Low interest rates are expected to damp third-quarter earnings at Canada's life insurers, offsetting modest relief from rebounding equities, analysts say.

Sun Life Financial Inc. (SLF.T, SLF) and Industrial Alliance Insurance and Financial Services Inc. (IAG.T) report their results Wednesday, while Manulife Financial Corp. (MFC.T, MFC) reports on Thursday. Great-West Lifeco Inc. (GWO.T), controlled by Montreal's Desmarais family, is scheduled to report next week.

"It's going to be a bit noisy in terms of the headline numbers, but the operating results will be reasonable," said Craig Fehr, an analyst at Edward Jones in St. Louis. "I don't think, by any stretch, these companies are firing on all cylinders yet. They've been fighting a lot of headwinds for several quarters now, but they are managing their results somewhat effectively."

Equity markets rebounded during the third quarter, which ended Sept. 30. The S&P 500 gained 10.7%, while the S&P/TSX Composite Index climbed 9.5%. But, sluggish economic growth kept interest rates on their downward trajectory, with long-term government rates in Canada and the U.S. falling between 20 and 42 basis points.

When stock prices or bond yields decline, insurers must build up their reserves to cover the long-term obligations on their products, such as annuities. Unlike in the U.S., Canadian insurers are required to mark-to-market their investments.

The earnings of the three largest life insurers--Manulife, Great-West Lifeco and Sun Life--are sensitive to interest rate and equity fluctuations in varying degrees. Great-West and Sun Life are far less exposed to market fluctuations than Manulife, which not only sold more long-term guaranteed product, it failed to hedge its investment portfolio.

Each 1% decline in interest rates reduces earnings by C$2.7 billion, Manulife has said. The company, which embarked on a hedging program in 2007, plans to hedge or reinsure at least 70% of its variable annuity guaranteed value by the end of 2012, up from 51%. It didn't make any progress in hedging its book in the second quarter, and analysts say they don't expect to see much headway in the third quarter either.

Manulife, which owns U.S. insurer John Hancock Financial, sideswiped investors in the second quarter when it posted a loss of C$2.4 billion, its biggest ever, sending its stock price reeling. The company took charges of C$3.2 billion from falling rates and equity prices.

The life insurer forewarned in August that it will take third-quarter charges arising from changes to its actuarial assumptions, including increased morbidity in its long-term care business in the U.S. and additional assumed volatility in its variable-annuity business and modifications to its ultimate reinvestment rate, or URR, that is the risk that future proceeds may need to be reinvested at a lower potential interest rate.

"It's really Manulife that'll have the messy quarter," said BMO Capital Markets analyst Tom MacKinnon.

He forecasts the company to report a loss of 89 Canadian cents a share. That is higher than the mean estimate of 73 Canadian cents from 11 analysts polled by Thomson Reuters. MacKinnon expects Manulife to post a per-share operating profit of 36 Canadian cents, which will evaporate from anticipated charges, including a 60 Canadian cent-a-share hit from its U.S. long-term care business.

According to Thomson Reuters, Sun Life is expected to report a profit of 61 Canadian cents a share, while per-share mean estimates for Great-West and Industrial-Alliance are 48 Canadian cents and 73 Canadian cents, respectively.

Unlike many analysts who are cautious on the sector, Edward Jones' Fehr has buy ratings on Manulife, Sun Life and Great-West. For investors with a longer investment horizon, he said the stocks are attractive buys.

"The valuations for these companies are very cheap because they're reflecting very pessimistic expectations," he said. "The environment isn't going to turn around for them in one to two quarters. It's going to be a longer-term timeframe. We have to see interest rates rise over time for these companies to start performing well."

-By Caroline Van Hasselt, Dow Jones Newswires; 416-306-2023; caroline.vanhasselt@dowjones.com
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