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Manulife Financial Corporation (NYSE:MFC)

Q3 2010 Earnings Call

November 4, 2010; 02:00 pm ET

Executives

Donald Guloien - President & Chief Executive Officer

Michael Bell - Chief Financial Officer

Beverly S. Margolian - Executive Vice President & Chief Risk Officer

Warren Thomson - Senior Executive Vice President & Chief Investment Officer

Anthony Ostler - Senior Vice President of Investor Relations

Jim Boyle - U.S. General Manager

Paul Rooney - Canadian General Manager

Scott Hartz - Executive Vice President, General Account Investments

Cindy Forbe - Executive Vice President & Chief Actuary

Analysts

Tom MacKinnon - BMO Capital Markets

Andre-Philippe Hardy - RBC Capital Markets

Michael Goldberg - Desjardins Securities

Darko Mihelic - Cormark Securities

Steve Theriault - Banc of America/Merrill Lynch

Doug Young - TD Newcrest

Robert Sedran - CIBC

Mario Mendonca - Canaccord Genuity

Colin Devine - Citi Group

Peter Routledge - National Bank Financial

Operator

Good afternoon, and welcome to the Manulife Financial’s Q3 2010 financial results for November 4, 2010. Your host for today will be Mr. Anthony Ostler, Senior Vice President of Investor Relations. Mr. Ostler, please go ahead.

Anthony Ostler

Thank you, and good afternoon. Welcome to Manulife's conference call to discuss our third quarter 2010 financial and operating results. Today's call will reference our earnings announcement, statistical package and webcast slides, which are available in the Investor Relations section of our website 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. Today speakers 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.

For additional information about the material factors or assumptions applied 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 website, as well as 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, Antony. Good afternoon everyone and thank you for joining us today. Our third quarter 2010 financial results announced this morning reflect a quarter in which we made considerable headway executing our business plan, both in terms of repositioning our business, reducing our equity and interest rate sensitivities.

I’m joined on the call today by our CFO, Michael Bell, as well as several members of our senior management team including our U.S. General Manager, Jim Boyle; Canadian General Manager, Paul Rooney; Warren Thomson for Investments and our accountant, the finance team.

Let me start with my assessment of our progress this quarter. We had a net loss attributed to shareholders of $947 million equating to a fully diluted loss per share of $0.55. Despite the reported results, it’s important to note that we generated strong underlying earnings from operations. Adjusted earnings from operations were $779 million in the quarter within the $700 million to $800 million range we estimated for fiscal 2010 in our 2009 annual report.

The operational contributions were more than offset by a $2 billion reserve strengthening and $1 billion goodwill impairment related to the current economic climate and the repositioning of our U.S. business. Manulife’s capital position remained strong in the quarter. Manulife increased its MCCSR ratio to 234%.

We achieved a 19% reduction in interest rate income sensitivity by lengthening the duration of our fixed income investments through swaps and other initiatives in both the liability and the surplus segments. Furthermore, we reduced equity exposure by hedging an additional $3.3 billion of inforce variable annuity guaranteed value and also lowered our equity holdings by almost $450 million.

With the actions taken, the total amount of guaranteed value hedged or reinsured was 54% as of September 30. As you’ve seen in our press release, we have adopted revised targets for hedging both interest rates and equities. Fortunately, equity markets have moved once again in our favor. The S&P 500 is almost up almost 20% since the July too low and in fact it’s pretty much on the yearly high.

We also hedged another $800 million just today. Our goal is to execute additional hedges so that approximately 60% of our underlying earning sensitivity equity market movement is hedged by the end of 2012. You will note that this is a more relevant standard than the notional standard we used before, the 70% notional amount hedged, now we are using a standard of earnings sensitivity and the goal is to have 60% hedged by the end of 2012.

And to go further than that through to 2014, we plan to use a combination of macro and dynamic hedging and other techniques until we are well within our targets. With the basis changes and interest rate moves in the quarter, our interest rate sensitivity was going to increase beyond levels that we would find tolerable.

In addition, the outlook seems to be for lower rates for a longer period of time. As a result, we are ranging our fair; so that we do not expect to see an increase in interest sensitivity and through a variety of measures, plan to decrease that sensitivity over the next four years. To the extent rates continue to decline, we would also except to generate additional gains on sale of bonds in surplus.

During the quarter, we saw positive results globally from our efforts to reallocate capital and resources to those products targeted for growth. Our repositioning is indeed working. In Asia, for example, sales of insurance products increased 50%. I am also particularly proud of our U.S. business, where adjusted earnings from operations increased 72% over the third quarter of 2009. This was driven by reducing strain, changing product mix and price changes.

In Canada, mutual fund sales increased 181% with deposits almost triple 2009 levels. Manulife Bank sales increased by 13% year-over-year and life insurance sales were up 11% in individual insurance. In fact, as of last night, our U.S. mutual fund business recorded $8 billion in sales year-to-date. Our credit experience remains strong, which is a reflection of the continued strength of our investment division.

Now we know a number of analysts like to compare our results with those of our U.S. peers, the basis of earnings and shareholders equity. On the U.S. GAAP, we are estimating that we will report a net loss of $212 million, which is approximately $700 million lower than that recorded under Canadian GAAP.

In addition, our total equity is about $9 billion difference. During the quarter, we also added to the highly successful John Hancock brand campaign in the United States by launching campaigns to tell our stories to Asian and Canadian audiences. These investments are helping to grow the value of our global brand.

In summary, we are successfully reducing our equity and interest rate sensitivities, also positioning our business for future earnings growth ROE [ph] expansion. I am also pleased to say that Manulife’s board recently had a board meeting in China, where we met with our many wonderful partners in China, signifying the strategic importance of Asia to Manulife’s future plans.

At that time, the board also reviewed and reaffirmed its support of the company’s strategic direction and plans. We are enormously pleased to be able to share those plans with you at an Investor Day planned for November 19. With that, I will turn the podium over to Michael Bell, who will highlight our financial results and then open the call to your questions. Thank you.

Michael Bell

Thank you, Don. Hello everybody. Today, we reported a third quarter shareholders net loss of $947 million, which equates to a loss of $0.55 per share on a fully diluted basis. I’ll first refer to slide 7, which provides a summary of the quarter’s results. Excluding notable items, our adjusted earnings from operations were $779 million and at the upper end of our previously stated range. And we knew these underlying business results to be strong.

We completed our annual review of actuarial methods and assumptions in the third quarter and this resulted in a total net charge of just over $2 billion after tax. And I’ll review these items in a few minutes. On a Canadian GAAP basis, we recorded an impairment of goodwill of just over $1 billion related to our revised outlook for our U.S. insurance business. This review of goodwill was necessitated by current economic conditions and our recent decisions to reposition that business. And as we’ve discussed, this goodwill impairment is a non-cash item, which does not impact regulatory capital.

During the quarter, we took important fixed income investment actions, which reduced our sensitivity to interest rate changes and increased our capital levels. We ended the third quarter with a strong capital position as MLI’s MCCSR was 234% at September 30, up 13 points from last quarter despite the impact of the annual actuarial basis changes. We also did a good job continuing to generate strong top-line growth in our targeted growth areas or effectively limiting sales of our other products by design.

Our credit performance continue to be strong, which is a testament to our investment discipline. We also significantly reduced our interest rate sensitivity and we have plans to continue to reduce both interest rate and equity market exposures over the medium-term. We expect to report a net loss of $212 million on the U.S. GAAP basis in the third quarter. And this results continue to be better than our C GAAP net result even though the U.S. GAAP result includes a larger goodwill impairment. So overall, we’re pleased with our progress on several key priorities in the quarter, although obviously not satisfied with our net income result.

Let’s move to slide eight, which provides a breakdown of the notable items in the quarter. Note that the net impact of third quarter’s higher equity markets and lower interest rates totaled approximately $1 billion after tax. This included $569 million of realized gains on the sale of bonds in our surplus segment. These bonds were sold to offset some of the negative impact of the decline in interest rates on the policy liabilities since the beginning of the year and therefore served as an important partial hedge.

We generated additional investment gains in the liability segments, including the impact of actions to lengthen the duration of our fixed income investments, which support our policy liabilities. We feel positive that these actions contributed to two objectives. They increased our capital and reduced our interest rate sensitivity. And as noted on the slide, these additional favorable investment related gains contributed $364 million in earnings.

So excluding the notable items, adjusted earnings from operations in the third quarter totaled $779 million, which we view as a positive result. Slide nine, summarizes our results by division and we’ve excluded the impact of the equity markets interest rates and investment results. So excluding the substantial losses in corporate for the annual basis change and the goodwill impairment, the divisional result were up materially versus the first half of the year.

Our U.S. insurance business demonstrated the most improvement in underlying earnings. As price increases and lower volumes drove a substantial improvement in new business strain. Improved policyholder experience contributed as well. In addition, we drove underlying earnings growth in the U.S. wealth management business primarily through more favorable sales mix.

In Canada, underlying earnings growth versus the prior quarter was driven by improved claims and laps experience. The Asian division experienced a decline versus the prior quarter primarily due to lower new business gains in Japan. So overall we’re pleased with the underlying trends in the divisional results.

Turning now to slide 10 our source of earnings, expected profit on imports was inline with the prior year. On a currency adjusted basis, the $930 million result was the best in the last five quarters, despite the additional earnings headwind from hedging more in-force variable annuity business.

New business strain improved primarily due to the better U.S. results that I mentioned on the prior slide. The net experience gain primarily reflected the higher equity markets and investment gains, which more than offset the impact of lower interest rates. Management actions and basis change of $3.1 billion pretax is largely comprised of the annual actuarial basis change and the goodwill impairment charges partially offset by the realized gains on the AFS bonds.

Slide 11, summarizes our regulatory capital position for MLI. The actions that we’ve taken over the last 12 months to increase capital and to reduce our market exposures had strengthened our company’s overall position. MLI reported an MCCSR of 234% for September 30th, a sequential increase of 13 points, despite the $2 billion impact of the actuarial basis change.

The debt proceeds raised in the third quarter and deployed to MLI contributed to this increase. Our strong investment gains, adjusted earnings from operations and the positive impact of equity markets also increased the capital ratio. The goodwill impairment charge did not impact this ratio, as goodwill is excluded from MLI’s regulatory capital calculation.

Slide 12, provides and updated estimate of earnings and capital sensitivities for equity markets and interest rates. As we’ve discussed before, these are high level directional estimates based upon changes to a single factor. While we disclosed these sensitivities to provide some general direction, in reality several factors change in the same quarter and no simple formula can model the earnings impact in any given quarter with precision.

The main highlight on this slide is that the actions that we took in the quarter significantly reduced our earnings sensitivity to interest rates to $2.2 billion for a 100 basis point parallel decline versus $2.7 billion sensitivity last quarter. So in other words, the lengthening of the duration of our assets more than offset the impact on the sensitivity from the annual basis change and the third quarter decline in interest rates.

Now the equity market sensitivity did not changed materially from the prior quarter, due to the impact of the basis change offsetting the combined impact of the sale of the surplus equities increased hedging in the equity market appreciation. I would note that the MCCSR sensitivities did improve relative to June 30th.

Slide 13, details the impact of equity markets on our results in the third quarter. As noted, equity markets generally performed very well, although the Topix was down 1.3%. We estimate that the combined impact of the positive equity market performance and variable annuity hedging program resulted in a net positive benefit of $683 million. Of this amount, we have gained $700 million for the unhedged VA business, which will partially offset by a loss on the hedged VA block due to higher realized volatility in some un-hedged elements of the program.

On slide 14, you can see that during the quarter, we reduced our equity exposure by hedging an additional $3.3 billion of the in-force variable annuity guaranteed value. As a result, the total notional amount of guaranteed value hedged or reinsured was 54% on September 30th. We also sold a significant amount of our equity holdings in our surplus segment, which generated gains and reduced our overall equity sensitivity.

And as noted in our press release, we’ve now established a goal of executing additional hedges, so that 60% of our underlying earnings sensitivity to equity market movements is hedged by the end of 2012 and approximately 75% is hedged by the end of 2014 through a combination of time-scheduled and market-based actions.

The other two important messages in this sentence that I’d like to reinforce. First, we do intend to implement time-scheduled triggers to supplement our current market-based triggers so that the planned reduction in our equity market sensitivity is not market dependent.

Second, we intend a transition to our equity markets earning sensitivity as our primary measure to describe how much we’ve hedged, rather than the 54% of notional guaranteed value hedged.

Our updated plan would entail a larger reduction in earning sensitivity than the impact of the original plan to hedge 70% of the notional guaranteed value by year end 2012. So by 2012, we intend to hedge a minimum of 70% of our overall VA earning sensitivity and 60% of our company-wide earning sensitivity to equity markets. Overall, our intention is a more certain glide path and a lower earning sensitivity to equity markets relative to our original plan.

Now moving to slide 15, under Canadian GAAP, changes in interest rates impact the actual valuation of in-force policies by changing the returns assumed on the investment of net future cash flows. During the quarter, both treasury and corporate bond rates declined and long swap spreads decreased, which resulted in an overall, that no simple formula can estimate the results accurately.

In addition, our corporate valuation spreads eliminate outliers to be more representative of our investable universe, which typically dampens our volatility to spread changes. Our estimated sensitivities as of September 30 include the following; for a parallel 100 basis point drop in all interest rates, we would expect to incur a $2.2 billion reduction in shareholders net income. For a 50 basis point drop in corporate spreads, we’d expect to incur reduction in net income of $600 million, and for a 20 basis point increase in swap spreads we would expect to see a reduction of $200 million after-tax. These estimated impacts on earnings are based on the September 30th starting point and the business mix at that date.

Actual results may differ materially from these estimates for a variety of reasons including additional management actions, the interaction between multiple factors and a variety of other variables.

In addition, please note that there is an incremental potential material impact of future changes in our ultimate reinvestment rate, used to calculate reserves if government bond rates remain near the current rates. As our URR is based on a 10-year weighted rolling average of government bond rates and will continue to be updated in the future.

Slide 17 details the actions we took, which reduced our net income sensitivity to interest rates by 19%. We are pleased with the progress that we made this quarter and trying to take further actions to reduce our interest rate exposure as measured by the impact on shareholders' net income by a minimum of 25% by year end 2012 and by 50% by the end of 2014.

In addition, as noted in our disclosures, our economic sensitivity is lower than our earnings sensitivity due to the embedded partial hedge from our long duration surplus bonds.

Now as noted on slide 18, we completed our annual review of all actuarial assumptions in the third quarter resulting in a total net charge of just over $2 billion on an after-tax basis. We completed our comprehensive long-term care claims experience study, which including estimating favorable impacts of in-force rate increases. This resulted in an after-tax impact of $755 million.

Within this calculation, expected future in-force premium increases reduced this charge by $2.2 billion pretax, resulting in a total of $3 billion pretax of future premium increases now assumed in the current reserves. Premium increases averaging approximately 40% will be sought on approximately 80% of our in-force business. And we made assumptions on our ability and timing of obtaining price increases although actual results could be materially different.

We expect that our actual experience in this area would result in updated assumptions overtime, which could be material to net income.

Now as part of our annual review, equity volatility parameters and expected bond returns for variable annuities were updated. In aggregate, these updated assumptions totaled $665 million in terms of their impact on net income. Changes to the ultimate reinvestment rates, and fixed income spread grading contributed to an after-tax charge of $309 million.

Liabilities were increased by $485 million on an after-tax basis reflected spirit from policyholder behavior including strengthening related to emerging recent overlaps experience on U.S. and Canadian variable annuity contracts that are in the money.

Now as you’ll note on slide 19, our goodwill review is accelerated this quarter due to the updated outlook for our U.S. insurance business. This resulted in approximately $1 billion goodwill impact under Canadian GAAP while not impacting our MCCSR.

In addition, as noted in our 2009 annual report and this year’s disclosures, the adoption of IFRS Phase I will result in additional testing of goodwill, which will be at a more granular level under Canadian GAAP. Our preliminary estimate is at this good result in an additional $2.2 billion goodwill impairment for a total impact of $3.2 billion and we expect to complete this analysis in the fourth quarter.

In the meantime, our US GAAP goodwill impairment this quarter was greater than the CGAAP charge previously noted. And it is estimated to total approximately $2.6 billion. This is attributable primarily to higher book value of our business on a US GAAP basis relative to the CGAAP basis.

And I’ll turn to slide 20, which shows that our fixed income portfolio continued to perform very well relative to overall market conditions. Impairments and downgrades were modestly better than the long-term expected credit losses assumed in the valuation of policy liabilities. So overall, we continue to be pleased with our portfolio’s results.

Slide 21, looks at the portfolio and it shows that it continues to be a high quality and well diversified, 95% of our bonds investment-grade and our invested assets are highly diversified by geography and sector with limited exposure to the high risk areas noted on the slide.

Turning now to our top line results. On slide 22, you can see the strong insurance sales results. Insurance sales on targeted growth products grew by 24% over the prior year on a constant currency basis. This would suggest an increase in sales market share for these targeted growth products.

In addition, overall wealth sales for targeted growth products grew by 11% over the prior year on the same basis and we view this as good execution in both of these areas. We also took measured actions to increase prices on new business for various products to better reflect current economic conditions and outlook.

Specifically, prices on Universal Life, the Lapse Guarantee products in the US will be increased by 13% on average. In Canada, Universal Life products will be increased on average by approximately 10% in December. And pricing for our long-term care new business, would be increased by an average of 24% over 2010 and early 2011. And these actions are expected to improve our financial results and help us shift our business specs.

On slide 23, you can see that the Asia division delivered record sales in the third quarter, increasing 50% over the prior year. Of particular note, Japan insurance sales doubled to prior year levels on the continued success of new product launches across several distribution channels. In addition, record sales were achieved in Hong Kong and Taiwan. In Canada, individual life insurance sales were up 11% over the prior year. And in the US, good progress is being made on our product repositioning efforts, as evidenced by the fact that our Universal Life sales excluding the Universal Life No-Lapse Guarantee product grew by 20% on the strength of our new products.

Now turn to slide 24, which shows that our plans include growth for our non-guaranteed wealth products. Asia division experienced impressive growth with overall wealth sales excluding variable annuities up 63% over the prior year on a constant currency basis. We’re also pleased with the results of our US Wealth Management business.

Sales of John Hancock mutual funds increased 26% in the quarter and 55% year-to-date versus the prior year, attributable to a broad diversified offering of competitive funds distributed through the retail institutional and defined contribution channels as well as we got some benefit from improved market conditions. Year-to-date sales in 2010 have already exceeded for year 2009 and are on pace for a record year.

In addition, retirement plan sales ended the third quarter with funds under management at record levels. These results are encouraging signs that our focused product repositioning efforts in the US are working. In addition, Canada experienced excellent progress, as part of our broader sales growth and diversification strategy, as evidenced by an impressive increase in Manulife Mutual Fund deposits, which were almost triple 2009 levels.

Slide 25, shows the growth in new business embedded value for our targeted growth products. New business embedded value for the insurance businesses that we’re targeting to grow, increased by 10% in the third quarter, reflecting strong growth in Asia and Canada, which is offset by the effect of lower interest rates on the John Hancock Life Insurance business.

New business embedded value on wealth products excluding variable annuities and the US book value fixed deferred annuities increased 6% over the third quarter 2009. New business embedded value for insurance and wealth products that were not targeting for growth decreased substantially reflecting lower sales volume.

As shown on slide 26, total funds under management on September 30 were $474 billion, representing an increase of $20 billion over last quarter. Now, similar to last quarter, I think it’s important to address key questions that you’re likely to have regarding these results. And the first is around our risk reduction actions around interest rate sensitivity. You might ask well why now? And to answer that, I’ll reinforce Donald’s prepared remarks, that with the basis changes and the interest rate decline in the third quarter, our interest rate sensitivity would have increased beyond levels that we would find tolerable.

In addition, our view of the outlook is that there is now a higher probability of lower interest rates for an extended period of time. And as a result, we took actions to reduce our sensitivity in the third quarter and through a variety of measures planning to decrease our sensitivity meaningfully over the next several years.

So to the extent rates continued to decline, we would also expect to generate additional gains on the sale of additional surplus bonds as a partial hedge. Another set of questions you might have is around goodwill. Now, why was this a third quarter event, what else is expected relative to IFRS?

Well, first let me remind you this is a non-cash, non-capital accounting charge and we believe that the impact should be trivial. The triggering event was our recent decision to lower our sales plan materially for 2011 for long-term care and for the Universal Life No-Lapse Guarantee business, reflecting our desire to shift our product mix in the low interest rate environment in order to reduce our risk sensitivity to interest rates on a C GAAP basis.

Current interest rates were also an important factor since they’ve reduced the future profitability of our inforce block and our new business. So why it was a judgment call? We view these circumstances as necessitating an acceleration of the goodwill review. We do not currently expect any additional C GAAP income impact in the fourth quarter. Nor do we expect in 2011 income impact at this time.

We do estimate that we will have an additional $2.2 billion reduction in the goodwill on the balance sheet on January 01, 2011 when we transition to IFRS Phase I. Now, another question you may have is regards to the U.S. life insurance business, do we still like that business?

The answer is an empathic yes. We value the life insurance business very much. And in fact our John Hancock Life Insurance business is a core franchise for our company. We feel good that we’re positioned to grow our life insurance business over time excluding the Universal Life No-Lapse Guaranteed product, which has the largest amount of interest rate sensitivity in the current interest rate environment. We believe that a shift to life insurance products without the lifetime no-lapse guarantee feature is the direction that the overall market will likely take. So we continue to value the John Hancock Life Insurance business very much and we expect to be successful. We simply want to contain the growth of the most interest rate sensitive products while growing the less sensitive product lines.

And the fourth question that I would like to address here is what’s our confidence level in achieving significant long-term care in-force price increases. Well, first we recognized that there is uncertainty around our proposed in-force rate increases. We do believe though we have strong actuarial support for our proposed rates including an independent review from an outside consultant. We also intend to offer equivalent benefit plan reductions to policy holders as an alternative to mitigate large rate increases. And we believe this will support our rate filings and reduce the potential policy holder reaction.

Finally, we also see other major long-term care providers filing for large rate increases and we believe it is widely recognized that this product is only viable if in-force rates reflect emerging experience for this business.

So by way of summary, our underlying earnings were strong for the quarter but we’re all set by reserve strengthening as a result of our annual basis change and the goodwill impairment. Excluding notable items, adjusted earnings from operations were at the upper end of our previously stated range. And mobilized capital position remains strong at 234% as of September 30th, up 14 points from the last quarter. We were able to increase our MCCSR in spite of the significant annual basis change. And we took important actions to materially reduce interest rate sensitivities.

We also made substantial progress delivering upon our business strategy, achieving growth in our targeted products and reducing sales in areas that we’ve not targeted for growth. Our credit experience remained strong noted to market conditions and overall, our businesses are well positioned for future growth as we continue to execute on our strategic plan.

This now concludes our review of the results. Operator, we can now open the call for Q-&-A.

Question-and-Answer Session

Operator

Thank you (Operators Instructions) First question is from Tom MacKinnon from BMO Capital Markets, please go ahead.

Tom MacKinnon – BMO Capital Markets

Yes, thank you very much. Just a couple of questions. First of all, can you talk about, throughout the press release, experience gains that were related to other non-fixed income returns being better than best estimate liability assumptions. I think we saw them in the Canadian, the U.S. division, the reinsurance division, the Asian division.

And I know that you are working to hedge your equity market exposure, your interest rate exposure, but there is a sizable sensitivity to changes in this other non-fixed income returns to the extent that they back best estimate liabilities, some $3 billion if we get 100 basis point decline.

First of all, can you share with us what sort of – you do share with the long-term assumption used for your equity products for equities 2% a quarter. Now, can you share with us what you have embedded in your best estimate assumptions and your actual reliabilities for these non-fixed income returns and if not, can you speak to how you might want to try to mitigate the, I guess, any sensitivity existing, which has increased quarter-over-quarter going forward and I got one follow-up.

Mike Bell

Okay. Tom, it’s Mike. I’ll start and then I’ll ask Warren and Scott to provide the investment perspective. First, just by way of overview Tom, as you know, we’re really proud of the non-fixed income investments that we have. This is a real core competency of the company, it has been for a long period of time. We think from a risk-reward standpoint, it’s great. We love to diversify our portfolios, so we think all of that is extremely important.

Now, relative to your question on valuation, as you know, we do follow the Canadian Institute of Actuaries guidelines and it’s been laid out in the MD&A, our NFI expected returns going forward are approximately inline with our public equity assumptions for that same basis.

Now, looking backwards for a second, if we look back at the last, say, five years or so, NFI has actually been modestly positive relative to those long-term assumptions, I mean it’s been bouncy quarter-to-quarter, but it’s overall been positive over the last five years and again this is a reminder that this is a very good diversification tool from a risk reward standpoint because even when public equities were bad, this was very useful. So again, we are sensitive to the same point that you made.

We are sensitive to future of returns on this block of business, it’s something that obviously we will have to evaluate every year, both for the public equities as well as for NFI, but at this point we’re real comfortable. Warren and Scott do you want to add.

Warren Thomson

Sure Michael, thank you. Yeah, I think the biggest point is that this is a very diversified portfolio. You can see the holdings in our asset. There is a combination of real estate, agriculture, timber, private equity and infrastructure investments and, for example, the last couple of years when the public market have been challenged, some of those categories have outperformed their long run returns, agriculture would be a good example of that. And over the past five years, we’ve seen the average returns exceed our long-term expectation, although certainly as Michael pointed out there can be volatility quarter-to-quarter.

I guess, finally I would mention that as we look in this category, we do look for the less volatile lower return type categories. Our real estates, for example, is largely class A properties in downtown markets and it’s fully unlevered. So that dampens the volatility quite a bit. We like infrastructure investments that tend to be stable.

So, I think, for all of those reasons, we’re fairly confident we can achieve the returns that are built into our reserves and that well yes they’ll create some volatility going forward, they really are and have to benefit for our long-term liabilities and we’re quite proud of the portfolio.

Tom MacKinnon – BMO Capital Markets

Okay, thanks for that and just as a follow-up on slide 16, when you talk about a 100 basis point drop in all rates hurting income by $2.2 billion and you talked about the predominant one is the long U.S. rates, first of all do you mean long treasury here and when you talk about long U.S. rates and secondly what would happen if the drop wasn’t parallel. What would happen if you got a steeper curve or a flattening curve or any of those, how does that change that $2.2 billion?

Mike Bell

Sure. Tom, it’s like I’ll start and others can answer. First thing, again we were attempting to respond to yours and other analyst questions around, can you give us some rules of thumb and I would emphasize our valuation model and the interaction between our valuation model and the investment portfolio is way too complicated to be brought down to three number for God sake. But the – what we are trying to communicate here is if you look at 30-year U.S. rates, those are, if you go and take one point, that would be the.

Tom MacKinnon – BMO Capital Markets

US government rates

Mike Bell

We will start with the 30-year government rates and we’ll talk about spreads, but you just look at the 30-year government rates in the U.S., that would be a good starting point and if for argument sake, the 30-year U.S. government declined, say by, God forbid 100 basis points again, the and U.S. and spreads stayed the same, so that meant that corporate A spreads, for example, were down 100 basis points.

And no other changes, which is a big caveat. We would expect a $2.2 billion, yet now again it’s not that pure Canada had some impact, Asia had some impact, the 10-year bond had some impact, but that really after our actions that we took in the third quarter, that’s the most powerful factor. Now, the point that we’re also making here is that if all rates dropped 100 points but we saw, a 50-point rise in spreads, that in fact would be, that would mitigate some of that $2.2 and hence the importance of 0.6 for the – and again I would tend to look at the 30-year bond spreads, although again 10-year bonds spreads are also important.

And then lastly we are now longer even from a swap perspective, so a drop in swap spreads helps us, widening in swap spreads hurts us because we’ve got a fair amount of those assets now on the books. Again, let me see if the investment guys would want to add anything to that.

Tom MacKinnon - BMO Capital Markets

Okay, and the swap spreads you are defining as?

Mike Bell

Spreads over government sign on swaps inter bank slots.

Tom MacKinnon - BMO Capital Markets

And what was the government rate.

Mike Bell

Yes.

Tom MacKinnon - BMO Capital Markets

For 30 years, is that…?

Donald Guloien

Operating duration.

Tom MacKinnon - BMO Capital Markets

Okay, alright. Thanks very much.

Mike Bell

I guess the other point that you should know that I think Mike mentioned about the shape of the year curve is very relevant the way that we position the portfolio and as a lot of people know there is some steepening going on. So we will be taking advantage of that, we are taking advantage of that.

Operator

Thank you. The next question is from Andre-Philippe Hardy from RBC Capital Markets, please go ahead.

Andre-Philippe Hardy - RBC Capital Markets

Slight clarification in Tom’s questions, when you talk about the returns on the non-fixed income assets, I would think of them as future expected returns thinking of the risk-free rate plus an appropriate risk premium, which would suggest that there is a real risk of these assts, seeing a lower expected return going forward givens what’s happened in recent years, is that a fair assumption?

Mike Bell

Well Andre, I’m not going to tell you that it’s without risk. The good new is if we look at the past five years, which has not exactly been a positive environment, this asset class in aggregate for us has exceed the long-term assumption, but again I am cognizant and would not hesitate though to point out that the future has all sorts of uncertainties, but we like the diversification and we like the risk for trade off.

Donald Guloien

I think it’s important to note that this is a portfolio, in many cases that we’ve been in 20, 30, 40, 50 years, some of these asset classes, the assets that we selected are what I would characterize as core, we managed and most of the management is executed by local teams that help ensure we have a good understanding of what’s going on in the marketplace.

And again, I think most of our assets have external marks put on by independent third parties, our real estate appraisals are done by third-party appraisal firms. In this most recent quarter, we had appraisal gains on both our Canadian and US, properties coming in from our third-party appraisers on the basis that we had very strong leasing and occupancy rate, so.

Donald Guloien

Yes, but you can describe, I guess in future economics, everything is described as risk free rate plus something, right depending on the asset class, which is not a bad way of looking at it to start with. The more important thing is the correlations between them and as Warren and Mike have pointed out, these things aren’t uncorrelated, I mean some of those asset class is during the worst part of financial crisis were going up in value, others were going down in value, but by nowhere near the same rate that, high yield bonds or equities were going down. And is that diversification in lack of correlation anything less than perfect correlation is a prank.

Andre-Philippe Hardy - RBC Capital Markets

Thank you and the question that I had was around long-term care and price increase requests of 40% to 80% of the in-force. And also price that you are seeking price increases on 80% of the in-force and maybe it is a misunderstanding on my part, but I thought that the blocks that you had issues with were there legacy blocks if perhaps they were 80% of the in-force and that’s what’s happening, is that the case, or?

Mike Bell

Andre, I’ll start and see if Jim Boyle wants to add, it is the case that the 40% is not uniform across the book of business, it is the case that the over blocks have tended to have the worse experience, the over blocks therefore on average are getting larger increases. Also remember Andre, that over the last several years, we have been steadily increasing new business prices. And so we are in an environment rate now, where our new business prices are materially above the average in-force rates.

And as a result, the business that we’ve written more recently in many cases needs either zero or small rate increases. The other point I would make is that just reiterating on my prepared remarks, we are offering policyholders, the option to a record benefit plan reductions as a way of mitigating those rate increases. So again, we think that’s another tool that will be useful in terms of executing on this. Jim you want to add?

Jim Boyle

No Mike, I think you summarized it correctly Mike 40% is clearly in average. The experience that we saw through our actuarial studies after 2004, when we put in some more scientific underwriting as the rest of the industry did we cogged in that screening and others. The results are much better and therefore the increases would be much lower than that average. But to your basic question, the 80% is largely the business that was written pre-2004.

Andre-Philippe Hardy - RBC Capital Markets

Okay, thank you. That clarifies, thanks.

Operator

Thank you. The next question is from Michael Goldberg from Desjardins Securities. Please go ahead.

Michael Goldberg – Desjardins Securities

Thank you. How you redeploy the proceeds from the sales of bonds and equities backing surplus that you discussed? Is there any change in your investment mix on assets backing surplus? And also, is there any change that you foresee in the investment mix and assets backing liabilities, given your concern of the interest rates staying lower for longer than you thought previously?

Mike Bell

Yes, Michael, it’s Mike. I’ll start and ask the others to add. The first, on your question on the surplus assets, the most important thing here is that, we harvested the gains that we had on the surplus funds on a large chunk of the surplus funds. And then we turned around and reinvested those proceeds into even longer bonds with a longer duration, in many cases, 30 year treasuries. And there are a couple of interesting points there.

One is that, we recollected the gains, but we have really only very modest impact, less than $10 million a quarter on a go forward basis in terms of lower IOS. Because as Donald mentioned earlier, the yield curve is so steep right now that being able to go out longer on the curve enables us to preserve the yield, even though we sold the bonds that were above the original book value. So the answer there is we lengthened the surplus bonds with those proceeds.

In terms of the liabilities, a couple of pieces there. On the liabilities, we also lengthened the duration pretty significantly both in the cash markets as well as through derivatives. We did as noted in the slides, we did take on $4.5 billion to $5 billion of additional forward starting swaps that also lengthen the duration of the liabilities. Scott or Warren you want to add?

Scott Hartz

Sure. Michael what I would suggest is that in surplus, we’re currently moving to higher quality more liquid mix, but longer. And as Michael said, those sort of offset each other with the steep yield curve you get a lot more yield for going out long, but we’re losing a little yield because we’re moving to higher quality more liquid.

In the liabilities I would say not so much the case. I think that the mix is intended to stay the same in the shortest-term. We do, we did move into treasures in order to get the duration we are looking for and then the intent and hope would be to roll that in to more corporate going forward, which would create the opportunities for trading gains going forward.

Warren Thomson

And where you would see that is, if you look at our assets mix as at the end of Q3, about 20% of our assets are now in government bonds on an in total basis. And the government bonds are in liability segments. They are a temporary hold, until we find appropriate corporate and that’s when we trade out of those governments in the corporate, that’s what gives rise to trading gains in our source of earnings analysis.

Michael Goldberg – Desjardins Securities

Thank you.

Operator

Thank you. The next question is from Darko Mihelic from Cormark Securities. Please go ahead.

Darko Mihelic – Cormark Securities

Hi, actually a couple of questions. The first is, if we can look at the source of earnings and the expected profit on in-force, can you just walk me through the big quarter-over-quarter junk? And how much was to think of that, all is equal, is that a good run rate for expected profit in-force, going forward?

Mike Bell

Darko, it’s Mike, I’ll start. In terms of the interest of the source of earnings, a couple things there are important. First of all, obviously it bounces around quarter-to-quarter. But I think if you look over the long-term pattern, the most important thing is that, their strategy is working. We’ve been growing the business that we want to grow, that give rise to a greater earnings at lower risk. And again that particularly shows up if you look at the currency adjusted expected profit on in-force.

Now in terms of your question on, is it a good run rate going forward? Again it will bounce around quarter-to-quarter. So again I would not get carried away as on any given quarters of results, but if you were to ask is that a reasonable expectation for the next four quarters on average, I’m not aware of anything today in either the Q3 results or in the outlook that would make that an unreasonable expectation.

Darko Mihelic – Cormark Securities

And maybe just another question on related with S&P put your ratings in watch for - with negative implications. Can you - is that matter or should we care, question maybe for Donald, but should we care about that and what is Manulife’s response to that?

Donald Guloien

We care, but I think S&P responded to the earnings number for the quarter and also there is a goodwill charge. I mean, the way we look at it, we have strengthened our reserve enormously and I think we have improved our claim paying ability the actions that we’ve taken in the quarter. By taking the stronger reserves, but also substantial repositioning of the business. I mean, the goodwill is a direct reflection of what’s going on in the economy and the substantial repositioning that we’ve taken in the business to reduce the risk profile on a current basis and going forward.

When Mike talked about the improvement in the adjusted earnings from operations, that’s coming from price increases. Price increases on products and the elimination of strain. That happens as a result of that and it shows up pretty quickly under the Canadian GAAP basis.

It’s quite appropriate. So, that repositioning is painful in terms of writing-off goodwill, but that’s a positive repositioning for the business going forward. And I spent a lot of my life reading credits and I would give a credit improvement for that nor that credit downgrade. But S&P have their own methodology. We respect them a great deal and they haven’t made up their mind and as indicated by what they’ve done so, we’ll be talking to them. We’ve adopted revised targets for hedging both interest rates and equities. We get the sense that investors are fatigue with interest rate and equity sensitivity.

And while we still want to be very much market dependent, Mike said, we’re not going to be market dependent. We are going to be market dependent, but we’re not solely going to be market dependent, we’ve adopted minimums, time-based minimums that we will fall. So that our investors and rating agencies and others who look at us, have comfort that we will get to the targets within four years, that they aren’t just a pipe dream. The goal is to have hedges that 60% of our earning sensitivity will be from equities will be decreased by 2002 and going to ‘12, and 75% by the end of 2014, a very, very substantial.

The underlying strength and quality of the US franchise remain high. The goodwill write-down again it’s a function of interest rates and it’s a function that repositioning the business. But we’re very committed to the business. Again, the adjusted earnings from operation is up 72%, and it wasn’t just up 72% from the prior quarter, the same approximately, order of magnitude against the first quarter and the quarter before that.

And there is no reason why that run rate would be expected to go down as Michael said. So, that’s a very, very substantial improvement in that business. And when I talk about the mutual fund sales, the mutual fund sales actually hurt earnings in the first year because of the way the acquisition costs are treated, not capitalized. So that’s actually been a hurt to earnings. But I defy anybody to sell $8 billion of mutual funds and feel bad about it, because the gift that keeps on giving as long as you keep the money and performance is good, which our performance is good.

So, the goodwill impairment has not impacted the regulatory capital, at least does not impact our earnings capability and in fact, the very things that gave rise to the goodwill impairment are things that are reducing our risk going forward and improving earnings going forward and you would think when you’re doing a credit judgment that that would put a figure pretty significantly in your mind.

So I guess the last thing I’d say is, just having the skim of the Standard & Poor’s release, I would draw your attention to the many positives outlined in the S&P press release. We’re growing our strong competitive position capitalization all the nice things they say about out investment risk, they are essentially acknowledging that the strategy of a blend and then if I and other assets keeps this out of the riskiest end of the fixed income spectrum, which is frankly where all of the real debacle occurred in the meltdown and we came through that as well as anybody. We’re very proud of it. It’s nice to see S&P recognized it. But our goal we should have amongst the highest ratings. Unfortunately, some of the decisions we’ve taken have not led to that results and we will get them back on track.

Darko Mihelic – Cormark Securities

But does the rating decrease hurts your business?

Donald Guloien

Well, if S&P were to decrease our ratings, it certainly doesn’t reflect the quality of Manulife that we think and that annoys our distributors, but we would be in line with other companies, other pretty good companies, is just that we believe we’re, we deserve to be a notch above and we’re a proud company and yes it would hurt some portion of the business, but I don’t think it would be that significant. But the fact the matter is, the rating should reflect the quality of the company and the quality of Manulife should be reflected by higher ratings and we have at present than lower than we have at present.

Darko Mihelic – Cormark Securities

So in other words, you wouldn’t do anything to project that rating balance sheet wise in other words?

Donald Guloien

No, we don’t manage our company for the quarter-to-quarter earnings. We don’t manage it for the quarter-to-quarter stock price and we don’t manage it for the quarter-to-quarter rates. We manage it for the long-term. We’re taking these decisions for the long term. They’re clearly in the long-term health of the business and that’s the way we’re going to run it. And lots of people entitled to the opinion, but we’re going to run it for the long-term in keeping with our strategic plan, we’re doing the right stuff.

And again, the actions that we’re taking that give rise to that goodwill write-off that is alarming to people. The $1 billion I don’t like that number, but the actions that we’re taking that give rise to that are actions to reduce risk, produce more stable earnings and a higher ROE for the long-term of this business and it’s not a pipe dream as indicated by everything we talked about the results are coming in this quarter.

Darko Mihelic – Cormark Securities

Okay, thanks very much.

Operator

Thank you. The next question is from Steve Theriault from Banc of America/Merrill Lynch. Please go ahead.

Steve Theriault – Banc of America/Merrill Lynch

Thanks very much. I just want to talk a bit about the hedging initiatives. Don, you pushed back pretty consistently from the idea of crystallizing some of the non-cash charges that have come true over the last couple of years. And we talked about the why and I appreciate a lot of the explanation.

But a couple of questions. In terms of the book value, how much potential notional book value upside do you think you are giving up as a result of the hedging initiatives? And can you talk a bit about the cost of employing the equity market and rate strategies that you described to us today or is it more of a question related to opportunity cost?

Donald Guloien

It’s mostly a question of opportunity cost. I think Deb [ph] has talked and she is here you can prefer to talk about some of the average cost we are hedging and so on, which we have not had any terrible surprises there. It has been consistent with what we viewed so far. We are going to be taking some different approaches putting on macro hedges, not necessarily with the interest rate laid associated with it, which is a little different approach. Again, not expected to cost more in percentage basis over time I think you are right; the way to look at it is in terms of opportunity cost if markets go up. And if you look at our equity or interest rate sensitivities, you can see the upside and the downside there.

Our goal is to eliminate as little of the upside as possible and I think we’ve acted consistent with that. We hedged $15 billion in the first quarter when equity markets were high. We didn’t hedge anything in the second quarter. In the third quarter, we did a little bit, $3.3 billion and this quarter we are at it again, given that markets are up above 20% from the lows of the summer, I think you should anticipate an acceleration of our hedging activity, because as I’ve said to investors we’re not going to hedge it at the bottom, we’re trying to get it out now, that equity markets are up, that’s in the interest of shareholders.

But we are also saying and again, I’ll be honest, some of our shareholders are getting fatigued and saying, “gosh, if markets stay flat or go lower, we won’t proceed on any hedging,” so we are introducing time-based triggers that basically forces us to meet targets. But the essence of it, we’ll still have a very opportunistic overlay, so you can expect the markets to stay where they are, more hedging in this quarter.

Steve Theriault – Banc of America

But on the rate side, you don’t view some of the interest rate hedging actions as necessarily locking in reserves?

Donald Guloien

Well, there is two things. What happens is when the actuaries put pads on the low rates and project the low rates for [Inaudible], an impact on the financial statement that is frankly I think, exaggerated relative to the economic impact, but given that impact capital and earnings, it gets to a level where you can’t tolerate it anymore, and that’s frankly what happened in the second quarter we said as we look to the third quarter, some of the basis changes lengthen our liabilities.

With rates going down, you got the conjoined impact of lengthening liabilities and lower rates, so that creates a rather dramatic effect. But we said we can’t let this thing go unconstrained. I mean, most of the people in the room would believe over the fullness of time interest rates will go back to normal levels.

But it looks like it’s going to be a longer period of time than anyone thought. I mean, the quantitative easing that’s taken place and continues for awhile. And so rates are going to be lower for awhile, plus you have to have a stop-loss eventually on everything. So we’re not embarrassed to be limiting the total exposure that we have and gradually over time getting it back in line.

I guess the thing that a lot of people overlook as they focused on earning sensitivity is the economic sensitivity. In Manulife, we always had a posture in the surplus segment to go fairly long in our fixed income investments. It’s interesting that just about everything we have here is mark-to-market for capital and earnings and other things. But what’s not mark-to-market for capital purposes and earnings purposes is our surplus bonds. So as rates were going down and we’re taking it on the chin in terms of the reserves, huge gains were being built up in the surplus portfolio.

We decided to trigger those gains to get regulatory capital credit, which is legitimate, right thing to do. The aberration was the fact that we didn’t get any credit for that before, so we triggered the gains and what we’ve done is reload it with the bond so that if interest rates actually go down further, we will generate more gains. And if those of you who observed our interest rate sensitivity and looked at it on an economic basis versus a earnings basis, you would have observed that the economic basis the risk was lower, and that’s why, because the surplus was a natural offset, not a perfect offset, I would like to say it was, but it was an offset to the direction of the – on the liability portfolios.

Steve Theriault – Banc of America

Okay, thanks for that. If I’m, one more question, if I might, just on the numbers question on the equity sensitivity, the target of having 60% of the underlying sensitivity hedged. So I’m trying to do a little work reverse engineering the math here. Would that imply that all else being equal, the $1.3 billion of sensitivity with 10% equity market decline drops to somewhere in the range of $700 million assuming no new business. If not, is there a way that I can think of that in terms of, in dollar terms?

Mike Bell

I bet single indeed you got it right on.

Steve Theriault – Banc of America

Okay.

Donald Guloien

To the accuracy displayed by her fingers, she had seven fingers up when you said that, so congratulations.

Steve Theriault – Banc of America

Thanks Don, I’ll leave it there.

Operator

Thank you. The next question is from Doug Young from TD Newcrest, please go ahead.

Doug Young – TD Newcrest

Hi, good afternoon. Just, I guess, a few questions. First one, I don’t know if it’s for Jim or for Michael. Just around the long-term care business and the reserve charge you took. Obviously, you’ve explained it in the release that it’s very dependent upon what your assumption is of what you get of 40% at average price increase and the timing of that and I am wondering if you can give us a sense of what you assumed in your model, is it 75% of that, 40% increase and over what timeframe and I think you’ve assumed it’s all implemented next year.

And the second part of the question is if you get 10%, let’s say, less than what you are assuming or if you have to wait another year before full implementation, can you give us a sense of what that means in terms of additional charges that you may have to take and I have a follow-up as well.

Mike Bell

Okay, Doug, its Mike. Just by way of background. There continues to be obviously uncertainty around this area, so we are getting more cognizant of the risk that you are pointing to here. We did go through a detailed analysis to come up with our best estimate of the timing of the regulatory approvals as well as exactly what will get approved. Now, and as you will know, under C GAAP, we actually have to add a provision for adverse deviation on top of that.

And we did all of that with the benefit of the experience we’ve seen from others and also help that we got from our outside actuary consultant who had a fair amount of data. So again, all in, the reserves accounting on $3 billion of additional in-force rate increases, the $3 billion being a pre-tax number, but I would really prefer at this point not to disclose the specific timing and percentage assumptions other than that. Again, we will certainly keep you updated as experience emerges. I mean, again, fair to say it’s going to take some time but I’d rather not go through that detail at this point.

Doug Young – TD Newcrest

I guess, I mean, the reason I ask is that we’ve gone through your filing in Pennsylvania loan and looked at the data and it, looks like you are asking for upwards of 90% increases in certain instances, which seems unlikely immediately, but maybe you are not assuming that you are going to get immediately 90% in Phase X. So we’re trying to get a sense of that, any additional color in that would be helpful?

Mike Bell

Yes, again, it’s fair to say Dough, that we’re not assuming that we are going to get it day one. So I mean we are not assuming that the minute the filing hits the department, it’s all set. But again, I just really prefer not to dig into the additional details at this point. Fair to say what we will continue to give you updates on future quarters as experience emerges.

Donald Guloien

I would like Jim to get in, but that’s clearly note worthy, Doug, I mean there are numbers that are that high, but anyway I’m going to pass over to Jim, but that’s not at all representative.

Jim Boyle

Yes Doug, I understand your desire for a number and an ability to model the sensitivity, but frankly there is a lot going on here. We just saw a significant election in the United States where more than 50% of the governors turned over and it’s likely we’ll have new insurance commissioners in many of those jurisdictions.

We are very comfortable with the actuary of analysis, now there is a process, very scripted process that you go through with the states. We’ve been through this before, I think you will recall in 2007, we had an in-force rate increase, it was less significant, it was closer to 15%. We had to make a lot of the same judgments around timing, effectiveness, et cetera. We’ve executed on or better than that plan in 2007.

And one of the key components that was mentioned in the prepared remarks was the fact that although we are filing for these rate increases, and your right in some cases it could be as high as 90%, that would be an outlier. In each case, we will offer the clients an ability to reduce their benefit and in most cases, products that had a 5% annual inflation feature, for example, if we can offer a client the ability depending on the product series and type, if you go to 4% or 3% and have virtually no rate increase whatsoever.

And our experiences then, more than 50% of the clients will opt for a benefit reduction, particularly understanding the slow interest rate environment we are in. So this is going to take more than a year, that’s built into our modeling here. There is a lot to play out here, because there will be a lot of new players, but the fact support this rate increase and we are not an outlier here. There is others in the industry that are dealing with the same math and so I think it would just be more prudent for us to continue give you updates on a quarterly basis as we learn more, but as of today we are quite comfortable in our assumptions, our methodology and our approach here.

Doug Young – TD Newcrest

Okay, and then just second on the slide 16, talking of those now spread widening or the impact from spread widening and so forth, and I know at the end of Q2, there was a discussion that spreads would no longer have an impact and I think as a result of a lot of changes that happened in Q3, spreads do have an impact, but I guess I’m a little confused about that and so if you can give some sense of why now we are looking at spreads again, because I just thought spreads were going to be created down to the long-term average after 20 years.

Mike Bell

Sure. Doug, it’s Mike. I’ll start and ask Cindy [ph] if she wants to add. First, when we talked about spreads not having an impact at Q2, the reason for that is that we had capped spreads in recognition that we were going to be moving to this graded approach, so we didn’t want to be in a position when spreads widened in Q2 to take a bunch of benefit from that only to then turn around and reverse it at Q3.

We’ve now moved to the methodology that says for corporate spreads we are going to grade over a five-year period from the current spreads to the long-term averages. So by the time we are starting to model, cash flows that are going to be coming in, six years from now, seven years from now, we are going to be looking at long-term average spreads rather than our current spreads.

The 20-year grading that I think you’re referencing is the grading to the ultimate reinvestment rate. So we do assume that throughout the 20-year period, we are investing a greater proportion of cash flow that gets invested in bonds, a greater proportion in government bonds over that period and by the time we get to 20 years, we are assuming that all of our positive cash flows that are being invested in fixed income investments are in fact being invested in government bonds at the ultimate reinvestment rate.

That URR, that ultimate reinvestment rate is subject to additional recessions [ph] in the future, because it’s a mechanical weighted average formula and if rates continue to stay down, that rolling average of formula will continue to drift down. So they are really two different issues, but with the methodology that we’ve implemented, grading the five-year spreads says that if spreads bump up tomorrow, we get a benefit from that because we’ll grade off for five years, but we’ll get a really benefit from that for cash flows invested in the next five years. Cindy, you want to add?.

Cindy Forbe

No, you answered the question well.

Doug Young – TD Newcrest

Now that helps a lot, just a last number question, what is your URR assumption now?

Mike Bell

Let’s say believe Cindy can correct me here. I believe the long bond rate is now 4% in the U.S. and 3.8% in Canada.

Cindy Forbe

You’re correct.

Doug Young – TD Newcrest

Thank you.

Operator

Thank you. The next question is from Robert Sedran from CIBC, please go ahead.

Robert Sedran – CIBC

Hi, good afternoon, just a couple of quick follow-ups. I know, you don’t want to and for a good reason, I guess, tell us what the probability that you have assigned on some of these long-term GAAP price increases, but you have to disclose it to the regulator when you make the application?

Donald Guloien

No Robert, we do not.

Robert Sedran – CIBC

Okay. Just following-up on the adjusted earnings from operations, Mike there is a lot of items on that slide 8, I know a shorthand that has worked in the past, its not working so well today, it’s basically zero out assumption changes and experience gain and then just apply a normal tax rate, and that approach would actually get me considerably below the 779. So, is there something in those two lines that is sort of a recurring or part of normalized earnings? How should I think about that?

Mike Bell

Well, let’s see. Robert, there are a number of different issues. Currency can play some havoc with that. We’ve now got the, there are lot of moving parts around, interest rates and equity markets. We’ve got for example, the investment gains for the realized capital gains for the surplus funds, we’ve got investment gains from the change in the mix for the assets backing the liabilities. Again, there are just a number of different issues that are impacting those numbers. The adjusted earnings from operation is calculated consistently with the definition that we defined back at the beginning of July here in 2009.

So we’ve kept that definition as consistent as possible. But I think there are other moving parts that are playing havoc with that.

Robert Sedran – CIBC

So some of those items that are on slide eight may well be in expected profit or earnings on surplus or somewhere else as well, in other words?

Mike Bell

It’s probably worth having some discussion offline, to talk about some of the geography issues, but…

Robert Sedran – CIBC

Okay. And just very quickly lastly, I gathered the full $2 billion in new holdco debt that was downstream during the quarter. Can you tell us how much of the $5 billion in long-term debt on the balance sheet might be sitting in MLI as equity?

Donald Guloien

Try assume, most of it is.

Mike Bell

Yes, Robert the vast bulk of it. Okay, it’s literally not every penny, but the vast bulk of it.

Robert Sedran – CIBC

Okay. Thank you.

Operator

Thank you. The next question is from Mario Mendonca from Canaccord Genuity. Please go ahead.

Mario Mendonca – Canaccord Genuity

Good afternoon. In previous calls, when the idea that the company might be a little more aggressive in hedging equity markets or interest rate exposure, when that was proposed, there was a sense of almost fatality to it that it would result in very significant charges, it would affect your expected profit going forward, you might have to raise capital. Those are some of the things that were brought up.

This quarter, has sort of a feeling that something for nothing to it. There’s a lot of hedging that you’re proposing that you’ve done and will do, but yes, when you talk about your expected profit going forward or your normalized earnings or core earnings going forward, doesn’t it sound like there’s much of an effect that you’re suggesting? Am I misreading it? Is there much of an effect going forward?

Donald Guloien

Well yes, there is an effect Mario. The big difference in, you’re one of the smartest guys out there. So I apologize if it sounds too basic, but it is where our equity markets are, and we’ve seen a huge move in equity markets since July. And we’re going to take advantage of that. The other thing that is associated with it is, and we’re going to be managing interest sensitivity on both course, but it’s a secondary. This is a little bit more tricky. And then there is many different approaches to hedging.

The one that we have been using up to now is been dynamic hedging, which is a fancy word for shorting the futures and since that gives rise to a certain amount of interest rate sensitivity in the settlements you basically put on a swap to take away some of that interest rate sensitivity. When interest rates are low, swap rates are low, particularly, that makes that more expensive to do.

And so what we’re looking on is macro hedges, which is like a macro call, like CIO saying, I just want to lessen my exposure overall to equity markets, not related to any individual policy or any group of policies, any cohort of policies, it can be equity risk giving rise from fees on mutual funds, fees on variable annuities or even balance sheet holdings of equities. But I want to reduce my equity risk, you put that on basically by shorting futures, there is less of an interest component embedded in it.

And in a situation like now, where equity markets have gone up, but swap rates are low, I am not sure it makes a lot of sense to put on the swap leg. So maybe we just short the future which is, called in the parlance of macro hedge.

And that’s probably more of what we’re likely we will be doing in the short-term. Although, the stuff that we did today was the more conventional dynamic hedging because of the level that these, the cohort of products was at we can put on the swap and even at the low swap rates should be effective.

Mike Bell

So Mario, it’s Mike just to add a couple of additional factoids. First, as we have talked about before, a reasonable rule of thumb, for the dynamic hedging that we have been doing in the last year and a half is that every billion dollars of guaranteed value that we have been hedging, when it’s pretty close to add the money under the dynamic hedging approach. That cost us approximately 50 basis points after-tax in earnings going forward.

So, as an example the $26 billion of in-force now that we’ve hedged since June 30th of 2009 would cost us $130 million of after-tax earnings going forward. That’s the rule of thumb we’ve given you in the past and that continues to be a reasonable one.

I think the point that Donald is making and if I got to add here, it should like is that as we look at different approaches to accelerate that hedging, including possibly going to a macro hedge kind of approach, we may have to update that 50 basis points. Again we are evaluating a number of different options and we’ll be back. But every indication is it’s roughly, I mean, if it’s 52 or 48, we are not going to go over, but and that actually depends on the circumstances roughly in line with the same. The other I’ve heard say that people sometime and this is, we are ahead of our hedging targets, right. At the end of the first quarter, we were 18 months ahead of the glide path that we had established for ourselves.

We’ve never been behind to that, you go a quarter, when the markets were down like the second quarter, everybody panic that’s going to continue forever. I will make a very simple point, but a subtlety that seems to get lost, is that if you told me with perfect certainty that the equity market was going to be same in four years from now, the level of the S&P the same as it was today.

I would take you a huge bet that at some point along that path is higher and another point it’s going to be lower. Because inherent volatility and where you’re going to take advantage of those swings and go aggressively in when the markets are a little higher as they’re now and pullback as we did in the second quarter when markets are lower. And that’s 100% shareholders’ interest, sometimes the rating agencies get annoyed with that approach, but it’s a good approach.

On the other hand, some of our investors say, and I want some certainty that you get to the endpoint and so what we’re also sort of committing to, is a time-based minimum to be measured on a progress basis on the to-date basis, not to say that every quarter we will have to do some hedging, but we are going to measure ourselves against the time base and make that we’re always ahead of that the vector, described by that. So our investors can have comfort that by the end of the four years, we will meet those targets, come hell or high water but we are going to opportunistic about the rate at which we progress in any given quarter. That makes any sense?

Mario Mendonca – Canaccord Genuity

Yes. So if I could take the six month stuff rather than, if you were to reduce your equity market sensitivity to 60% by the end of 2012, what would that imply? What will the effect to be on your expected profit from where it stands today?

Mike Bell

Bev, why don’t you answer that?

Beverly Margolian

Probably about, perhaps a $100 million.

Mario Mendonca – Canaccord Genuity

Additional

Beverly Margolian

Additional.

Mike Bell

Additional to what you would done to-date.

Don Guloien

Although getting very importantly Mario, that will depend upon exactly what tools we use, where markets are at the time. So again, we’ll give you further updates on that.

Mike Bell

I just wanted to, I need to say one other thing. That doesn’t mean I need to correct the answer that I gave Darko that is obviously something that would impact the run rate on expected profit from in-force, that I wasn’t thinking about when I answered his question, I assumed his question was not including the impact of the hedging. So just a clarification there for Mario for you and Darko.

Mario Mendonca – Canaccord Genuity

That $100 million you’re referring to that on an annual basis, pretax on your expected profit from going to 60%.

Don Guloien

Importantly, that would be after-tax.

Mario Mendonca – Canaccord Genuity

After-tax

Don Guloien

And again that would be the equivalent if you will of the drag we would expect from hedging $20 billion of guaranteed value at the money. And again, there are lot of moving parts that would impact that what that ultimately is.

Mario Mendonca – Canaccord Genuity

And I’m sorry, if…

Beverly Margolian

And it looks like that that $100 million is, there is a range around and that we can’t predict exactly what it will be. So, it could be higher, it could lower depending on when we actually hedge all along the way. So that is in the range.

Mario Mendonca – Canaccord Genuity

And we’re trying to do those get a sense for, like these are cost to everything, if there wasn’t a cost, so that she would have done this ages ago so?

Don Guloien

The biggest cost Mario and I think we’ve been clear, Bev estimated before, I can ‘t remember exactly what the number was, but the full task of getting to our target at the end, people asked about it, what she underlined importantly that assumes that we are doing sort of have the money for whatever, the timing when we execute. But the biggest cost is the opportunity cost of putting on the hedges too early.

I mean, if you do the math, there were a lot of people around in May and June of 2009 saying hedge is a stuff, get it behind you. We didn’t do that. We took a lot of pain. We had to cut our dividend. We have to raise equity and so on. We’ve paying billions by deferring to this time and we have a really good plan and we’re going to follow it.

Mario Mendonca – Canaccord Genuity

And all I’m trying to do is just to understand the numbers. I’m not pointing on whether it was a good call or bad call or anything. $100 million after-tax over a full year to get to that 60% target, and then to get to the 75% target I believe. Bev would that be say another 100 on top of that?

Beverly Margolian

It would probably be another 150 after that. But it’s a range, and you know what we depend I mean it could be another 100 to 200 because really depends on what markets are at when we do that and what swap rates are when we go there and what’s happened in between with the volume of our business. So it’s a quite a range.

Mario Mendonca – Canaccord Genuity

Yeah, no I appreciate that and then maybe finally question for you.

Don Guloien

Mario, could you ask me some good questions? The other thing that would happen and as we put it for instance now using dynamic hedging with low swap rates, we would take a earnings charge in addition to what Bev described, which is the on going run rate, you do have an upfront earnings charge. And no offsetting credit on the capital for hedging at this time. So we wouldn’t view that is necessarily the right thing to do.

Mario Mendonca – Canaccord Genuity

Right, so I just want to follow-on to something for nothing kind of idea, because I don’t believe that that’s what you’re actually saying I think.

Don Guloien

No, no, not at all.

Mario Mendonca – Canaccord Genuity

When you take trigger gains in your AFS book to reduce the effects of declining interest rates. Is it fair to say that that those are gains now that just they’re on they’re used, you can’t use them again. So are you giving up some future earnings in your earnings on surplus as a result?

Mike Bell

Well Mario, it’s Mike. It obviously depends upon how we reinvest those proceeds. As I mentioned on one of the earlier answers, we win longer with the reinvested proceeds and therefore, it was really a de minimis impact on overall interest on surplus expectations going forward. So again, that’s not always going to be the case. What we view is being the more permanent ongoing item is this is a natural hedge, a natural partial hedge to the interest rate sensitivity that we have on the liabilities, naturally be the main point.

Mario Mendonca – Canaccord Genuity

Mike, I understand the interest argument that you are using there. What I am referring to is, as you said yourself, AFS is not mark-to-market. So once you have marked it by selling it, those unrealized gains are now realized, so they’re gone forever, is that true?

Michael Bell

Yes, yes, I think that’s a fair comment Mario.

Mario Mendonca – Canaccord Genuity

Okay, then…

Donald Guloien

They weren’t Mario, just as everybody understands. I think you got it, but there is other people on the call. The gain was never finding it’s way to the capital calculation, it was a bigger gain than many companies would have. There is a whole story there about why it wasn’t mark-to-market historically. But that big gain is there. It’s not we are not getting any capital credit for it whatsoever.

So it’s a latent item. We’re making it a real item, but then we are also reinvesting in long bonds into surplus, so we are reloading because the yield curve is now so steep, the carry difference between writing the old bonds that were obviously had a higher coupons and the new bonds being reinvested because of the steepness of the yield curve. There is not as much give on the carry as one would assume.

And when we get, people talked about contingency plans on our last call, what are your contingency plans, if the interest rate go lower? Well, we had a multiple of things that we could do and this was highly palatable alternative.

Mario Mendonca – Canaccord Genuity

I totally got it. Finally Donald, a final question then. Now that the company is taking, it would appear some of the downside risk off the table and probably a good thing investors are sort of reacting to it I think positively. Does this change your perspective on what Manulife’s long-term ROE capabilities are?

Don Guloien

Well, it will be to improve Manulife’s long-term ROE capabilities and let me be clear here, not through the goodwill write-downs.

Mario Mendonca – Canaccord Genuity

I know, I know that.

Donald Guloien

We’re not that kind of people that take credit for lowering the denominator. But yes, what we’re trying to do, you will be able to see this is very transparent in what we are doing. Again timing is very essential here. And we are taking the risk off at the most appropriate times. So, no I don’t think it diminishes the ROE potential. In fact, we are enhancing the ROE potentials through the other changes that we are making to the business mix as evidenced by the all of our comments on the growth and the adjusted earnings from operations. We’ve been dedicated to and it’s a pretty simple story, but we’ve executed well as a couple of things.

Number one, we recognized that we wouldn’t be able to control equity markets and interest rates and how they profited our income statement. So we want to focus on growing earnings unadjusted or adjusted for those factors. Grow the corns, if you will, as aggressive as you can.

The second thing we want to do is to make sure that we’re shifting our capital allocation to products that have the highest ROE potential and the lowest relative risk potential. And we’re doing that, and we’re doing it incredibly successfully. And if we keep doing those things and opportunistically hedge away some of the other risks, we will end up with a more stable income stream than before, a higher ROE than before and a very nice earnings growth.

And so far, we’re executing.

Mario Mendonca – Canaccord Genuity

Thank you very much.

Operator

Thank you. The next question is from Colin Devine from Citi Group, please go ahead.

Colin Devine – Citi Group

Good afternoon. I have a couple questions. I guess, first on just to be very clear with S&P’s action, because certainly it seems to me that you replaced the capital pretty quickly that the company lost on the second quarter, that if it comes to a downgrade you’re not prepared to raise common equity to avoid that. I think everybody will feel better getting that clarified.

Second, with respect to, if I look at the long-term [Inaudible] line and I’m trying to understand exactly what has gone on there over the past year. And I’m looking at how much the assets backing that line are up. Is the bulk of what’s been, I don’t know, almost a 50% increase? How much of that is coming from reserve adds?

And then finally, with respect to interest rates, if I look at the hedging you’re doing this quarter finally, is it fair to conclude that Manulife has worked out that it’s in fact perhaps more sensitive to interest rates than it is to equity markets?

Donald Guloien

Well, let’s see, we had a series there. The first one is easy to deal with. S&P didn’t ask us to raise equity, it didn’t suggest it, at least to my knowledge. Any discussions I had with them and they knew what the answer would be. We don’t intend to do that, we don’t think this is necessary. Again, let’s be clear, this whole interest rate thing is a mark-to-market and these are very long liabilities.

And if you believe that rates will eventually go back to more normal levels and quantitative easing will stop, which we have to believe if you believe in the future of the global economy. It’s not going to be a long-term problem, but under Canadian GAAP, we’re mark-to-market and people have reacted to that.

And so we understand it, but it is the mark-to-market. The same is true, the liabilities don’t come due, I think on average for something like 15 years, the earliest that comes due is Japan block in seven years. Again, very substantial reserves decide that the odds are that markets will go up and that will make profit on those businesses, but we got a very heavy mark-to-market on those businesses and indicative of our comparison between U.S. GAAP and Canadian GAAP, a much more heavy mark on Canadian GAAP than it would be true on U.S. GAAP.

So those things, I think waiting ease is not react to that, but that’s not the thing that you go and raise equity for unless you really get up above the wall. And then as we said in our last call, and I have indicated in this quarter and other quarters, we do have other things that we can pursue, to restore capital position if we found it necessary.

The other thing is again the opportunistic hedging is going to reduce the sensitivity of those things. The relativity, Colin, it depends on what happens, right? As rates go lower due to convexity, the interest rate sensitivity goes up. And as equity markets go lower, there is something comparable that occurs there. So it depends on what situation is. If rates went back up, you would find our interest rate sensitivity diminishes quite a bit. And if equity markets go up our equity sensitivity, it all depends on what happens, but I think the most important thing to remember is both of them are mark-to-markets.

Colin Devine – Citi Group

And Don, I guess, two points we need to clarify. One, where the annuities do not have a maturity, there is a benefit, it’s started by the age of the policy holder as to when they can use it. So it’s not a question at five years or six years or seven years, it’s when they get the age and I think frankly you misspoke, because once if they do start systematical trials, then you’re looking at a life annuity at that point.

The second thing, while you took great credit earlier that you did not hedge the equity exposure when the markets were down and that has made Manulife billions, I guess, it seems to me that the decision not to hedge declining interest rates, such as some of your peers did, whether it’s Sun Life or Met by in-force, why wouldn’t I conclude that that has cost Manulife billions looking at the losses over the past year. Why is that an unfair conclusion?

Donald Guloien

Well I think it’s fair to say that interest rates fell more than, I guess, a lot of people expected, people who bought force, I think did really well with those force. Again, it’s a mark-to-market, Colin, I mean. But [Inaudible] there is a lot of things you could have done, that’s a fair comment. But it is what it is and we’re dealing with it and we are very comfortable with a certain amount of interest rate risk, again with a view, but people’s view of how long this thing is going to last has changed. Our views certainly has, and the end of the day you can have all kinds of bets on that work, but if the bet goes against you, the obligation is to close off the bet at some time, not to take unlimited amount of risk and that’s what we are doing.

Colin Devine – Citi Group

You are questioned with selling the bonds out of the corporate surplus and I certainly appreciate why you did that, but why hasn’t that been extended to your real estate properties. I would assume the same rationale would hold and frankly as I look at Manulife seems to be really the last major North American life company to have a significant owned real estate portfolio, it’s hard, I just have a tough time believing that your liabilities are so different versus everybody else’s.

Donald Guloien

Well, everybody might not be as capable of managing real estate. Colin, if you look at the…

Colin Devine – Citi Group

You’re a life company, Don. With all due respect, you’re not a real estate company, you are a life insurance company.

Donald Guloien

We manage real estate as well as anybody, but if I call that the minor point, the more major point is…

Colin Devine – Citi Group

The $6 billion portfolio is not.

Donald Guloien

Okay, Colin, just let me finish. The more major point is I defy the name of company, any sizable company that’s performed better on the general account assets than we have, and the reason for that is the highly diversified portfolio.

Colin Devine – Citi Group

Again I guess MetLife has, I’ll tell you right now, so it’s true frankly so but I guess what you agree to disagree.

Donald Guloien

Well Colin, I think you have to look at not net unrealized losses but gross unrealized losses, right? The fact that interest rates have gone down don’t necessary skate you onside with strength of credit problems. And I’m not speaking of either one of those companies specifically, but I think you have to look at that. If I’ve a got a bond that’s worth 50% of par despite the fact that interest rates have come down, I have got another bond, that’s a government bond, that’s worth 120% of par, just because interest rates have gone down, adding the two together to say I have got a net gain is hardly informative to anybody. I think you understand what I am saying there. Our portfolio is read the S&P analysis very well, and those are real estate, a funny thing happened during the recession, the tenants kept paying.

So it kept the yield up on those assets and they are mark-to-market. They are mark-to-market on a rolling basis. So Colin, if we sold them, there wouldn’t be a big staggering gain because they actually are mark-to-market right now. And that’s why we actually took some losses, very minor losses relative to the size of the portfolio on real estate last year when the mark-to-markets were in the negative direction. It’s coming back now. In fact, we tried to buy real estate at those prices. So we like real estate as a part of a highly diversified portfolio. Warren, you want to...

Warren Thomson

No, I think you captured all the key points there, Donald. I think the key point is the real estate is in fact mark-to-market whereas the surplus bonds were not. We had to sell them to realize the gains.

Operator

Thank you. The next question is from Peter Routledge from National Bank Financial. Please go ahead.

Peter Routledge - National Bank Financial

Hi, good day. I’ll be quick, I know it’s kind of late. Just on the assumption changes. There’s $2.8 billion pretax this year, $1.9 billion last year, and it kind of provokes the question is it over? And I guess the area of concern to that have been at Universal Life where by your own actions increasing the price 13%, which tend to suggest there may be some latent reserve risk. And I wonder if you could comment on that and could you put any, or could you quantify any potential risk, say, a percent of liabilities backing Universal Life Policies. Thanks.

Mike Bell

Peter, it’s Mike. I’ll start and I’ll let Cindy to add. On your specific question on Universal Life, the increases there have been primarily due to the drop in interest rates. And so I would not conclude that there is some correlation between the UL price increases and incoming basis change. Other than the second order impact that we mentioned and that’s the ultimate impact on the ultimate reinvestment rate, which in some sense has some correlation.

But other than that, we’re not aware of anything at this point on the Universal Life block and I wouldn’t try to correlate it to the rate increases. On your more general question, again we’ve got a huge balance sheet. And it’s very complicated portfolio of products that we have actuarial liabilities set up. So it’s not surprising that in any given year there are going to be changes in those assumptions that get leveraged because these are long duration liabilities.

The long-term care is the obvious one that has the uncertainty for all the reasons that Jim Boyle described a few minutes ago. That’s the one we’ll provide updates as we have them, whether that ends up being a positive or a negative is impossible to tell at this point. We’ve given our absolute best shot including that independent review.

Cindy, anything you want to add?

Cindy Forbes

That’s a good answer Mike. Just, I guess, one thing to add is for Universal Life the, price increases are on new business and they are related to the fall in interest rates in turns what we’d be investing new, to start a new business. So no issues with respect to mortality or that sort of issue on the, or lapses on the, in-force businesses.

Peter Routledge – National Bank Financial

There is certainly some, let’s call it risky pricing order, risk rating practices in that product line, industry ride over the last couple of years. And this feels like what we went through with long-term care over the last couple of years. So it’s actually that you can’t really rule that out?

Paul Rooney

It’s Paul Rooney here, Jim might want to time in as well. You are correct, there were some practices in the marketplace, I think you’re referring to underwriting practices are aggressive cable waiting programs. We did not, participate in those in Canada.

Peter Routledge – National Bank Financial

Not in Canada, but in the US. Did you or did you not?

Jim Boyle

No, I don’t think that you’re going to the emergence of issues that you’re describing in your question. Frankly, this quarter we had to claims gains in our U.S. Life Insurance business. We did see some lapse losses in the early duration in the last couple of years, but we believe that was a bit of anomaly driven by the economy. We’ve priced this product with very low assets, 1.5% grading down to less than 0.5% overtime. So we’re pretty comfortable with the in-force luck.

Paul Rooney

I’ll say the same for Canada.

Peter Routledge – National Bank Financial

That’s it. Thanks.

Anthony Ostler

Very well, thank you operator. We will available after call if there are any follow-up questions. Have a good afternoon everyone.

Operator

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

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