Sun Life's Insurance Businesses Should Benefit From Higher Interest Rates

Equity Analyst

Suryansh Sharma

Sun Life provides a variety of financial-services products including life insurance, retirement solutions, and investment management, mainly in the U.S., Canada, and Asia. The investment management business of the company has achieved adequate scale and is a source of stable earnings and cash flows.

The company’s strategic priorities include investing in digital tools and services, deepening the synergies between the asset management and insurance businesses, realizing scale benefits, and enhancing capabilities through M&A and partnerships. Following the 2008-09 financial crisis, Sun Life made several positive changes to its business operations, most notably selling its lagging U.S. life insurance and annuities business. We believe that steps like this have resulted in reducing the overall risk profile of the company. The company’s current business mix is adequately diversified with a 40% contribution from asset and wealth management, 21% from traditional long-duration insurance, and 39% from group and shorter-duration insurance, which is relatively less risky. Sun Life’s medium-term objectives include underlying EPS growth of 8%-10%, underlying returns on equity of more than 18%, and a dividend payout rate of 40%-50% of underlying profits.

Sun Life has a leading market position in Canada in the individual life and health insurance business. It is also a market leader in Canadian group benefits and group retirement services, which include defined contribution business and defined benefit solutions. In the U.S., the company is more focused on the group benefits market, which includes products like life, disability, absence management, dental, vision, accident, and critical illness. The company has been generating strong returns in its U.S. and Canadian businesses, but returns in the Asia segment have been lagging due to its relatively weak market positions.

Sun Life, like other life insurers, has its financial results tied to interest rates. Rising interest rates should be beneficial in the near term, but we do not expect long-term rates to return to pre-financial-crisis levels.

Business Strategy & Outlook

We assign a Morningstar economic moat rating of none to Sun Life Financial because of the unfavorable competitive dynamics in the industry. The life insurance industry is fiercely competitive with most insurance and annuities being undifferentiated and commoditized. Whether sold individually or to employers, we believe that pricing is the primary driver for customers buying Sun Life’s products. Additionally, the relatively low fixed costs in the insurance business model do not lend themselves to a cost-based competitive advantage.

We acknowledge that certain adjacent businesses such as asset management can have narrow moats, but on a consolidated basis, these businesses are not large enough for us to have confidence that they will result in consistent returns on equity exceeding the cost of equity for the whole company.

Industry Dynamics

The upside potential for life insurance and income-related products is capped by the market dynamics and the additional margins that are built into the products for extreme events. The company can earn outsize returns in the short run but those returns will be lowered by increased competition or additional regulation in the long run. However, there is no floor for policies that are poorly underwritten. As we have seen in prior periods, poor underwriting can put pressure on the company for many years and even result in bankruptcy. Insurers do not know their cost of goods sold for many years, allowing them to underprice policies without knowing it. Managers at firms may also have an incentive to chase growth without regard for profitability, a cycle in which competitors are forced to match low prices or risk losing business. Due to these reasons, disciplined underwriting is particularly crucial in the life insurance industry.

Sun Life is among the Big Three of the Canadian life insurance industry that also includes Great-West Life and Manulife. Fitch Ratings estimates that the three large Canadian life insurers represent more than two thirds of the Canadian market. In Canada, Sun Life provides retirement products and life, health, and other insurance solutions to employers as well as individuals through multiple channels. The company is the largest player in the individual life and health insurance market in Canada when measured by premiums. It also holds a dominant market position in the lucrative group benefits segment in Canada where products like life, dental, extended healthcare, disability, and critical illness are sold through long-standing relationships with corporate employers. This business is relatively capital-light and entails lower risk because the company can reprice its products quickly based on experience. Sun Life also provides defined-contribution pension plans and defined-benefit solutions in Canada and is a market leader in the group retirement services segment. The company was ranked first in the defined-contribution market based on total plan assets as per the 2020 Fraser Pension Universe Report. It was also ranked first in the defined benefit solutions annuity market as per LIMRA in 2021. Despite the size and strong market share of the company, we do not see evidence of competitive advantages over its peers, given the competitive intensity and product structures in the Canadian life insurance industry.

Sun Life’s U.S. business is mainly focused on the group benefits segment, where it provides group insurance products and services to corporate employers. The company has built this business through both organic and inorganic investments over the past decades. The company acquired Assurant Employee Benefits in 2016, which brought new group benefits capabilities. In 2018, it acquired Maxwell Health to enhance the digital enrollment experience for employees of small- and medium-size businesses. The company acquired PinnacleCare in 2021 to strengthen its product capabilities and competitive positioning in the stop-loss business. The company has leadership positions in various niches of the group benefits business. For example, Sun Life is the largest independent medical stop-loss provider and largest turnkey disability provider. With the recent acquisition of DentaQuest, Sun Life is the second-largest provider of dental benefits in the U.S. Overall, the company is among the top 10 providers of group benefit services in the U.S. as per the LIMRA 2020 report. Sun Life also services more than 90,000 individual in-force life insurance policies in the U.S., but it does not actively sell new policies. We expect the earnings contribution from the U.S. life insurance business to reduce over time as these policies roll off the book.

Sun Life’s Asia business provides asset management, wealth, protection, and health solutions through a multichannel distribution approach in eight countries. It also offers specialized insurance and wealth products for high-net-worth individuals in these markets through its international hubs business unit. Sun Life is the largest insurance company in the Philippines based on total premiums and is also the largest mutual fund provider. Except for the Philippines, the company does not have a dominant market position in any of the other Asian markets where it operates. The relatively weak competitive positioning of the company in its Asian markets is also reflected in the returns of the segment. The company has earned around 10% adjusted underlying return on equity from this segment in the past three years compared with midteens adjusted underlying ROE from Canada and the U.S. segment.

Sun Life’s asset management business is composed of MFS and Sun Life Capital Management and reported above CAD 1 trillion of assets under management and administration as of the second quarter of 2023. MFS was acquired by Sun Life in 1982 and competes primarily in the global institutional, U.S. retail, and select non-U.S. retail markets. MFS accounts for approximately 77% of AUM in the investment management segment with a diversified asset class and investor mix—82% of MFS’ AUM is in equities and 13% in fixed income, with the rest in balanced funds. In terms of investor mix, 54% of AUM is from U.S. retail, 32% from institutional clients, and the rest from insurance and non-U.S. retail clients. We believe that MFS has achieved adequate scale in the U.S. market and is the 10th-largest U.S. retail fund manager. The firm's attractive record and broad portfolio of products should enable it to generate positive flows in the long run. Active asset managers like MFS continue to face headwinds from passive investment products and downward pressure on fees. To address these headwinds, management plans to grow its retail business outside the U.S. and diversify its global business with fixed-income products.

Sun Life Capital Management provides liability-driven investments, fixed-income, and real estate solutions in the U.S. and Canada and accounts for approximately 23% of AUM in the investment management segment. SLC Management leverages Sun Life’s long-standing expertise in LDI and private asset class investments to offer customized investment solutions to institutional investors. The investment capabilities that the company uses for its clients are arguably the same capabilities that are used in managing its general account. In terms of investor mix, 50% of AUM came from pension funds, 24% from insurance companies, and the rest from trusts and others. Consistent with moat ratings for other asset managers, we believe that the asset management segment has a narrow moat driven by switching costs and intangible assets. However, Sun Life’s asset management segment contributes approximately 35% of the company’s overall earnings, so it is not large enough to affect the company’s overall moat rating.

Global Financial Crisis

The profitability of life insurance policies and other income-related products is highly contingent on implied actuarial assumptions and product pricing. The life insurance business model typically entails interest rate, investment, and underwriting risks and potentially exposes the industry to outlier capital market events that can lead to unanticipated divergence from the implied actuarial assumptions. Recent periods of economic turbulence like the global financial crisis have shown that the traditional life insurance industry has underwritten complex products and has taken on additional risks beyond mortality and morbidity, thereby exposing the industry to other systematic risks. Also, the complexity, diversity, and limited disclosures into the details of these products and the extensive use of opaque derivatives have made it very difficult to understand the inherent risk profile and exposure of life insurance companies in stressful market environments.

Variable annuities with living and death benefit guarantees were partially responsible for the stress on the life insurance industry during the global financial crisis. Minimum benefit guarantees and other similar products offered downside guarantees to the customers, thereby exposing the underwriter of these products to capital market risks. These products gained popularity during the 2000s with their sales being highly correlated with the stock market. The stock market optimism in the mid-2000s resulted in insurers offering the most generous terms on these policies with the most unfavorable risk and return characteristics. We can think about underwriting VA guarantees as writing a put option on the market. The underwriter of these products is highly leveraged to the market because of the option-like characteristics and the VA fees being contingent on AUM levels that are also partially dependent on the market. When the market rises, the put option (guarantees) move out of money and the VA fees also increase because of higher AUM. On the other hand, when the market goes down the VA fees reduce and the put option (guarantees) moves in money thereby increasing the embedded liabilities.

In addition to this, insurance companies booked heavy credit losses on their investment portfolios due to the economic turbulence, pressuring the statutory capital ratios of the companies and raising solvency related concerns. The global financial crisis demonstrated the complicated and to some extent opaque nature of potential liabilities and showed that outlier capital market events can have a significant impact on insurance companies. Having said this, we believe that the industry has become more cognizant of the risks that they are taking and has tightened its underwriting standards after the financial crisis. Currently, the industry as a whole and the company are much better positioned to steer through an extended recession, but we think that investors should still consider these risks.

Intangible Assets

Large and renowned insurance companies like Sun Life have often emphasized that their brand is a differentiating factor. A well-known brand can certainly be helpful, but we do not believe that it leads to pricing power as insurance is mostly a commoditized industry. As an example of how life insurance is commoditized, there are plenty of websites that allow prospective buyers to compare rates for life insurance policies with similar terms.

Sun Life is among the largest insurance underwriters in the Canadian market, which means that it should have some advantage in leveraging its proprietary database to better price and select risks than smaller peers, and recent investments in technology should allow it to better exploit this potential advantage. However, we believe it is especially difficult to develop a knowledge-based intangible asset moat in the life insurance industry as underwriting risks are easily understood and contract structures are largely homogenous.

Established insurance companies like Sun Life have risk management, product development, and investment management capabilities that have been developed over decades and will be difficult to replicate for a newer entrant. Having said this, insurance is a mature industry with a high degree of competition among existing incumbents, and we do not think that the company has a market intelligence or a technical know-how advantage compared with other competitors of similar size.

We believe that the asset management business of the company benefits from intangible assets (such as strong and respected brands and manager reputations derived from successful track records of investment performance), which can provide it with a degree of differentiation from its peers. While the barriers to entry are not all that significant for the industry, the barriers to success are extremely high as it not only takes time and skill to put together a long enough record of investment performance to start gathering assets but even more time to build the scale necessary to remain competitive. This has generally provided the larger, more established asset managers like Sun Life with an advantage over the smaller players in the industry, especially when it comes to gaining cost-effective access to distribution platforms. But we don't think Sun Life’s asset management business is large enough to affect the firm’s overall moat rating.

Cost Advantage 

Policy acquisition costs that are incurred up front and amortized over the period of the policy represent a sizable expense for life insurance companies. Therefore, having an efficient distribution system for selling its products is a key determinant of profitability in the life insurance industry. A costly customer acquisition channel can lead to higher pricing of the product, which will make the company uncompetitive in the market, or it can lead to lower margins. Sun Life’s scale allows it to leverage various distribution channels to sell its broad portfolio of products.

Sun Life is one of the largest players in many of its markets, but it is far from dominant with respect to market share. We think that having a large scale is somewhat beneficial as it allows the company to invest in technological capabilities, better leverage its distribution channel, offer a comprehensive product portfolio, and provide cost-effective customer service. However, the life insurance industry has relatively few fixed costs, thereby limiting the advantages of scale. Moreover, the larger competitors of the company also have comparable scale, negating a competitive advantage to Sun Life. Overall, we believe that the company benefits from its scale, but it is not material enough to constitute a cost advantage-based moat.

Switching Costs

Most life insurance policies and other income-related products are typically priced when a new business is written and corresponding liabilities for future benefits are established based on various underlying actuarial assumptions like mortality, lapse rate, and investment returns. Generally speaking, insurance policies and other income protection products have long durations, but companies seldom have the ability to reprice the products or adjust premiums on the products that were previously sold. Since the company has limited opportunities to reprice its previously sold products, the high retention rate of existing policies does not translate into pricing power. In addition to this, customers can easily buy insurance products from multiple insurance companies based on pricing as there is no substantial benefit to buying all required products from the same insurance provider. This indicates a lack of switching costs for customers, especially in the retail channel.

Lapse rates, which are essentially annualized attrition rates, vary by product with fixed-annuity and variable-annuity products typically having higher lapse rates. The voluntary termination rate for life insurance policies, which includes the lapse rate and surrender rate, was around 5.5%-6.8% over the past decade for the U.S. life insurance industry as per data from the American Council of Life Insurers. The termination rate for life insurance products declined to 5.0% in 2020 due to the pandemic, but we expect this number to normalize to prepandemic levels in the upcoming years.

Having said this, Sun Life’s group insurance business in the U.S. and Canada and its asset management business somewhat benefit from switching costs. In the asset management business, although the switching costs might not be explicitly large, inertia and the uncertainty of achieving better results by moving from one asset manager to another tend to keep many investors invested with the same funds for extended periods. As a result, money that flows into asset management firms tends to stay there. For the asset management industry as a whole, the average redemption (retention) rate, has been around 25% or less (75% or greater) annually during the past 5-, 10-, 15-, 20-, 25-, and 30-year time frames. In the group insurance business, the products have relatively more stickiness because they are sold to and through corporate employers with long-standing relationships, and the company has an opportunity to reprice its product offering based on experience every couple of years. Further, it is logistically a hassle for employers to switch to another provider and there are no clear benefits of switching to a different provider. As an example, the company’s peer MetLife has reported persistency of over 96% in its U.S. group insurance business. We think that there are some traces of switching cost advantages in both the group insurance business and the asset management, but it is not material enough for us to award a moat to the entire company.

Conclusion

We use adjusted return on equity to determine whether a company has shown or is forecast to have the characteristics of an economic moat. We calculate adjusted return on equity by adjusting the equity to exclude accumulated other comprehensive income. We have included goodwill in the ROE calculation since the company has had a history of various acquisitions and allocating capital for opportunistic inorganic growth is part of management’s capital allocation framework. The idea behind these adjustments is to evaluate the profitability of the core business by excluding highly volatile components that flow through the financial statements of the company. Even with the high-margin, capital-light asset management business Sun Life has achieved an average adjusted ROE that is only slightly above our assumed cost of equity of 11%. The average return of the core insurance business should fall below the cost of equity if we exclude the wealth and asset management segments from the overall numbers. We expect the adjusted ROE of the core insurance business of the company to remain below our cost of equity over the projected period. Therefore, we believe there is currently not enough quantitative or qualitative evidence to support a moat for Sun Life.

None

Economic Moat

Sun Life Financial

Sun Life Financial, Inc. is a financial services company, which engages in providing insurance and asset management solutions to individual and corporate clients. It operates through the following segments: Canada, United States, Asset Management, Asia, and Corporate. The Canada segment offers individual insurance and group benefits and retirement services. The United States segment consists of group benefits, international, and in-force management services. The Asset Management segment focuses on the design and delivery of investment products through MFS investment management and Sun Life investment management. The Asia segment consists of the Philippines, Hong Kong, Indonesia, Vietnam, Malaysia, India, and China markets. The Corporate segment represents the United Kingdom business unit and corporate support operations, which include run-off reinsurance operations as well as investment income, expenses, capital, and other items. The company was founded on March 18, 1865 and is headquartered in Toronto, Canada.

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Sun Life Financial, Inc. engages in the provision of insurance and asset management solutions to individual and corporate clients. It operates through the following segments: Canada, United States, Asset Management, Asia, and Corporate. The Canada segment offers individual insurance and group benefits and retirement services. The United States segment consists of group benefits, international, and in-force management services. The Asset Management segment focuses on the design and delivery of investment products through MFS investment management and Sun Life investment management. The Asia segment consists of the Philippines, Hong Kong, Indonesia, Vietnam, Malaysia, India, and China markets. The Corporate segment represents the United Kingdom business unit and corporate support operations, which include run-off reinsurance operations as well as investment income, expenses, capital, and other items. The company was founded on March 18, 1865 and is headquartered in Toronto, Canada.

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