doug Young of TD Newcrest. Please go ahead.

Doug Young – TD Newcrest

Good afternoon. I'll try this again. Hopefully, I will be quick. The first question I guess for Michael or Simon, are you done with the reserve basis changes? Meaning if everything stays unchanged from where we’re today, are you comfortable at the end of Q4 that there isn't other things going to come out of the wood work?

Simon Curtis

It's Simon here. We did a very thorough and complete review of the third quarter. It was our full annual review. We've booked all the reserve adjustments that were appropriate that went through our review process with internal auditors and peer reviewers. So I'm confident in saying that at the moment the balance sheet is totally up-to-date, and there is nothing that's been deferred to the fourth quarter.

Doug Young – TD Newcrest

Okay. Second, just on the hedging for a second of variable annuities, you did it for the business in Canada, for the in-force business in Canada, the 3.8. It doesn't look like you did any in-force in the U.S. And I am just curious as to why that was. Is it just because you weren't able to get that 50 basis point margin? And I guess the second part of the question is, Don, when you look at this do you look at your gross value at risk? What's the optimal amount to have hedged eventually?

Donald Guloien

Well, you answered your first question very well, so let me just confirm your answer, we look at all the inputs, the cost of swaps, the cost of hedging, and so on, and where the market is and how much the net amount of risk is and look to make roughly 50 basis points from issue. Obviously there is some judgment apply we can press the accelerator a little heavily and do it less than that we could do a little bit more than that. It depends on market conditions.

But that is the general tenor of it. We would like to get a substantial amount of this. I would love to say, 70% of it hedged and when you combine that with what we’ve reinsured that would be a very substantial decrease in the amount of sensitivity. But again, we’ve the shareholders interests at heart here and we’re not going to rush into it and do it before it's most appropriate. That's served us well. It's not that we’re being emboldened by the approach we’ve taken. That could be dangerous. But we will watch situation and if we perceive that there is a greater downside equity risk we will accelerate. Otherwise, we will stay the course. We think it's a very good plan of action.

Doug Young – TD Newcrest

Okay. Just lastly on the changes to assumptions in Q3, part of the investment return as you mentioned was long-term care and the URR. On the long-term care side I know you had a mismatch on that on the asset duration, asset liability match. Have you turned that out? Is that what you are referring to? And on the URR side, can you give us an indication of where you stand relative to where the end of the year might come out in terms of the calculation? Thank you.

Donald Guloien

Yes, there is some degree of a mismatch, but that is more overwhelmed by the structural nature of the businesses, where we simply do not know what we’re going to invest future premiums at and there is no practical way of hedging out both the underlying treasury and the corporate A rate. So structurally you're going to be exposed on an interest rate basis to these large changes in interest rates that we’re seeing today. That is the biggest part of it. This isn't some sophisticated ALM [ph] call, where we think we know better than the markets and are short. The products, the valuation ask the question what will that premium in the 16th year earn, what will the premium in the 19th year earn, what will it earn the 23rd year? And the convention is to use today's spreads as if they persist for that whole period with a swap curve. The interest rates applied with a swap curve.

And obviously, when you apply those things in today's market you get very conservative results. It's anybody's guess what we will actually obtain in the future. We will look at ways of desensitizing ourselves to those interest rate movements, but structurally, it's part of the product. I think long-term frankly, companies that are exposed to this, will move to build more adjustability into their products, or charge more for taking the risk, because we’ve such large accounting volatility associated with that. But that’s really what it is, accounting volatility more than an investment decision to mismatch. Simon?

Simon Curtis

I will just answer the second part of the question, which is about the ultimate reinvestment rates. The long rates that we’re using at the moment, the long bond rates, ultimate rates are 4% in Canada and 4.1% in U.S. Those rates were set looking forward basically a year from today to what we think the ultimate rates would be under the VA standard, if current market rates didn't change. So we took a one-year look ahead and use that to set our ultimate reinvestment rate.

Doug Young – TD Newcrest

Thank you.

Donald Guloien

We've gone 20-odd minutes past our time. I hate to close off the call, but why don't we take one more question, if that's all right.

Operator

The next question is from Mario Mendonca of Genuity Capital Markets. Please go ahead.

Mario Mendonca – Genuity Capital Markets

Good afternoon. Thank you for all the details you've provided. Much more than this company ever did when it first mutualized. I certainly appreciate everything. The question that trumps everything though, at least that I get is I mean there are investors that can understand Manulife will eventually emerge as a strong company with good earnings. The question is will they be diluted before then, an existing shareholder. So going back to this whole MCCSR and maybe even the holding company and rules around the segregated funds, Don, can you help us understand what is this fortress capital?

And you refer to 150, as this sort of minimum MCCSR, but I think we all appreciate that Manulife can't get anywhere near 150, without the stock price being much lower or the regulators and rating agencies losing it. So what is the real number for Manulife in terms of an MCCSR you could go to? And maybe I will stop there and ask, help us understand what this fortress capital means and what the minimum really is?

Donald Guloien

Well, as Mike said before, and I've said, fortress capital, level of capital that would allow us to sustain the most draconian scenarios. But not all of them. I mean there will always be scenarios you can construct that are worse. There's great deal of comfort that we wouldn't have to go to capital markets. I think you used an expression there, Mario, describing regulators and rating agencies, I am not sure I would use the same expression, but it's clear that if the S&P were to go to, let's say, 650 in the next quarter, the rating agencies, regulators would say so what are you going to do about it.

I don't think they would be so perverse to expect that it would be dealt with immediately, but they sure want to see a plan for dealing with it. So that's why we’re opting on a lot of things on the conservative side without subjecting our shareholders to, what I think is the ultimate indignity, which would be to hedge it all out at the bottom of the market.

Mario Mendonca – Genuity Capital Markets

Don, can I just interrupt for a second? If Manulife's MCCSR were at 190 next quarter would that cause you to want to raise common equity or some kind of equity or some kind of capital to get it back up above 200?

Donald Guloien

Mario, my answer, I can't speak for – you asked the question in the context of regulators and rating agencies. My answer would be clearly, no. If the equity market moved down, I mean you could look, you could find days in March, where MCCSR was a heck of a lot lower than it was today. I would hope you wouldn't have a knee jerk reaction to that. If you felt that it was going to go down and stay down, that's a different story.

Mario Mendonca – Genuity Capital Markets

Even 200 then certainly not your threshold?

Donald Guloien

No, as we said before we’re trying to provide a comfortable cushion between where we’re and the ultimate level of 150, which is the regulatory action level. I think you have captured it correctly though. I think, again, if markets fall people look to you. The sort of standard is – I think rating agencies and others are not looking through the cycle anymore. They're saying at your worst point do you have the capital of a AA or AAA company? So it's a tougher standard.

I mean I have been very open with that saying regulators, rating agencies, and some equity investors and the general public expect companies to have very high levels of capital under the most odious circumstances. You just have to pick up the paper and you know that's a true statement. So that's why we’re moving in the direction of fortress capital and took the actions we did on the dividend however unpopular they were at the time and may continue to be.

Mario Mendonca – Genuity Capital Markets

And then, finally, on the segregated funds. OSFI has talked about holding company capital. I think, Mike, you said way too early to ask about that. How about the notion that they're going to review all the internal models for segregated funds and they're going to comment on next year? Maybe for Mike or Simon, I know it sound strange, could they essentially reverse what they did in the fall of 2008 on seg fund?

Mike Bell

Mario, it's Mike. I just think it's not very productive exercise to speculate on how OSFI might think about this in the future. I mean the bottom line is the seg fund product meets a societal goal here and that is to provide a floor on people's equity risks. It also seems to me very unlikely, at least, I would like to believe that our regulator would be very thoughtful and would be unlikely to enact standards that would hurt the Canadian insurance industry or put us in a relative competitive disadvantage versus companies in the U.S. or Europe. And so, again for those reasons I don't think it's very useful to try to speculate.

Mario Mendonca – Genuity Capital Markets

What do they refer to it then in that speech? What did they make a point of specifically saying the internal models were flawed?

Donald Guloien

Well, they made some changes to the internal models, Mario, I think that's what it reference to. Remember they made some changes. Now remember when they made the changes it was a complex series of changes, right? In some conditions it gave forbearance, in other conditions, it actually got tighter. They built-in essentially an anti-pro-cyclical measure, which I think is actually quite clever and good, and that is that it gave some forbearance in down markets on the assumption that –

Mario Mendonca – Genuity Capital Markets

Don, I am referring to the speech that was made a couple of weeks ago.

Donald Guloien

Yes, I know, let me finish. It actually will tie into your question, believe it or not. They gave some forbearance recognizing that the fundamental approach has some conservatism in it. When markets have gone down 50% to assume that they then go down model them at a very high CTE level that assumes they maybe go down another 30%, stay down for ten years, and then very slowly recover. After they have already come down a dramatic amount, is projecting an extremely draconian scenario. So what they did is they gave a little bit of forbearance and said that may not be appropriate, especially, if it's a long time, there is a long time until the liabilities come due.

But contrary to public opinion, they didn't give just one side in forbearance. What they did is said when things improve we’re going to put an averaging formula and that's going to grab some of that back. And guess what, that averaging formula is grabbing some back. I am not at liberty. I don't think to talk about how much is being grabbed back at this time. But if you made the assumption that the reserving standard is less conservative today than it was six months ago or a year ago, it may not be accurate, Mario.

Simon Curtis

It's Simon here, Mario. I just like to jump in. OSFI is consulting the industry on a number of things, learnings they've had from the last year. Now the worst of it has hopefully passed, OSFI is looking at all of the areas of provided stress points, stress testing, holding company rules, fundamental MCCSR rules, seg fund guarantees. And I think it's dangerous just to pick out one area. The reality is OSFI is looking at a number of areas; they are trying to do this on a consultative basis. I think it would be wrong for us to say seg fund rules will never change. But I think anything that that will be introduced will be done in a very thoughtful way and it will have a lot of impact studies and discussion I think before OSFI is ready to implement any changes.

Mario Mendonca – Genuity Capital Markets Sounds like some give and take. Thank you very much.

Operator

Thank you. That concludes today's question-and-answer session. I would now like to turn the meeting over to Mr. Gorgi.

Amir Gorgi

Thank you, operator, and we will be available after the call for any further follow-up questions. With that I'd say good afternoon.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time. Thank you for your participation.

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Source: Manulife Financial Corporation Q3 2009 Earnings Call Transcript
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