Sun Life (TSX: SLF) reported on Monday that when they report their next quarterly result, it will contain a very negative quarter. In the event of this quarter, it will be negative $621 million, operating amount negative $572 million.
By definition, financial insurance companies (such as those that provide annuities and “guaranteed income funds”) make their living by hedging. If they sell Joe Retail a product that will guarantee them 4% for the duration of the investment, the company will usually have a way of finding somebody else to give them 5% for the same period of time so they can skim the 1% in the meantime. Banks operate under the same principle, except for some strange reason they do not call it insurance.
When financial insurance companies cannot hedge properly, it will result in losses. In the event of SLF, and indeed, in the event of others such as Manulife, they have not hedged against the drop in equity markets and also the low rate environment and have been caught exposed – subsequently forced to take losses.
I have no idea whether SLF or other similar companies are under or over-valued at present. They are not easy companies to analyze and to determine where the risk is compared to the broad market.
Why some insurance companies do not hedge against a drop in equity markets (although they sell products that guaranteed 10 year positive returns) is that there has been very few 10 year periods of negative stock returns.
I have been tracking the TSX since 1956 and there is only one 10 year period (1974) with 10 year negative return.
You’ve got a good point with respect to the 10-year returns, albeit those are nominal and not real returns. I don’t think, however, that 55 years is too large a sample space where one can make sweeping conclusions about the 10-year performance of the marketplace.
Financial engineering-wise, if your models take the assumption that there will never (or at least be a very, very, VERY low probability) be a declining 10-year period then you can skim a few percent by selling long-dated index put options, of course at the risk of the said event not occurring. Warren Buffett essentially did this on the S&P 500 back in 2007-2008, and I believe the duration of that was around 15 years. His entry timing was sloppy considering it was done just before the economic crisis.
Retail investors can get a taste of this by trading SPY options. For example, if you think the S&P will not drop roughly 1% from present levels by December 2013 then you can receive about a $20 premium on a 120 strike put option.