DBRS Confirms Ratings on The Empire Life Insurance Company, FSR at “A,” Stable

DBRS Limited (DBRS) confirmed The Empire Life Insurance Company’s (Empire or the Company) Financial Strength Rating and Issuer Rating at “A,” as well as its Subordinated Debt rating at A (low). DBRS also confirmed the Preferred Shares rating at Pfd-2. All trends are Stable.

KEY RATING CONSIDERATIONS
The ratings and Stable trend reflect Empire’s position as a consistently performing life insurer with a proven track record of generating stable earnings while maintaining a conservative risk profile. The Company is a smaller player in the largely consolidated Canadian life insurance industry, maintaining a market share of approximately 2% of industry direct premiums. Empire has demonstrated consistent revenue generation over the years, resulting from a diversified mix of products across the individual life insurance, group insurance and wealth management segments. The Company’s strengths lie in its stable earnings generation, prudent risk management and strong capitalization relative to the risks undertaken. Empire’s market-related exposures are significant, particularly its equity market exposure resulting from the Company’s large block of segregated funds. Countering the exposure to market risks is Empire’s excellent Life Insurance Capital Adequacy Test (LICAT) ratio (150% as of Q1 2019), which is one of the highest in the Canadian life insurance industry and provides a solid capital cushion that should serve to mitigate any risks that may arise from adverse movements in equity markets and interest rates.

RATING DRIVERS
Positive ratings pressure may arise from an improved risk profile, including continued management of risks within set limits arising from products offering sizeable guarantees. Over the longer term, a demonstration by Empire of sustained growth in individual and group insurance sales resulting in an increase in market share while maintaining a prudent risk profile could also result in upward rating pressure. Conversely, ratings may be negatively pressured if the Company experiences a loss of access to distribution channels resulting in eroding earnings and market share. A significant increase in exposure to equity market risk relative to capitalization would also create downward ratings pressure.

RATING RATIONALE
Factored into DBRS’s ratings confirmation is Empire’s good earnings ability, which has shown resiliency with good return on equity values (11.2% as of Q1 2019). Empire has managed to maintain its market position in the competitive Canadian life insurance industry, including in the group business market, where it does well in the small group (fewer than 200 employees) segment, and in segregated funds where it continues to generate assets. The Group business is profitable, with the Company benefitting from good claims experience in 2017 and 2018, as well as from efforts undertaken to improve profitability, including repricing its block of business in order to improve margins and improving its claims management practices. Individual insurance sales have improved from the prior year, as the Company increased sales of whole and term life insurance, offsetting some of the impact resulting from its decision to stop selling Universal Life policies in 2016. Empire has been successful in growing its market share in the segregated fund space, increasing it to 7.0% in 2018, as measured by assets under management. The Company has de-risked its segregated fund offerings in recent years by reducing the level of guarantees in its Guaranteed Minimum Withdrawal Benefit product, which has resulted in lower net sales even as deposits remain strong. Facing industry headwinds, the Company’s mutual fund business has struggled to grow to a significant size since it was launched in 2012, remaining a very small portion of the overall business.

Empire has demonstrated an improvement in its capital position in the past year. Financial leverage has reduced to 28.8% at Q1 2019 from a high of 39.2% at Q4 2017, as the Company redeemed $300 million of subordinated debt. Empire is not expected to increase its leverage to reach the high end of the 30% to 40% range again in the near future. At 7.2 times (x) earnings as at Q1 2019 (three-year average of 8.1x earnings), the Company’s fixed-charge coverage ratio is lower than usual but still strong relative to the rating. Empire exhibits good internal capital generation with its financial flexibility enhanced by owners who have demonstrated their willingness to forgo dividend payments if necessary. Empire takes on minimal credit risk, with its $8.9 billion general fund investment portfolio composed primarily of fixed income (79.5% of general fund invested assets as of Q1 2019), the majority of which are rated “A” or higher. Empire has a negligible amount of intangibles on its balance sheet.

Empire benefits from a well-articulated strategy, conservative management and a supportive primary shareholder. The Company is currently focusing on achieving organic growth by targeting streamlined insurance and wealth products toward the middle-income Canadian market using a variety of distribution channels. Empire has demonstrated expertise in developing innovative digital capabilities to serve both advisors and clients in a cost-effective manner. The Company is also focused on enhancing its distribution capabilities and maintaining access to advisors amid the acquisition of independent managing general agents by carriers.

One of the Company’s primary risks arises from its sensitivity to interest rates and to equity markets in both its general fund and segregated fund portfolios. Interest rate sensitivity is well managed even as the Company maintains some duration mismatch for some of its products. The sensitivity of regulatory capital ratios to adverse movements in interest rates appears to have significantly declined under LICAT. The Company’s exposure to equity market risk arises primarily from its segregated fund portfolio and, to a lesser extent, from equities in its investment portfolio. The segregated fund risk lies with maintaining regulatory capital ratios for its tail risks rather than an immediate cash need. Unlike many of its peers, Empire does not fully hedge its equity market risk. Instead, a high level of capital is maintained above the minimum regulatory capital requirements. The additional buffer positions Empire well to be able to handle any adverse developments, including allowing it to maintain adequate solvency ratio levels against equity market swings. Empire is expected to maintain relatively high levels of regulatory capital in anticipation of future regulatory developments, including the implementation of IFRS 17 in January 2022 and new segregated fund capital requirements. Empire has also taken actions to reduce risk within its product mix, including selling segregated funds with less generous guarantees, focusing on sales of less capital-intensive products and discontinuing sales of products no longer deemed profitable. Mortality and longevity risks are appropriately reserved for, and there is a sizable yet manageable amount of risk related to policyholder behaviour.

The Grid Summary Grades for Empire are as follows: Franchise Strength – Good; Risk Profile – Good; Earnings Ability – Good; Liquidity – Excellent; Capitalization and Asset Quality – Excellent.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodologies are Global Methodology for Rating Life and P&C Insurance Companies and Insurance Organizations (January 2019) and DBRS Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers (November 2018), which can be found on our website under Methodologies & Criteria.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found on the issuer page at www.dbrs.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Lead Analyst: Komal Rizvi, Vice President, Global FIG
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG, Global FIG

For more information on this credit or on this industry, visit www.dbrs.com.

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