Great-West Lifeco's (GWLIF) CEO Paul Mahon on Q2 2016 Results - Earnings Call Transcript

| About: Great-West Lifeco, (GWLIF)

Great-West Lifeco, Inc. (OTCPK:GWLIF) Q2 2016 Earnings Conference Call August 4, 2016 10:00 AM ET

Executives

Paul Mahon – President & CEO

Garry MacNicholas – EVP & CFO

Arshil Jamal – President & COO, Europe

Bob Reynolds – President & CEO, Great-West Lifeco US

Mark Corbett – CIO

Dave Johnston – President and COO, Canada

Analysts

Gabriel Duchaine – Canaccord Genuity

Peter Routledge – National Bank Financial

Doug Young – Desjardins Capital Markets

Tom MacKinnon – BMO Capital Markets

Sumit Malhotra – Scotia Capital

Mario Mendonca – TD Securities

Darko Mihelic – RBC Capital Markets

Operator

Good morning, ladies and gentlemen, welcome to the Great-West Lifeco Inc.'s Second Quarter of 2016 Conference Call. I would now like to turn the meeting over to Mr. Paul Mahon. Please go ahead, Mr. Mahon.

Paul Mahon

Thank you, Louise. Good morning to all participants and welcome to Great-West Lifeco's second quarter 2016 conference call. I'm joined today by Garry MacNicholas, Executive Vice President and Chief Financial Officer; Bob Reynolds, President and Chief Executive Officer of Great-West Lifeco US; Arshil Jamal, President and Chief Operating Officer, Europe; Mark Corbett, Lifeco's Chief Investment Officer; and Dave Johnston, President and Chief Operating Officer, Canada.

I would note that this is Dave's last analyst call as he transitions leadership of the Canadian operations to his successor Stefan Kristjanson, and I want to recognize Dave for his important contribution to our companies for over 38 years and in particular his leadership of our Canadian operations over the last three years. There are a number of other senior officers available on the call to respond to specific questions as required. I'll review the highlights of Lifeco's second quarter results, including headlines for our Canadian, US and European business operations and Garry MacNicholas will then provide a more detailed financial review.

And after our prepared remarks, we'll open the line to questions. Before I start, I'll draw your attention to our cautionary notes regarding forward-looking information and non-IFRS financial measures on slide 2. These cautionary notes will apply to the discussions you'll hear today as well as to the presentation material that we've provided to you online. Turning to slide 4, this is really our first analyst call since Lifeco's Investor Day in June and I want to thank those of you who participated.

We look forward to spending more time with investors in the coming months, as we expand our Investor Relations efforts. During the Investor Day presentation, we talked about common themes across our businesses, including discipline and expertise and our insurance operations, the breadth of our asset management businesses globally, the strengths of our retirement platforms and our investments in technology and innovation to better meet customer needs and the health advisors be more productive.

Success for us will be driven by leveraging these strengths and driving collaboration across our Group, and I think these strengths are quite evident in our progress this quarter. We extended our leadership position in Canada in Individual Insurance with application counts up 25%. In the US, the Empower integration is tracking well with over 8 million participants. We announced the closing of the Aviva Health acquisition in Ireland, positioning Irish Life as the leading player in the health insurance market in Ireland.

So as we turn to slide 5, I would note that we're making good progress notwithstanding a challenging external environment in recent months. These charts highlight volatility in the key market factors that impact our businesses. This includes a weakening of the pound sterling relative to the Canadian dollar. I would note volatile equity markets and although they recovered outside Europe, I would remind you that our fee income was driven by average market levels throughout the quarter and not quarter-end levels and also the continuing downward pressure on interest rates that is affecting all insurance companies. A key in this challenging environment is that we stay on top of pricing to ensure our margins remained strong and focus on building and delivering product strategies that will thrive regardless of the environment.

Turning to Slide 6 for a summary of our results. Last night, Lifeco reported its second quarter earnings and also declared a quarterly dividend on its common shares of $0.346 per share, and this was unchanged from the prior quarter. Quarter two earnings were CAD671 million and this was up 2% despite external challenges as I previously noted. I would also note that the result is a solid 8% improvement over a softer Q1. Our capital position remains strong with our MCCSR at 232%. The modest 4% decline from Q1 2015 is due to the impact of currency movements. And I would also note that this does not reflect CAD800 million in liquidity at the Lifeco holding company level.

Looking to sales on slide 7, our Canadian sales declined year-over-year, driven by lower wealth management results and this was consistent with the industry and down from the peak RFP season levels. This was partially offset by strength in our Individual Insurance sales and this is a benefit of our diverse channels and diverse product offerings in Canada. In recent quarters, our US sales have been bolstered by a number of mega plan sales at Empower and while we didn't see any large Empower sales in Q2, our pipeline remains very strong in that business.

I would also note that Putnam sales saw strong growth year-over-year, driven by institutional results. In Europe, a highlight was growth in our UK payout annuity sales and in particular an increase in retail where we continue to write new business with strong margins. In Ireland, sales growth was driven by strong Ireland sales results and strong Ireland net cash flows where we benefited from both the domestic Irish and international growth. Germany continues to see strong sales growth, benefiting from products that are well positioned in the Solvency II environment compared to traditional German competitors' guaranteed products.

Now, turning to expenses on slide 8, our overall expense growth year-over-year was just 3% on a constant currency basis and this really reflects a balance of investments in our businesses and continued operational expense discipline. Canadian expense growth moderated this quarter, reflecting a balance of continued investment in IT and digital services and good expense management.

US expense growth includes continued investment in Empower for both integration and platform enhancements. I would note that we expect the integration to be broadly complete by Q2 2017. These higher Empower expenses were mostly offset by lower variable expenses at Putnam.

And finally, lower European expense growth this quarter reflects the completion of the Irish integration and the close-off of most of our Solvency II project spend. Turning to slide 9, fee income, we would note that our fee income was steady year-over-year against the backdrop of volatile and on average lower equity markets.

Canadian and European markets declined significantly compared to a strong first half in 2015. While our various managers of strong domestic franchises they're invested assets are diverse with International Holdings. As such the income reflects market level changes across multiple regions. Our fee income is also driven by the mix of equity and fixed income. And with that backdrop, let's look at the segments.

Canadian fee income increased modestly, reflecting positive cash flows, which offset the impact of lower market levels. In the US, we've seen a decline in fees, primarily driven by lower retail mutual fund sales and net outflows.

And in Europe fee income growth reflected strong higher net cash flows which more than offset weaker offset values due to lower market levels. Turning to slide 10 I want to touch on Brexit because this is really been primary focus in the news and it's been focused globally. Well, the results of the referendum we are surprised to many, we were well prepared for this eventuality.

At our Investor Day, we talked about the range of scenarios we had considered in our preparations leading up to the vote and that even under extreme impacts we believe our capital position was very strong and our business model was resilient. Its early days at this stage but what has unfolded the date is a modest impact relative to the range of scenarios that we have tested.

Even with the uncertainty that will continue for some time, we're confident in the strength of our balance sheet and our businesses. Our assets and liabilities are well matched with assets that are high quality and well diversified. Property-related exposures have been a particular area of focus and we're well positioned with long leases and low LTVs. There is additional disclosure on our invested assets in the appendix to provide greater detail on this topic. It's also important to note that our UK business is a domestic one, in any passporting that we do into Europe we do out of Ireland. We're staying close to our customers and our people at this period of uncertainty. But I would note, that our businesses have continued to operate very smoothly. We obviously need to remain diligent in monitoring and responding. But at this stage, we're driving the business forward and we're seeing very sound results,

I would close the slide by noting that we've seen two opportunities emerging out of Brexit. Firstly, we're seeing UK clients seeking security in gaurenteed products like payout annuities, where we are well positioned to serve their needs. And secondly, should the situation arise where companies shift their operations to Ireland, we would be very well positioned to leverage our dominant market position there across the range of corporate and retail customer solutions. I'll close out on slide 11 with my comments by taking a moment to remind you of three areas of focus that we shared at Investor Day. We have a goal to grow both organically and through our M&A and we've touched on that, on this slide. Our ongoing investments in innovation and customer experience are key to our growth going forward and we continue to invest. In our drive to increase collaboration across our geographic platforms. in particular, in asset management, is providing good gains for us.

I'm now going to turn the call over to Garry for a few moments to review Lifeco's financial results. Garry?

Garry MacNicholas

Thank you, Paul. Starting with slide 13, operating earnings in the first quarter were CAD671 million or CAD0.675 per share, versus CAD0.66 a year ago. Earnings this quarter, up 2% year-over-year in a challenging market environment. Canada's earnings were up 6% from the second quarter of 2015 in spite of lower average markets, notably the TSX, which pressured fee income. Strong yield enhancement results and the sale of our property more than offset lower wealth management earnings.

We were pleased to see continuing improvement in group long-term disability results, which are increasingly benefiting from the rate increases being implemented. In the US earnings were down from the prior year quarter primarily as Putnam. Putnam fee income declined due to lower asset levels, particularly in mutual funds and lower average market levels only partially offset by lower variable costs. At Empower, favorable investment results were offset by higher operating expenses due to business growth. As the number of participants has grown from 7.3 million last year to over 8 million just in the last 12 months. Europe's operating earnings of CAD293 million remained strong with a higher contribution from basis changes this quarter offsetting adverse impairment charges on the insolvency of UK retailer, VHF and annuity new business gains and longevity experience also contributed favorably. And I would echo Paul's comments regarding Brexit, very little direct impact in the earnings results this quarter. Our liabilities are backed by the well-matched high-quality diversified investment portfolios. The vote with the resulting currency moves came late in June and didn't have much impact as currency translation is at average rates for the quarter. [indiscernible] sterling is lower today than earlier this year, R&D the latter part of 2015. So that may be a factor weighing on earnings, if it persists.

Turning to slide 14. As a reminder, the Source of Earnings category above the line are shown pretax. I'd like to highlight the few specific areas starting with net income before tax and that's in the middle of the page. Year-over-year this is up 2% in line with post-tax earnings, but the results show a strong bounce back from a softer Q1, up over CAD100 million or 15% sequentially. That increase from last quarter came in a number of areas. A higher contribution from basis changes, lower new business strain reflecting better pricing margins and improved experienced gains including Canada group long-term disability results, which we've done a CAD10 million this quarter. Going back to the topline Lifeco's year-over-year expected profit decreased CAD46 million from 2015. Europe was steady at 5% increase but the US and Canada were both lower. In the US this is largely due to business mix and lower starting asset levels of which was down CAD35 million and an expected profit from Q2 2015.

In Canada the decline was CAD27 million, again impacted by lower starting asset levels compared to those heading into Q2 2015 and recalling Canadian markets in particular were quite elevated levels in the early part of 2015. In addition, there were lower expectations for group disability business profits given our recent experience and recognizing the time it takes for our collective pricing actions to take hold and contribute fully. I just hope the declines we expected from in Q1 was largely currency movement.

New business strain improved to CAD44 million as volume and pricing improvements in UK pay annuities and German pension products more than offset an increase in non-deferrable sales costs at Empower. Experienced gains and changes in assumptions again contributed to the bottom line this quarter and were a significant source of the improvement from Q1 results. Experience gains of CAD49 million are higher than recent quarters, but lower compared to last year and longer-term averages. This was in large part due to an experienced loss of CAD26 million in Europe and again these are pre-tax. Europe results were adversely impacted by CAD34 million on the impairment and loss of yield on four mortgage loans as a result of the insolvency of UK retailer BHS British Home Stores earlier in the quarter.

Beyond that more unusual one-time hit, we had good longevity experience in Europe and trading gains contributed very strongly in Canada. Market impacts were a net small negative in period relative to expectations at the start of the quarter.

Assumption updates resulted in release of CAD129 million this quarter compared to CAD54 million last quarter and CAD90 million last year. The release this quarter is primarily related to refinements made to asset default models in the Europe segment.

The earnings on surplus of CAD25 million is CAD22 million higher than last year due to a gain on the sale of real estate in Canada and gains on seed capital investments relative to loss of last year. Turning to slide 15, Lifeco's uncommitted cash position remained strong at just over CAD800 million.

Our book value per share was CAD19.04, up 4% from Q2 2015 but has declined in 2016 as the Canadian dollar has strengthened against the US and particularly being sterling since the start of the year.

Return on equity was 14%, reflecting the impact of currency on average equity and earnings in this quarter higher compared to Q2 2015. ROE continued to be strong in Canada and Europe. The 6.1% return in the US is a combination of 11.7% ROE agreements was financial and closer to zero at Putnam reflecting the earnings structures and after as described earlier, driven by lower AUM and therefore lower fee income.

And finally on slide 16, we show our assets under administration, which grew 3%, primarily impacted by sales activity and currency. Paul, that concludes my remarks.

Paul Mahon

Thanks very much, Garry. Before we open up the line to questions, I want to take a few moments to sum up the quarter. Overall I would say our diversification of businesses led to a satisfactory quarter given market headwinds and they were significant market headwinds.

For Putnam we remain focused on reaching scale in a challenging environment. And we continue to invest in and remain confident in the strategic direction and growth prospects, which we shared at our June 7, Investor Day. So that concludes our formal remarks and I will now turn the line over to Louise, our operator, so we can get some get set up for questions. Thanks.

Question-and-Answer Session

Operator

[Operator Instructions] The first question is from Gabriel Duchaine of Canaccord Genuity.

Gabriel Duchaine

Hi, just a quick question on the tax rate. Seemed low this quarter, can you give me some details on any one-time items in the tax line this quarter? I know you had some last quarter, so

Paul Mahon

Yes. Thanks, Gabriel, I'll turn that one to Garry, you can provide a little color.

Garry MacNicholas

Sure. The tax rate just between 10%, 11% this quarter, so quite similar to the same quarter last year. A lot of that is driven by our earnings which are increasingly in the Europe segment, which generally speaking those jurisdictions have lower tax rate. So, that is driving the averages down just on a going forward basis and a lower contribution from the US, which is our highest tax jurisdictions. So. that's one factor that sort of in the background in recent quarters. We did have a couple of older tax issues cleared up from prior tax years. I think we've had a number of those over quarters, that's not unusual as we set up provisions when issues first arise generally on a cautious and more conservative basis and then as we resolve these older issues, there's often contribution to the bottom line.

Gabriel Duchaine

How much were those recoveries?

Garry MacNicholas

This quarter would have contributed about 4% to the tax, reducing the tax rate.

Gabriel Duchaine

Great. Okay, great, thanks. Now, I just want to dive into the UK property fair value adjustment and then the offsetting the reserve release I guess. And then I guess, so for first of all, the impairment loss of four mortgages has nothing to do with the 3.5% mark on your property portfolio.

Paul Mahon

I'll start out with that one Gabriel. No, that's nothing that happens to be a retailer that has been under some pressure for a number of years.

Gabriel Duchaine

Okay.

Paul Mahon

And so, nothing to do with the retail portfolio those were actually mortgages, the retail property portfolio I'm going to let Gary get into the details on this, but those are assets that are backing policy holder liabilities. So, that under strong assets with good cash flow. So I'll let Gary kind of get into the mechanics of that.

Gabriel Duchaine

Really the 3.5%, I'm wondering where that mark kind of comes from? I know some other companies have done 10% to 15%, but this might be because you don't have as much exposure to Central London and that's a good thing in this case, is that correct?

Paul Mahon

Yes, as a general rule, we've got quite a good diversified rent roll and diversified portfolio. So we've got our relative balance of exposure to Central London. At the end of the day, it's going to be a function of your book of assets and it's going to be a function of those markets, Arshil, anything you'd add?

Arshil Jamal

No, I just emphasize that the on balance sheet property assets that we have are all income producing. They're all subject to underlying tenants with long leases in place, so the relatively modest impact on the price I think with plus those defensive characteristics in the portfolio is no development within the on balance sheet portfolio, and we are significantly underweight London and we're significantly underweight office. So I think it's – those characteristics that got us comfortable with the 3.5% fair value

Gabriel Duchaine

That makes sense. So that high-end now into the reserve release or you look at the Europe segment you have management actions or reserve release of positive CAD110 million or something like that, so that would imply a net or a growth reserve release of CAD200 million, so CAD200 million minus the CAD 100 million mark on the real estate sorry you kept CAD100 million.

Paul Mahon

Here we get into the actuarial impact of that adjustments in the pricing. Yes, I think it's important to separate into two items. First of all our, it just a quick reminder that the actuarial approaching Canada depends on cash flows, it's a cash flow growth. So to the extent and I think articulate this the cash flows on these properties are not impacted and it's very similar to a bond portfolio, just market values go up and down, there's an automatic adjustment in the liability going up and down with, its own a fair value basis. So unless the cash flows are impacted. It doesn't impact reserves. It's not a reserve release or it's not just an impact.

Garry MacNicholas

Just to clarify asset values down in our present liabilities down 3.5% and that has no impact, no reserve release backing any of that, that's just normal come..

Paul Mahon

And that's because of the cash flows that are associated with the properties haven't changed. So there is no impact on the reserves, so the second one was that the reserve release, it was related to modeling of asset default provisions and we had a an older model, we moved to a more refined model that really reflects the duration of our assets and we had an older more conservative levelized approach and as we move to the new model, which we have in a number of our segments over the last year or so it produce separately. So again, unrelated to the property moves, just related to modeling update for asset defaults.

Gabriel Duchaine

So there was no – okay, the property there is an offsetting liability reduction under the calm methodology and then I guess the gross reserve release this quarter is something over CAD100 million pretax like CAD129 million, I guess is the number?

Garry MacNicholas

Yes, pretax.

Gabriel Duchaine

Okay. But when you do that, your – those are PFADs you're releasing, so your future expected profit aren't going to – they're not going to come to expect profit in the future. Correct?

Garry MacNicholas

This would actually be a combination of our best estimate and our PFADs and in terms of that. So it's not all PFADs.

Gabriel Duchaine

Okay, thank you. I got a follow-up on group in Canada, but I'll re-queue.

Paul Mahon

Good, thank you.

Operator

Next question is from Peter Routledge of National Bank.

Peter Routledge

Thanks, just a quick follow-up on the property. At what point would you have to impair your investments in UK property and take a loss to earnings?

Paul Mahon

Have to think about that, it would be when the cash flows will be impacted really.

Garry MacNicholas

It's when the cash flows. If we felt that's, our cash flows that associated probably a combination of the leases and then the residual values of the property. And these are very long leases, so the residual values are some ways off. And so it would be related to either an impairment to the lease cash flows. If this somewhere probably got a very low vacancy rate well book and ….

Peter Routledge

You need details of your lessees basically.

Paul Mahon

Default to lessees [indiscernible] significant change in our view of residual values many years from now.

Garry MacNicholas

A default of – provided with a replacement wouldn't have an impact. So, It's only sorry last and we could replace the rental income cash flows so directly related to tenants but and in a number of situations we would be very confident that even if the tenant can't the underlying property and the level of market rents. In some cases, we actually might see uptick because the level of rents that are currently in place are lower than the market rents and at default of a tenant might give us an opportunity, I don't think that would happen in any case , every case, but I wanted to highlight that that was sort of a two-way potential exposure. So

Peter Routledge

Yes, it's basically a big bad recession in the UK and that might be a problem. Okay. Slide 14, just I guess a question for Gary and I've noticed it's not just in slide 14 but over the last several quarters, number persistent decline in its expected profit on in-force and in looking at it, it doesn't seem to be all currency, there seems to be other factors. I'm wondering you could talk to why we're seeing the just persistent kind of draw- down on expected profit and when that might turn around?

Garry MacNicholas

Okay. Certainly the last couple of quarters, one of the larger drivers and you'll see this is in the supplemental that we have the Putnam source of earnings shown there and certainly as assets under management have declined recently at Putnam, I think for a number of reason, the cash flows [indiscernible] plus market levels. There has been quite a period over period drop in the expected profit legacy numbers that were well in the 20's of drop down into minus level, minus nine, minus 12 last few quarters. So that's a big drop, and also I made reference earlier to the higher levels, particularly the CSX but in markets in the early part of 2015. So these higher levels when we're setting expected profits, we look at our funds under management in our wealth businesses across the Company at the start of each quarter. And so the market levels had really produced higher starting asset levels and therefore higher expected fee income in quarters in Q2 2015 and Q3, 2015 we had good starting levels going into those quarters. And then as we've come into the 2016, you're seeing a much lower level. So that's going to drive it. And the last one I'd note is that we have ourselves, we said we've recognized that recent experience in Group Ltd and we've lowered our expectations for a few quarters before our pricing actions take hold and as those pricing actions take hold we will revisit our expected profit on group.

Paul Mahon

Yes Peter maybe to summarize what Garry was saying is that each quarter we set an expected profit expectations. This is not a linear number that we set at the beginning of the year. This is looking at the prevailing conditions in terms of the markets. It's looking at where we're at in terms of, for example our pricing recovery on the Group Ltd. So at the end of the day this expected profit was our expectation going into the quarter. And as markets recover or as we continue to see the benefit of pricing impact on group will see those expected profits coming back.

Peter Routledge

Again, so you said the expectation at the start of the quarter and then that's what you show at the end and then you've got experience gains and losses.

Garry MacNicholas

Exactly, yes.

Peter Routledge

That's clear, thanks.

Operator

Next question is from Doug Young of Desjardins Capital Markets.

Doug Young

Garry, just maybe a few number questions. The tax rate, I think before you'd guided to something in the high teens, should we be looking at something more in the 15%, 16% range. And then, another just on that I think there was a sale of a property in Canada wonder if you could quantify what that added and where which line did that go through and then I have a follow-up.

Paul Mahon

Okay. to take those the on the tax agreement, when you say the high teens, I think we've said mid to high teens in the past and based on the current mix of earnings is probably closer to the mid. So your estimates aren't too far of there just on that again mixing the Europe and the US earnings how they blend in lowering the overall Canadian rate. So that's one, the impact of the pre-tax impact on that sale of the property in Canada was about CAD25 million and that would show up in the earnings on surplus line. That was held in our surplus account in Canada.

Doug Young

And that's a CAD25 million of pre-tax number.

Paul Mahon

That's a pretax number.

Doug Young

Okay. And then I just thinking, with Canada wanted to dig into those big group long-term disability experience and I know that it improved sequentially in year-over-year. Are you in positive territory or is it just still negative, it's just better than it was last year and how far through are you now in terms of the actions you have taken to rectify the issue in that business?

Paul Mahon

I'll start on that question and then I'm going to turn that to - to give will more color. We are absolutely in positive territory. The reality is, we view of the LTV book is highly possible important book growth critically important for our customers. And you know it's a been good contribute over time, but it is a cyclical benefit in a sense be cyclical with the economic environment and employment levels and things like that. So it's a good contributor. And I would say at this stage, we've been re-pricing quite frequently on group not only to address the impact of claims levels, but also the prevailing interest rate, so they can provide a little bit of color in terms of when we've done our pricing increases and how those will cure into future results

Garry MacNicholas

Thanks Paul. On the interest rate issue, that's generally downward trend has been going on for quite a number of years, so we've had a rate increases to reflect that we are going back five years for sure at different points in time. The more specific issue to for the last few quarters has been on the morbidity side and in particular, our non-refund LTD result which is, I characterized that as sort of a mid-market segment results. Our small market has been quite well performing and the large it's somewhat volatile, but nothing out of the ordinary from past year. So it's been that mid-market what we call non-refund LTD. And I did mention in prior calls, the loss on that in Q4 was, these are before tax, CAD17.5 million. Q1 was CAD12.5 million and Q2 was about CAD6 million before tax gain. So the trend, the trend is definitely improving. I would say where we're maybe halfway through our pricing actions. This is yearly renewable business. So we still have further renewals to execute on over the balance of this year. And so I would expect that we will continue to execute on those rate increases. But to date, we seem to be seeing an improving trend in its following our expectation.

But it's going to be over the next year, is the reality. It will continue to with our expectation would be is to continue to try to have the impact of those and that those renewal rates were put in place and then the premium rates to get up to full form after about 12 month prior with that plan.

Doug Young

And you're seeing no impact on your the retention of your business as a result of this, essentially the market moving in the same direction as you are?

Dave Johnston

I would say that the impact on our retention in that mid-market has been quite marginal and our retention there would be 91% and maybe it's 90.5% or 90%. So it's a very marginal change. We did expect some slight deterioration. Actually it's better than our expectations but it's been very slight.

Doug Young

Thank you very much.

Garry MacNicholas

The important context there too, Dave, is typically you will tend to see the deterioration happen with clients, maybe where we were having some more challenges. So the net impact on your overall earnings is going to be also modified that would.

Doug Young

Thank you very much.

Garry MacNicholas

Thank you.

Operator

The next question is from Tom MacKinnon of BMO Capital

Tom MacKinnon

Yes, thanks very much. Morning. Just a couple of questions with respect to Empower. First, Garry, you talked about non-deferrable sales cost going up at Empower. I'm just wondering if you might be able to quantify what the non-verbal sales costs are at Empower and how they've been trending. And just a couple other follow-ups with respect to Empower.

Garry MacNicholas

Okay. The non-deferrable cost, this is moving from insurance-type contracts to investment contracts where you don't have the same deferral of upfront cost. So with Empower, it's more their mix is on the investment contracts, so you're using that rather than the allowable acquisition under the reserves and that's been a trend. I think this quarter, each quarter the amounts are in the, I think the move this quarter was in the CAD10 million range just from memory moving relative to the prior quarter. So it's enough for the magnitude.

Paul Mahon

Yes and the important thing to notice that so therefore you're covering that cost upfront and you're not going to have the drive, I guess the business growth into the future. So we're talking about the timing issue as opposed to a profitable ..

Garry MacNicholas

Yes, this is what we've internally reproduced is good change.

Tom MacKinnon

What's the absolute value of it though in the quarter? The change is CAD10 million, but what is the absolute value?

Paul Mahon

I'd have to have a quick check for the absolute value, we can get back on that.

Tom MacKinnon

Would it be safe to say it's the commission's?

Paul Mahon

I mean the absolute value of the strain in the US is CAD30 million of which I think CAD8 million was Putnam and then the CAD22 million is in [indiscernible] individual markets.

Tom MacKinnon

Okay.

Paul Mahon

But in that sort of magnitude of total strains, but at the end of the day it's the upfront acquisition costs, so that's going to be whether the cost put it on the books in your commissions and the fact that you can refer that in the same way you took with an insurance contract.

Tom MacKinnon

That's right, now the Empower sales I understand that can be lumpy, especially if you get into some of the larger cases, but maybe you can give a little bit of color as to what happened in the quarter here and what you see in the pipeline?

Paul Mahon

Okay, just as a general rule we saw very, very large cases coming through. We saw in particular a year ago there was a key account that came through. So it is lumpy, Bob can speak to the, the sales pipeline that we Empower, Bob?

Bob Reynolds

Yes, just to reiterate what Paul said, the second quarter last year we have made major client as we call it with CAD2.8 billion which was dominate. We had a very big first quarter this year, second quarter, there was not a major client, but the pipeline is, looks very, very good and looking the other with next three, six, nine months.

Tom MacKinnon

So what kind of growth do you think we should put on sales for Empower going forward?

Paul Mahon

We look to grow 800,000 around participants a year, that's sort of the target, but I think again, you hit on it right, it is lumpy and the sales process is up to the plan sponsor and usually the integration takes depending upon size of plan can take anywhere from three months to a year. The other thing I'd note, Bob, is that we've also got a very diversified book of business. We're big in the public, non-profit. We like the core market, small case market. Mega is great and we want to grow mega, but we're focused on all those markets and the other reality is that when we win a mega client, typically that transition that moving them on to our system, that's the complex process. So it takes time. So it's lumpy. But it's good business.

Garry MacNicholas

Yes. I would also add that the business we bought from JPMorgan completed seven Waves, we have four left. Those numbers are already in our numbers for participants and plans. So even though there a tremendous amount of work going on to bring those clients over already in the numbers.

Paul Mahon

So this is all organic growth that we're referring to.

Garry MacNicholas

Yeah.

Tom MacKinnon

Okay, thank you.

Paul Mahon

Welcome. Okay.

Operator

The next question is from Sumit Malhotra of Scotia Capital.

Sumit Malhotra

Thanks, good morning. Just to follow up on Empower, maybe get a better understanding on what drives the income statement for this business. So, I certainly hear you that sales can be lumpy, and we saw a lower number this quarter. But the last three quarters you had very strong sales momentum and it doesn't seem to that quickly make its way into the earnings of this business, which this quarter were one of the lowest levels we've seen in the past couple of years. Can you help me think that through? I understand when you book the sale, there is going to be some upfront costs, but I thought you would then subsequently begin to profit in the run rate numbers and it doesn't seem like that's the case, what am I missing here?

Paul Mahon

So I'm going to start by you don't for a little bit of color on the dynamic we have going here. This business is – to understand a fee-income business, but you've got a lot of it is a function of market levels. So as we see market levels decline or be flat, we're going to tend to see that occur is one of the issues that we're facing. The other reality is we're still in middle in the integration. So, we're carrying a fair bit of integration spend, plus we're continuing to build out the platform. As Bob said, there are waves of clients. We're still doing system modifications and upgrades and capability to actually support the remaining waves, but we will finish out into Q2 next year and then like any other business, you're going to have the other movements. Garry, I don't know if you had any other color on that or

Garry MacNicholas

Yes, just I did note some – you made the comment about the earnings being down, I think that's the US segment overall. Empower was more flat in the quarter. So I just made that comment. You want to make sure you've backed up the Putnam impact and because the Putnam earnings have been under pressure with the lower AUM.

Sumit Malhotra

Yes, just to be clear. So on page 38, when I look at your supplement, I think this says when I look at the Empower retirement page, that shows me $18 million in net earnings, US dollars. That's the clean number, right?

Garry MacNicholas

Yes. That's the one you want to be looking at, yes.

Sumit Malhotra

Okay. So I was talking sequentially, it's been moving lower despite the fact you've had those big sales numbers.

Garry MacNicholas

Our revenue up year-on-year. So I just want to make sure when you look at the right spot. On the second one I'd note, I think this is an important one is that it does take time. I think Bob alluded to it, it takes time to actually bring the case on board. So we've got the sales-related costs, but you have an initial and it's whether it's six months or whatever period it is bringing these large cases and we've had tremendous growth. While we are still doing integrated tremendous growth in new clients coming on board. So you have a higher expense growth in that early period when you're first betting down the client on your systems. So it's not just the sales cost at the time, but you do have a higher run rate in that early period.

Sumit Malhotra

Bob, you could speak [indiscernible] as the cash flows will come in.

Garry MacNicholas

Yes. When you're hired by a plan sponsor, there is no revenue till the plan goes live and usually, there is a body of work anywhere. As I mentioned three months to a year that Empower is involved in implementing that plan on to our system. During that period, there is no revenue on that client, but that's all based in a pricing of overall to that client. So revenue does not start till a client goes live on our system.

Paul Mahon

The expenses too.

Garry MacNicholas

Yes.

Sumit Malhotra

Look, we see that here. If I just look at your year-to-date numbers on that same page, clearly your revenue is up, has almost doubled on the back of the sales momentum, but I think from what you're telling me between the integration and some of the upfront cost, that's what's eating into the profitability of why we actually see a decline year-over-year.

Paul Mahon

Absolutely.

Sumit Malhotra

Alright. Second and last question, just to go back to the European segment, obviously a big source of your earnings power. Paul, in your opening remarks, you talked about how at least in the interim, you haven't seen a major impact on the business as a result of Brexit but just to play devil's advocate, the earnings were flatter or up very modestly year-over-year in Q2. And when we think about whether it's the macro factors like currency, bond yields, equity markets or even just economic activity in Europe or inflows into the region, why should we are you confident that this is still a growth business for GWO in the near term or should we be expecting Europe to have lower earnings than we've seen in the last year or so?

Paul Mahon

I look through our business, Europe is not the UK alone. As a matter of fact, Europe might not include the UK. So the reality is we're seeing good growth at Irish Life. We've just bet down the health transaction there, which is going to drive growth. We're seeing our German business grow and I think frankly when look at our businesses in the UK, two of the drivers, one is our group business, a lot of that is in the small and medium-sized case market where we have a really dominant share and we're not really seeing any impact there and we're seeing strong mortality, morbidity and we're actually seeing a lot of growth because of pension auto enrollment in the group business.

So that's where pension plans have to auto enroll as a function of legislation typically along with those pension plans, there is a life and potentially income production benefit sales. So we see a big pipeline of growth there and I don't think that's going to be based on that. This is a requirement that our companies are dealing with, when I look at the payout annuity business I do think clients are actually, there's a bit of a flight to security, but another important driver is the growth in assets that are going into retirement payout in the UK is very, very high growth and at our Investor Day, one of the things we talked about was the fact that we believed that the payout annuity market would be growing back to sort of historical levels over the next five years to seven years, or maybe 10 years. So I think you got two dynamics [indiscernible] natural growth of assets into that market, you have clients seeking the certainty of lifetime income, longevity protection, notwithstanding the low interest environment.

And you have probably a bit of instability; you're concerned about equity market volatility. So they're seeking the security of those products. So our businesses, and we don't have a huge exposure to equity market, that's not kind of what are the businesses we're in. We don't have a large asset management footprint there, so the businesses that are driving that profitability including a very strong, stable, I'll call it illiquid [indiscernible] annuity is strong and stable and remain that way and we're adding to it. So we don't in the near term other than the currency impact in terms of the translation of that earnings. We don't see an impact in the near term. You never say never. We don't know what the world will look like in three to five years. But we actually continue to like the business and we see it as a contributor. Anything else, Arshil?

Arshil Jamal

No, I think we're cautiously optimistic that we'll be able to drive growth given our mix of business given the market opportunities we have across all of the businesses in Europe and then I'd also add that our reinsurance business, which is also part of the Europe segment has also contributed very strongly. And I see lots of opportunity for us there as well. So we're appropriately cautious, but we are cautiously optimistic that we can drive growth from here.

Sumit Malhotra

Thank you for that robust answer.

Operator

The next question is from Mario Mendonca of TD Securities.

Mario Mendonca

Good morning. Maybe just a few quick-clean-up questions. Are there any UK either commercial mortgages or property reported in surplus that are actually available for sale securities were in surplus again.

Arshil Jamal

In the UK that is a immaterial amount. We have some properties in surplus in Europe, in the UK and Ireland. But that is almost exclusively head office properties so that properties that we have our own use or whatever. I think there might be one property in surplus that would be on a fair value basis without a liability of that.

Mario Mendonca

Any risk of an impairment there or is that first of all just not big enough to worry about?

Arshil Jamal

It is one of the offices that we partially occupied in the middle of the City of London it is fully – and in fact the rental income is going up. So, simply in the near term, it wouldn't be that, but.

Mario Mendonca

Okay. And sort of a related question, I think I've made mistakes in the past of looking at this exposure but certainly in the case of your sovereign exposures, way back of assuming that charges were inevitable. Could you help me sort of handicap this? Would it be, is it your view probably for Arshil Paul, that the odds of a charge related to this UK exposure are pretty minimal over the next few years.

Arshil Jamal

I mean if your question is about the UK sovereign our starting point is that in that home currencies at each of our business units Canadian dollar and the Canadian government in Canada, the US dollar and the US government in the US and the UK sterling and the UK government in the UK that the risk-free asset is the government bond and the returns and asset default provisions held that's the starting point to move off of that would be a very dramatic change within our framework.

Garry MacNicholas

Arshil, No, I wasn't so much talk, I was using the sovereign exposures, as an example of a time when I thought charges were coming and I'm referring to when we were all concerned about Portugal and Italy, I was just referring that as an example of where I may have got it wrong in the past. I'm still referring to the UK commercial mortgages and property here. The odds of charges there over the next few years are very minimal.

Paul Mahon

Yes. So I'm going to touch on the commercial mortgages and then I'm going to turn it to Mark. Our commercial mortgage book is diversified extremely low LTV. We give you some relative values, strong debt service coverage ratios. We don't have high concentrations in UK office, diversified geographically and by type.

So that is not something that we're sitting here to think about. We talked about the various scenarios that our risk area did pre-Brexit. We were looking at moderate, severe and extreme scenarios, and we have strength that was going to we think carry us regardless of whether those things landed. We're seeing moderate to date. Now who knows what the future will look at, but Mark, any more detail to provide some context?

Mark Corbett

Our mortgage book is very solid when you study the composition, it's low LTV across our entire UK block of business as well as the London block of business and in particular the office exposure which we're watching a little more closely. We have very minimal office exposure in the property segment as well. The core risk around the property is the residual value risk and as Garry mentioned that's more of a cash flow modeling risks and even with a 10% type potential adjustment on residual values, the potential impact is quite small when we model that out from a risk standpoint with Brexit.

Mario Mendonca

Okay. Now given the timing of the vote, it would be it was certainly this quarter, we wouldn't have seen much of an effect on institutional behavior, institutional sales, for example, frames and deposits. Is there anything you can point to that you've seen so far in Q3 that may be point to a change in behavior.

Garry MacNicholas

No, I mean as Paul indicated, we continue to update our pricing to be in line with interest rates, so the color that I'd add sort of post the quarter is that we've been regularly updating particularly our annuity prices as interest rates have continued to fall past June 30 and we're still continuing to see a good level of activity and good takeup. So we alluded to that in the introductory comments or whatever that we see the trends towards payout annuities and the growth there [indiscernible] continuing and there's nothing in the early days of the third quarter that would change that view.

Paul Mahon

And I'm not sure if you're referring to institutional behavior in terms of rental other people were looking at traits. At this stage there's been very few traits for example in the property market. But frankly they they've held up values had held up. And I go back to our LTV's that we provide in the in the appendix where you know our London office weighted average LTV is 55%. So we've got a very, very strong book. This is a very conservative book of mortgages that we have in place.

Mario Mendonca

And just to wrap it up then on premiums and deposits then. It seems like it's unlikely from where you're sitting today that we would see a significant change in premium deposits from your European business, when we look outside three months from now.

Paul Mahon

Yes, it's certainly over a three month horizon whatever its premiums and deposits are influenced on the group side by persistency on our back book and on the annuity side by the sales level. And then we also have our wealth management business and that has been quite lumpy, and we had some softness this quarter on the wealth management side. So absent the noise on wealth management, the core group insurance revenues as well as the PLD annuity sales team to beat doing just fine post June 30 and we'll report on that on the next quarter.

Garry MacNicholas

And premium deposits is been very the growth in consoled and continuing in Ireland and Germany. Germany has been a real standout for us in terms of growth there. Office small base but we, we really like our position there right now

Mario Mendonca

Great, Thank you, again.

Operator

Thank you, our next question is from follow up question from Gabriel Duchaine of Canaccord Genuity.

Gabriel Duchaine

Hi, just have a follow-up not on group insurance but on yield enhancement. So in the past, I believe you benefited a lot from moving out of guilt into other asset classes mainly real estate. I'm wondering if that was UK real estate was actually a big component of that yield enhancement strategy that is 65% your property portfolio. I'm not worried as much about the no market to market risk or anything like that, but there may be less yield enhancement potential for you in the future is that a consideration.

Arshil Jamal

Well, that real estate is a relatively small proportion of our overall asset mix and the historic real estate contribution to yield enhancement would have been quite modest or whatever that out that the vast majority of our past yield enhancement would have been moving from Gilts into other fixed-income assets, corporate bonds, publicly traded corporate bonds, private bonds, finance leases and commercial mortgages and that's been the predominant activity and that represents about 80% of the investments that we make to support our new payout annuity. So real estate type investments has always been on the order of 10% or 15% and that wasn't the large factor in yield enhancement.

Gabriel Duchaine

Okay. And was it yield enhancement within Europe, you weren't taking Gilts and buying Canadian real estate or was it mainly in-market kind of transaction?

Arshil Jamal

The vast majority of in markets and whenever anything is cross-border, it's absolutely currency hedged or whatever, so that we're matched to those local currency. I would add on yield on real estate that in the past, we would have had some modest positive contribution to experience gains as the underlying property values would have been increasing, we would have been increasing the residual values. And as rental rates would have gone up, and we extend leases or sign new reserves. All of that gets reflected on a regular basis in our cash flows and to the extent that this period would have included more or less cash flows than the prior period, that would come in as experience gains and as property values and rental income over the last three to five years in the UK would have been on a positive trend, each period, that would have modestly been contributing to experience gains and the investment performance that we had always highlighted which would have been the trading activity plus these improvements in cash flows.

Gabriel Duchaine

But again, Arshil, we are talking about on a weighted basis 10% to 15%.

Arshil Jamal

Absolutely.

Gabriel Duchaine

Right. So it was the UK and Europe business overall a big contributor to your experience gains in the past, like whether real estate or other asset classes.

Garry MacNicholas

No, the Europe business has contributed rightly to experience gains. A lot of them have been the yield enhancer. We've also had the good longevity results for quite a period. We've had some good results in Ireland [indiscernible]. So we've gotten a number of areas, but Europe has the minus 26 I think was unusual and as I mentioned earlier that had won a large one-time item in it and there was less yield enhancement the last three months. I think some of that activity was just a bit of a wait and see. But I'm sure the activity will resume to normal levels.

Gabriel Duchaine

Fair enough. The one-off this quarter, I can look through that, but I guess in the past, you've talked about yield enhancement not yield enhancement, experience gains broadly as a CAD75 million or more kind of run rate number. But with payout annuities still lower than they were in the past and maybe yield enhancement opportunities maybe a lot lower than what they have been in the past, at least in that region, that we're probably what we saw this quarter might be closer to what a new run rate could be for that item.

Paul Mahon

I'd just make a couple of comments. First, it is very difficult to predict a run rate for this. I think I would still characterize this as lower than our longer-term average and again, if I was even just doing a rough math of taking that BHS CAD34 million, I'd put it back in, you're now in the mid 80s and that's more in line with our longer-term average.

Gabriel Duchaine

Okay. Alright. Thanks.

Paul Mahon

Thank you.

Operator

[Operator Instructions] The next question is from Darko Mihelic of RBC Capital Markets.

Darko Mihelic

Hi, thank you. Most of my questions have been asked and answered. But Paul, just in your opening remarks, you mentioned that you needed to remain vigilant on pricing. And when I hear that, I often get concerned about strain. Is there something that we should be thinking about with low rates on a go-forward basis with respect to strain or maybe you could just elaborate a little bit on what you meant?

Paul Mahon

No, actually, you should take comfort in my comment, which is as interest rates are falling and we think about new business, if we have assumed too high return in the interest rates, we're going to have strains. So what we're doing is re-pricing to ensure that we've got the right interest rate assumption built into our new business pricing. Therefore, we're not going to take on what we would refer to as bad strain. Gary?

Garry MacNicholas

Yes. Just a note. If you look at the new business strain this quarter just as an example, in Canada, it's basically zero to CAD3 million negative. At the US, we've talked about earlier, that's a different type of strain, that's on investment contracts, both at Putnam and Empower which again I would characterize as a good strain as you're adding business and it's not got that same pricing issue per se. And then, in Europe, again very modest. We're seeing some growth there and some of that Europe strain. In fact, a good portion of that is going to be the Irish investment contracts, which again are having good sales. So, I think a lot of the strain we have right now we feel we're on proper pricing and a lot of our strain is coming through those investment contracts.

Darko Mihelic

Okay. I just wanted to make sure because it sounded almost like foreshadowing of some sort of pricing changes that were coming down the pike.

Garry MacNicholas

No, my point was that's been a long-term discipline we've had is that we remain on top of pricing. You can have a sales force very excited about underpriced products. That's good, but what we need to do is make sure that we've got that right balance in terms of consumer value, that we're sort of delivering solid returns to the shareholder and ultimately we're really sending to our making sure that we're looking after the balance sheet. So that was my only comment that we keep that same discipline, notwithstanding a low interest environment.

Darko Mihelic

And then, on that topic, topic, just with respect to Europe, the one thing that I can't reconcile is the payout annuities business I understand is rebounding, but I would have thought that annuity yields are going down. And in keeping with your pricing discipline, this would mean that people buying annuities would be getting less for their money and they no longer are required to buy annuity, so I'm a little bit it's just one of the things that I think in a go-forward post-Brexit world, I'm having trouble reconciling.

Paul Mahon

Yes. So as a general rule, one would think that if you're given a number of options and you got a low interest environment and you had a strong, stable equity performance, you would probably go there, you would go on the risk and say, certainty of lifetime income, I'm okay to write the volatility that could occur. What we're seeing right now is a growing pool of assets that are coming into payout. So by definition, there's going to be a general uplift. And secondarily, we're seeing people who are generally the world economy is not at its most stable point right now. And people are thinking about long-term security and this sounds a bit quirky, but very often, people are focused more on return of capitals than return on capital. So they want to make sure they're going to have a retirement income. So I think there is a natural movement there. I'm not saying it's going to everyone is going to go there. I think if interest rates were to rise over time, we would see payout annuities become even more attractive, but at this stage, we're seeing customer behavior where they're seeking the security of a payout annuity.

Darko Mihelic

Okay, great, thanks very much.

Paul Mahon

Thank you.

Operator

Thank you. This is the end of the question-and-answer session. I would now like to turn the meeting over to Mr. Paul Mahon.

Paul Mahon

Thank you very much, Louise. Well, I want to thank everyone for participating and listening in today and for your good questions. We look forward to connecting with you at the end of Q3. And I guess, that will be in November sometime and I hope everyone has a great summer. Take care.

Operator

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

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