Manulife Financial - Q2 2023

Transcript

Operator (participant)

Participants, please stand by. Your meeting is ready to begin. Please be advised that this conference call is being recorded. Good morning, welcome to the Manulife Financial Second Quarter 2023 Financial Results Conference Call. Your host for today will be Mr. Hung Ko. Please go ahead, Mr. Ko.

Hung Ko (VP, Group Investor Relations)

Thank you. Welcome to Manulife's earnings conference call to discuss our second quarter and year-to-date 2023 financial operating results. Our earnings materials, including the webcast slide for today's call, are available on the investor relations section of our website at manulife.com. Turning to slide four, we will begin today's presentation with an overview of our second quarter results and strategic update by Roy Gori, our President and Chief Executive Officer. Following Roy's remarks, Colin Simpson, our Chief Financial Officer, will discuss the company's financial and operating results. After the prepared remarks, we'll move to the live Q&A portion of the call. We ask each participant to adhere to a limit of two questions, including follow-up questions. If you have additional questions, please queue, and we will do our best to respond to everyone.

Before we start, please refer to slide two for a caution on forward-looking statements. Note that certain material factors or assumptions applied in making forward-looking statements and actual results may differ materially from what is stated. I would also refer you to slide 38 for a note on a non-GAAP and other financial measures used in this presentation, which includes an explanation of our use of transitional results for 2022 comparison. With that, I'd like to turn the call over to Roy Gori, our President and Chief Executive Officer. Roy?

Roy Gori (President and CEO)

Thanks, Hung, thank you everyone for joining us today. Yesterday, we announced our second quarter 2023 financial results. In our second quarterly reporting under IFRS 17, we delivered strong operating results, including Core earnings of $1.6 billion, net income of $1 billion, strong growth in EPS and Core EPS, and Core ROE of 15.5%. I'm encouraged by the strong top-line momentum that we're building across our new business metrics, with double-digit growth in APE sales, MBV, and new business CSM compared with 2022. We also generated global WAM net inflows of $2.2 billion. APE sales increased by 12% from the prior year quarter, led by Asia, where APE sales increased 26% year-on-year, as we capitalized on the post-pandemic recovery in the region.

The strong sales supported a 10% increase in MBV and a 15% increase in our new business CSM. The increase in new business CSM was in line with our medium-term target. The strong growth in new business CSM, particularly in Asia, gives us confidence in the future growth of our insurance service results. Turning to slide seven. Our strong core earnings of $1.6 billion were up 4% from the prior year quarter, as growth across our insurance and corporate segments was partially offset by a decline in global WAM. Our continued capital deployment through share buybacks contributed to our core EPS growing 6% from the prior year quarter. Net income of $1 billion was impacted by lower than expected returns on our older portfolio.

While some of the older classes are facing headwinds, we continue to generate overall positive return from the portfolio. We also delivered strong Core ROE of 15.5%, which is in line with our medium-term target of 15%+. Turning to slide eight. We continue to maintain a strong capital position, supported by a LICAT ratio of 136% and a leverage ratio of 25.8%. We also reported adjusted book value per share of CAD 29.42, a 5% increase from the prior-year quarter over a period that had sizable interest rate movements and during which we returned significant capital to shareholders. While this amount was modestly down from the first quarter, the majority of the decline was attributed to the currency translation of foreign operations, which does not reflect the fundamental performance of our business.

This graph is a great illustration of the strength and stability of our adjusted book value under IFRS 17. Turning to slide nine. Overall, we have a very attractive business mix, including exposure to the emerging middle class in Asia and the developed North American economies, as well as a scaled global asset manager. The 3 megatrends that underpin our business remain unchanged: a growing middle class in Asia, an aging population, and digitization of the consumer. We are strongly positioned to capitalize on these opportunities, and the momentum that we generated in the quarter is an illustration of our growth potential. In Asia, the team is capturing the opportunity as the region continues to recover from the pandemic. I'm really excited that Phil Witherington, formerly our CFO, returned to Asia in July to lead the business.

Phil has a deep appreciation of our Asia franchise, having previously served as Manulife Asia's interim CEO as well as its CFO. In the short time that he's been there, we are seeing strong momentum building in our Asia businesses in the third quarter. Our top-line metrics bode well for the future earnings growth of the segment. I'm confident that Phil will lead our team and double down on our growth ambitions in the region, and he's here on the call with us today. I would also like to thank Damien Green, whose transition to the position of Chair of Manulife Financial Asia, for his leadership. In Global WAM, we delivered strong net inflows of CAD 6.6 billion in the first half of 2023, supported by our unique business profile, which is diversified by geography and business line.

We've maintained strong sales rankings in many of our key markets, including the number one spot in Canada and Hong Kong retirement, and number two in the U.S. mid-case retirement market. Core earnings were down from the prior year period, due in part to higher investments as we strive to continue building new business. I'm encouraged to see us building momentum with our core earnings improving 12% and Core EBITDA margin improving by 2.2 percentage points from the first quarter. As part of delivering value to shareholders, we're committed to helping our customers live longer, healthier, better lives, we're executing against our ESG strategy and commitments. In Hong Kong, we launched enhanced healthcare coverage to better address the growing demand for health and protection services. In Canada, we further expanded our behavioral insurance program, making Manulife Vitality available on new Manulife Par individual insurance policies.

Currently, our own timberland and agriculture properties already remove more carbon from the atmosphere than our operations emit. We strengthened our commitment to reducing emissions by disclosing Science-Based Targets, including an increased ambition to reduce absolute Scope 1 and 2 emissions 40% by 2035. This is all part of our commitment to helping make decisions easier and lives better, which will drive value for shareholders. Finally, since we resumed our share buyback program in 2022, our strong capital position has enabled us to return over $6.6 billion of capital to shareholders through dividends and share buybacks, including more than $440 million of share buybacks during the second quarter. As of the end of June, we still had capacity to purchase approximately 30 million common shares under our current NCIB program.

Overall, it was a very encouraging quarter with strong top-line momentum. Our strong sales performance leaves me optimistic for the future. With that, I'm happy to turn it over to Colin Simpson, who has succeeded Phil as our Group Chief Financial Officer. Colin brings a wealth of experience within the insurance industry. You'll get to know Colin very well as we intensify our focus to generate value for our shareholders and customers. With that, I'll hand it over to Colin.

Colin Simpson (CFO)

Thanks, Roy. I wanted to start by saying I'm really excited to take on this role. I truly believe Manulife has an enviable portfolio of businesses and incredible potential. As I get my feet under the desk, I look forward to connecting with the investment community. I'll start on slide 11, which shows a snapshot of our financial KPIs for the second quarter of 2023. We delivered strong results. Core EPS increased 6%. We generated strong momentum in our top-line metrics with APE sales, new business value, and new business CSM, each up by double digits. We also delivered positive global WAM net flows of CAD 2.2 billion. Our balance sheet remains strong, with 5% growth in adjusted book value per share. Our LICAT ratio of 136% provides ample financial flexibility.

Moving to our top line and turning to slide 12, we generated APE sales of CAD 1.6 billion and new business value of CAD 585 million. New business CSM of CAD 592 million increased 15% from the prior year, which is a step up from the first quarter 2023 growth rate and in line with our medium-term target. Asia led APE sales growth, fueled by Hong Kong, where APE sales doubled, primarily due to a return of demand from mainland Chinese visitors. I will say, the emergence from the pandemic has been uneven across our operating regions in Asia, but momentum is encouraging, with 26% growth in new business CSM.

In Canada, APE sales declined 11%, driven by lower group insurance sales, as the prior year included very strong large case sales and Segregated Funds products, which was broadly consistent with the industry. Despite the decline in sales in Canada, new business CSM increased 21%. In the U.S., APE sales declined 15%. We continued to see higher short-term interest rates attract customers away from longer duration accumulation products, particularly for our high net worth customers, which is a target market for John Hancock. We have maintained pricing discipline in a competitive environment, and we saw quarter-on-quarter growth in both new business value and new business CSM. Slide 13 illustrates the changes in contractual service margin balance, which is an important store of future profits under IFRS 17.

During the first half of 2023, the contribution from new insurance business and expected CSM roll forward exceeded the CSM recognized for service provided, which sets the foundation for organic CSM growth. This was partially offset by insurance experience reported through the CSM of $127 million. Unfavorable lapse experience in the U.S. and persistency in Asia emerging markets outweighed favorable long-term care experience. As a reminder, under IFRS 17, it's important to consider insurance experience through both core earnings and the CSM. A holistic view is available in the appendix of this presentation. I would add, because I know it is a focal point for some, that LTC experience was a modest net gain this quarter across core earnings and CSM combined.

Putting this all together, organic growth in CSM was 3% during the first half of 2023, or 5% on an annualized basis. Inorganic CSM movement, which is influenced by market impacts, declined by $342 million over the same time period. Largely driven by foreign exchange rate movements, which are not reflective of the fundamental business performance. Overall, the total CSM balance increased 4% in the first half of 2023 on a constant exchange rate basis, and we remain focused on achieving our medium-term CSM growth target of 8%-10%. Turning to slide 14, our global WAM business recorded net inflows of $2.2 billion, up from $1.7 billion in the prior year. We experienced lower mutual fund redemption rates, which improved retail fund flows.

The prior year also benefited from a CAD 1.9 billion institutional equity mandate. Overall, global WAM's average assets under management and administration increased by 1%, driven by the acquisition of full ownership interest in Manulife Fund Management in mainland China, which in itself is an exciting opportunity for us. Net fee income yield of 44 basis points increased modestly, reflecting higher fee spread and a change in business mix. We've been investing in our global WAM business, resulting in higher expenses, and you can see that the core EBITDA margin decreased 350 basis points to 24.6%. This was also slightly impacted by lower earnings from C Capital as we repatriated funds.

Moving to slide 15, which shows our drivers of earnings analysis, which we are showing relative to the prior year and prior quarter to give you a sense of our progress. The first area I'd like to focus on is how higher interest rates are flowing through core earnings. You will notice higher expected investment earnings, driven by higher investment rates in fixed income securities, as well as business growth. In addition, we earn more interest on surplus in the higher yield environment. These two factors are partially offset by higher debt costs, which you can see in other core earnings, and slower CSM amortization on certain VFA or Variable Fee Approach contracts, impacting the overall insurance service result. The second point to draw out from the slide is on insurance experience, which shows a modest experience loss of $22 million.

The prior year quarter had a significant benefit in U.S. Life during a period of volatile mortality related to COVID. You will notice that our expected credit loss is neutral this quarter, which is a significant improvement on the charge in the first quarter. Slide 16 shows our earnings reconciliation to net income attributed to shareholders for the second quarter. Despite the improvement from the prior year quarter transitional net income, there was a $570 million market experience net charge. This included a $478 million charge from lower than expected returns on ALDA, largely driven by real estate and energy-related private equity investments. The $141 million adverse other investment result mostly reflects a change in the Japanese yen currency rate, which saw a sizable movement during the quarter.

Note that while we reported a net ALDA charge reflecting challenges faced by certain asset classes, the portfolio generated a positive return in the quarter, albeit below our long-term expectation. The commercial real estate market continues to be difficult, in recent quarters, we've seen capitalization rates rise as interest rates have increased, adversely impacting valuations. It is worth reiterating that the vast majority of our real estate portfolio is independently appraised on a quarterly basis. While difficult conditions persist in the office commercial real estate market, we believe our valuations are current. For example, our most recent valuations on our U.S. office portfolio reflect an approximately 30% reduction from peak. I would also note that over the past decade, our North American office exposure has decreased from over 40% of ALDA in 2013 to close to 10% today.

Turning to slide 17 and our ALDA portfolio. Returns have been lower in the recent quarters. We invest in asset classes that are well suited for insurance liabilities and generate attractive returns, with lower volatility relative to both equity and credit indices over a medium to long time period. In 2020, for example, our ALDA portfolio generated a $1.4 billion loss relative to expectations, though we more than recovered that loss in 2021. In the five years preceding 2023, the portfolio outperformed our assumed returns on a net basis during a volatile period that included the pandemic. Over the years, Manulife has built up strong asset origination and management capabilities, which I view as a competitive advantage. The historic return profile, which we show on the slide, gives us confidence in achieving our expected long-term returns.

We have also added a slide in the appendix to show all the performance over the past five years. Moving to slide 18. We delivered Core ROE of 15.5%, in line with our medium-term target of 15%+. When you consider our current valuation, I believe a mid-teens ROE, coupled with improved stability of earnings and book value, offers investors significant value. This is a key factor in our decision to remain active in our share buyback program, and during the quarter, we purchased for cancellation nearly 1% of our outstanding common shares for over $440 million. You can see, we've steadily returned capital to shareholders over the past five quarters. This has contributed to the expansion of our Core ROE. On to slide 19. We continue to maintain a strong balance sheet and capital position.

This underpins our commitment we make to our customers with every policy sold and gives us financial flexibility. At the end of the quarter, we had $21 billion of capital above our supervisory target ratio, and our LICAT ratio of 136% remains robust. The 2 percentage point decrease in our LICAT ratio in the second quarter was primarily driven by the redemption of subordinated debt and share buybacks, which also drove a net 0.2 percentage point reduction in our financial leverage ratio.

Finally, moving to slide 21, which shows how we're tracking against our medium-term targets. Our Core EPS growth has been solid in the first half of the year, though slightly below our target. Core ROE of 15.2% year to date is in line with our medium-term target. Although our CSM metrics have performed below target in the first half, we built strong momentum in the second quarter, including new business CSM growth of 15%. All in, we've delivered strong results in the first half of 2023, and are well positioned to deliver for our customers, shareholders, and colleagues. This concludes our prepared remarks. Before we move to the Q&A session, I'd like to remind each participant to adhere to a limit of two questions, including follow-ups, and to requeue if they have additional questions. Operator, we'll now open the call to questions.

Operator (participant)

Thank you. We will now take questions from the telephone lines. If you have a question and you are using a speakerphone, please lift your handset before making your selection. If you have a question, please press star one on your device's keypad. You may cancel your question at any time by pressing star two. Please press star one at this time if you have a question. There will be a brief pause while participants register for questions. We thank you for your patience. Our first question is from Meny Grauman, from Scotiabank. Please go ahead.

Meny Grauman (MD and Financial Services Equity Research)

Hi, good morning. First question I wanted to ask about, expected investment earnings. We're seeing a big improvement sequentially and then very, very strong growth, year-over-year. Just trying to understand the sustainability and the potential variability in that number going forward. I guess the first question is: what we're seeing from a year-over-year basis, is really just a function of the higher rate environment, or there's some other key factors that we should keep in mind? As we look forward, if we assume that, you know, the rate environment maybe has peaked to some extent, what does that mean about the trajectory of this line item going forward?

Colin Simpson (CFO)

Yeah. Hi, Meny, it's Colin here. I'll kick off, and others can join in. I mean, what you're seeing is absolutely, as you, you intimated, higher yields. We're looking at in, in through core earnings, to the extent that yields stay where they are, we would expect this to persist. Absolutely sustainable. If yields go up even further, we would expect to earn more through that line item.

Meny Grauman (MD and Financial Services Equity Research)

Yeah.

Phil Witherington (President and CEO of Manulife Asia)

Okay.

Scott Hartz (CIO)

Sorry, Scott. To add a bit to that. What's driving it is the higher rate environment, and as Colin said, if rates stay where they are, you know, we would expect it to be sustainable, and in fact, even grow a bit. As the portfolio turns over, we will be turning it over at higher yields.

Meny Grauman (MD and Financial Services Equity Research)

How does the, the inversion of the yield curve, is that playing a factor here in terms of how this line item behaves? And how should we think about sort of the, the, the sort of the shape of the yield curve in terms of what the impact is on this line item?

Scott Hartz (CIO)

I, you know, I think while the yield curve's inverted, all, all yields are higher, than, than exist on the current portfolio, so that's, that's all positive.

Meny Grauman (MD and Financial Services Equity Research)

Okay. Got it. Thank you.

Operator (participant)

Thank you. Our following question is from Paul Holden, from CIBC. Please go ahead.

Paul Holden (Director in institutional equity research)

Thank you. Good morning. Strong results out of Hong Kong sales, as you highlighted, and then Roy also mentioned continued positive momentum in Q3. I guess what I want to understand there better is just everything we read here talks about sort of the stall of the consumer recovery in China. Wondering how we square those two factors. Then also want to understand, was Q2 like an abnormally strong quarter because it was a little bit of a catch-up based on pent-up demand, or do you think there is momentum based off sort of that run rate?

Phil Witherington (President and CEO of Manulife Asia)

Hey, Paul, it's Phil. Thank you for the question. Can I just start by saying how fantastic, fantastic it's been to be back on the ground in Hong Kong and in this role representing our Asia segment. Paul, that leads me into your question. There is a lot of media talking down the conditions in Hong Kong and China, but the reality is, being on the ground, there's a tremendous amount of activity, and it, it feels to me very much like it did pre-pandemic. I think you're seeing that in our performance in the second quarter. You know, a 26% growth in APE across Asia, translating to a 26% growth in new business CSM. I think that's very encouraging. Of course, as we've said before, that CSM growth will translate to a future core earnings growth as well.

I, I remain very optimistic about the prospects for Hong Kong, China, and Asia. I will point out that actually in China, we, you know, we hear about the potential stalls to the recovery in China, but our second quarter was the strongest second quarter on record in China. I think that does demonstrate the, the robust emergence from the pandemic. You referenced in the second component of your question whether Q2 should be seen as abnormal. I, I don't see it as abnormal at all. I see what we've experienced in the second quarter is a continuation of the momentum across Asia from the first quarter. As Colin mentioned, there is an uneven recovery from the pandemic across markets, but that's the benefit that we have of a diversified portfolio.

Of course, an important driver of our growth in the second quarter is the mainland Chinese visitor customer segment to Hong Kong. That has been very notable. It's consistent with our strategy to capture a greater share of the MCV flows. I don't want that to overshadow a strong domestic business, a strong domestic performance in Hong Kong and across Asia. The same statistic is true if we strip out the benefit that we've seen from mainland Chinese visitors, which I believe is sustainable. If we strip that out, we've still seen high single-digit growth rates in APE in the second quarter. A strong domestic business in Hong Kong, supplemented by incremental growth in mainland Chinese visitors, that I believe is sustainable.

I don't think we'll see the same levels of growth that we've seen in the first and second quarters, but I think this is, something that will continue to be in the run rate, reflecting the fact that the underlying customer needs remain in place, and Hong Kong is right at the center of the Greater Bay Area, and that's been formalized and, really confirmed through government policies put in place during the pandemic.

Roy Gori (President and CEO)

Hey, Paul, Roy here. Just a couple of adds. Two of the core strengths of our Asia franchise are, A, that we are at scale. You know, in fact, we're the 3rd largest pan-Asian player. That makes a big difference in terms of the ability to defray costs and actually continue to deliver momentum. The second big advantage of our franchise is that we're incredibly diverse, both from a geographic perspective, but also from a channel perspective, with good contribution from agency, banker, as well as direct now. That really does fill us with confidence, as, as Phil highlighted.

Paul Holden (Director in institutional equity research)

Thanks for that. My second question is on commercial real estate. Obviously, higher cap rates, as you highlighted, have been a drag on returns. I guess what I want to understand better is if cap rates stop increasing and just kind of level out from here, would you be able to meet your long-term return assumption, do you think, at this point on real estate? Are we going to be in for sort of a longer period of below normal returns?

Scott Hartz (CIO)

Yeah. Hi, Paul, it's Scott. Thank you for the question. To, to your point, there's been a couple of factors driving the, the underperformance in real estate versus assumptions. One has been obviously the stress in the, in the office market with, you know, a lot of the work from home, reducing demand, which, you know, and it's hard to say where that's going to go, although we do see positive signs with companies like Zoom coming back to the office. The other one, which is probably more in, in recent quarters, what's been driving it, has been the rise in cap rates.

There may be a little bit of continued pressure on that in the short run, but I'll remind you that rising cap rates mean that we're, you know, we're discounting at higher interest rates, the, the future cash flow off of those properties. Higher cap rates actually imply higher future returns. I'm, I'm very confident over the long term, we'll be able to achieve those, those assumptions. In, in the short term, it's obviously hard to predict in the short term, but there, there may be a bit more pressure in, in the, in the coming quarters.

Paul Holden (Director in institutional equity research)

All right. I'll leave it there. Thank you.

Operator (participant)

Thank you. Our following question is from Tom MacKinnon from BMO Capital Markets. Please go ahead.

Tom MacKinnon (Managing Director and Senior Analyst)

Yeah, thanks very much. Just a question with respect to the Asia sales. If I look at, you know, year-over-year, the 25% increase in the Asia APE translates into a 25% increase into the new business CSM. This is all from page 22 of your SIP, you're only getting a 3% year-over-year increase in your Asia new business value. Help, help me understand the differences here. CSM obviously be a function of the sales here, what's the difference in the calculation in the new business value? Is there capital take into account here? Just help me understand that. Thanks. Why is that so much lower than the growth in the CSM?

Phil Witherington (President and CEO of Manulife Asia)

Hey, Tom, this is Phil. Thanks for the question. You're right to point out the growth in APE and new business CSM, both growing 26% across the region. 3% new business value growth. You know, I'll, I'll hand over to Steve to comment further, but one thing that I will highlight is that, you know, new business CSM and NBV are both good metrics to look at as indications of the value that we generate from the growth that we deliver. There may be variations quarters to quarter, and one thing to highlight with respect to 2023 versus 2022 is product mix. You may recall that a year ago, the Voluntary Health Insurance Scheme in Hong Kong was introduced. That drove quite a lot of interest in health products in Hong Kong.

That's an annually repriceable short-term product that for IFRS 17, therefore, doesn't impact the CSM because it goes through the Premium Allocation Approach model, but it is-- it was something that was reflected in new business value. That's one thing that reflects the divergence in growth rate in 2023 between the two metrics. Steve, you may wish to comment further on the methodology.

Steven Finch (Chief Actuary)

Yeah. I Tom, I'd call your attention to the fact that total company level, we saw a broad alignment between new business CSM growth at 15%, APE growth at 12%, and NBV growth at 10%. You know, just as under IFRS 4, you'll recall, we would see some variability between the new business gains and the NBV, and similarly, under IFRS 17, we'll see some variability between new business CSM and NBV. Over time, they will be directionally consistent, and that's what you should expect to see in all of our business. I just want to add to Phil's, we also from higher interest rates, we increased risk discount rates in Asia, which was a slight headwind to NBV. Thanks.

Tom MacKinnon (Managing Director and Senior Analyst)

Just as a follow-up, the NBV margins in Hong Kong were running like 80%, and now they're 50%. Is there a business mix issue there? They haven't really moved quarter-over-quarter, despite the big jump in the sales.

Phil Witherington (President and CEO of Manulife Asia)

Well, thanks for the question, Tom MacKinnon. You, you're right to point that one out. Hong Kong total, Hong Kong total NBV margin, approximately 50%, just over 50%. What's happening here is that we have seen a shift in business mix, you know, with the volume having doubled in Q2 2023, relative to the second quarter of 2022. The big driver of that being the MCV customer segment. Important to note up front that MCV business is high quality business. It's profitable, but it has been lower margin than the rest of our business in Hong Kong. Consistent with the rest of the industry in Hong Kong, we are seeing customer demand from MCV customers being skewed towards lower margin, savings-oriented products.

That is a notable difference from the pre-pandemic period, where we saw greater demand for protection, critical illness, health products from the MCV customer segment, and we do see an opportunity here to improve product mix, help our customers fulfill a wider range of their needs, and that is something that could be a potential tailwind to our margins in the future. Really important to note as well, that our domestic business in Hong Kong remains very important. It's been growing in a stable manner, during the pandemic. In fact, we've taken share domestically in this high margin, business that we have in Hong Kong. Relative to the first, relative to the second quarter of 2019, our business has actually grown. Domestic business has grown by 11%, whereas the market as a whole, the domestic market, has contracted by just over 20%.

I, I think that speaks to the, the quality of the underlying business, which is our highest margin business across the region. I think I'll leave it there, Tom, but happy to take any further follow-ups.

Roy Gori (President and CEO)

Tom, I might, I might just add as well, that 50% NBV margin is incredibly high. That's really solid and strong. We're really, you know, very happy with our margins out of Hong Kong, quite frankly, out of Asia. The 80% margin that you referred to is slightly elevated versus our more average medium-term NBV margin coming out of Hong Kong. There is a bit of a comparison year-over-year that makes that look more dramatic than it actually is, and it still highlights, you know, our focus is on growing NBV absolute. Obviously, we want to do that at high margins, and we think there's more opportunity to continue to grow our margin, as we have over the years.

Tom MacKinnon (Managing Director and Senior Analyst)

Is the distribution of the MCV business, is that, more broker-related or more, yeah, of career agent-related?

Phil Witherington (President and CEO of Manulife Asia)

Thanks for the follow-up, Tom. Brokers are really important part of it, but also agency is an important part as well. We have made some specific investments over the course of the pandemic in order to take a greater share of the MCV customer segment, and we feel that's appropriate, given that really the legitimization of this segment through government policies that have been put in place over the course of the pandemic, and the important role that Hong Kong has to play in the development of the Greater Bay Area. You know, some of the things that we've been doing, we've opened customer service centers in places that are convenient for Mainland Chinese customers. As well as that, we've been developing our hospital network in Mainland China. In fact, we're a leader in that regard.

We've been enhancing the customer materials that we, that we have into multilingual materials, so not just traditional Chinese for the Hong Kong domestic market, but also simplified Chinese as used in mainland China. Lots of things that we've been doing, and in particular in agency, which is a really important channel for us in Hong Kong. We've been really looking at hiring a greater proportion of Mandarin-speaking agents that will be able to interact more comfortably with mainland Chinese visitor customers.

Tom MacKinnon (Managing Director and Senior Analyst)

Thanks for the color, Phil.

Phil Witherington (President and CEO of Manulife Asia)

Thanks, Tom.

Operator (participant)

Thank you. The following question is from Gabriel Dechaine, from National Bank Financial. Please go ahead.

Gabriel Dechaine (Senior Equity Analyst)

Hi, I've got a strategy question and a numbers question. I'll start with the numbers one. You know, your slide 25 is pretty helpful, very helpful, actually, to show the balance between, you know, experience items that go through P&L and then through the CSM. If we can drill down a little bit on, on some of the moving pieces. There were some... Can you quantify the bigger pieces? I mean, I'd like to know, you know, how, you know, the negative LTC experience and that went through P&L, positive through CSM, and then I guess some, you know, individual life experience with a bigger drag on the CSM as well. Maybe we can just kind of break down some of the bigger, bigger chunks flowing through that graph.

Steven Finch (Chief Actuary)

Sure. Yeah, thank, thanks, Gabriel. I'll, I'll take that one. It's Steve. Start with LTC. You know, as, as you know, overall, I remind you that I look at total experience. It does show up in both P&L and CSM, and I'll touch on that. Total LTC experience was a, a modest gain in the quarter. The negative that went through P&L, that's the cash payments that we're making in the quarter, so higher cash benefit reimbursements than expectations. That was more than offset by favorable incidents experience, favorable lapse experience, slightly offset by lower levels of, of mortality. If we look more broadly at some of the drivers overall of the, you know, between the, the two sections, CAD 110 million in total pre-tax impact.

The, what's going through the P&L, so I mentioned the LTC. Overall, we had positive claims experience across a number of areas, including continued favorable experience in Canadian group benefits.

Gabriel Dechaine (Senior Equity Analyst)

Mm-hmm.

Steven Finch (Chief Actuary)

That was offset by expense results. Moving to the CSM, the two, the two material drivers there of the experience, one is adverse persistency, primarily from Vietnam, and the other is continued low lapse rates in the U.S.. Both of those trends are not what we expect over the long term. I'll, I'll stop at that, but happy to drill into more detail.

Gabriel Dechaine (Senior Equity Analyst)

Well, I mean, that's what I was hoping for, was some numbers, but, throw some numbers at me?

Steven Finch (Chief Actuary)

I, I think I, I mentioned the biggest, the, the biggest drivers there.

Gabriel Dechaine (Senior Equity Analyst)

Okay. Now, the strategy question. You're one of your peers in Hong Kong, Canadian domiciled one, but with operations in Hong Kong, sound similar to you in the sense that you want to increase your mainland Chinese sales or sales to mainland Chinese customers in Hong Kong, compared to what you did in prior years. I'm wondering, you know, what the motivation is there, just to get a, get better sense of, you know, why that strategy makes sense now, whereas it didn't pre-COVID?

Roy Gori (President and CEO)

Let me, let me start, Gabriel, and I'll hand over to Phil. The first thing I'd say is that MCV sales has always been part of our strategy. We've been focused on the, the Chinese consumer that's been moving to Hong Kong or, tapping into Hong Kong for their insurance and health needs. Again, a core competency of our franchise is that we are diverse, but we also have a strong presence both in Hong Kong and in China, which lends itself to capturing that segment. I would highlight that, you know, for us, the key differentiators on why we think we can win and why we, quite frankly, have won in the MCV space, is, A, our strong brand. You know, and, and having a strong brand in Asia makes a massive difference.

Obviously, being there for more than 127 years and having established a credibility with consumers and all other stakeholders really matters because people can trust us. We, we also aspire to have the best products in market, and we have the best people. I think those combinations are why, you know, we will continue to outperform in Asia and quite frankly, in the MCV space. It's always been a part of our focus. Now with the reopening, given that that market had, had gone away for some time, we're just doubling down on it, is the way I would position it. Phil, you might wanna supplement that.

Phil Witherington (President and CEO of Manulife Asia)

Sure, happy to. Gabe, thanks for the question. A couple of supplements to what Roy has said. The first thing, and I referenced this a few minutes ago, is really over the course of the pandemic, the formalization of the Greater Bay Area framework, that put Hong Kong right at the center of the GBA. I, I think that, that is something for us, that provides us with confidence. This is a good market for us to capture strategically. I think the second thing is that looking at the underlying customer needs that exist within our Chinese mainland customer, mainland, customer segment, those needs are there, greater than ever before.

The need for long-term savings for retirement, the need for healthcare, the need for critical illness, and it absolutely makes sense that that's an appropriate market for us to capture. The final point that I'll make is that given our scale position in Hong Kong, we have the capabilities, we have the products, it just makes strategic sense for us to scale that with the flows that are coming into Hong Kong through MCV visitors. What I will say is that we've seen a big surge in the first and second quarter. I do expect that to be maintained, but I, I don't expect those rates of growth to continue. I think that, that rate of growth reflects a bounce back.

As we'd seen pre-pandemic, you know, there can be variation quarter to quarter in MCV volumes, but, it, it's there over a long period of time, and I expect the, the customer segment demand to continue.

Gabriel Dechaine (Senior Equity Analyst)

Thank you.

Speaker 18

Thank you. Our following question is from Mario Mendonca, from TD Securities. Please go ahead.

Mario Mendonca (Managing Director and Research Analyst)

Good morning. first, going back to Asia for a moment. The addition to the CSM from new business was obviously very strong this quarter, and when I try to connect that to something like insurance sales, it would just appear that this quarter was far greater than the increase in insurance sales. My question is: am I missing something? Should I also be considering the annuity sales, or is it appropriate to just compare that increase to the insurance sales?

Phil Witherington (President and CEO of Manulife Asia)

Hey, Mario, it's Phil. Thanks for the question. I, I would, I would encourage you to look at APE sales in total, taking into account both insurance and annuity sales. The annuity sales, as presented in the SIP, are absolute dollar amounts, not APE, and therefore it can be skewed by single premium, regular premium mix. We, we look at APE sales as the key metric, and that's been in, in aggregate, as Steve mentioned earlier, closely correlated between new business CSM and APE.

Mario Mendonca (Managing Director and Research Analyst)

Would you agree this, Phil, that this quarter, the increase in new business, the CSM, was outsized relative to the increase in APE? It just appears that way. Like I can see APE this quarter, CAD 879, very similar to last quarter, yet the increase in the CSM was from new business was far greater.

Phil Witherington (President and CEO of Manulife Asia)

Yeah, I'll, I'll, I'll answer with respect to Asia and then hand over to Steve.

Mario Mendonca (Managing Director and Research Analyst)

I'm asking about Asia specifically, so it's appropriate for you, I guess.

Phil Witherington (President and CEO of Manulife Asia)

Yeah. No, no problem, Mario. I know Steve may still wish to supplement.

Mario Mendonca (Managing Director and Research Analyst)

Right.

Phil Witherington (President and CEO of Manulife Asia)

There, there is the, there is a higher new business CSM this quarter. We have made some refinements to our methodology, which have had a benefit. Specifically for Asia, the-- if we strip out the impacts of those refinements, we'd still be seeing growth of approximately 20% in new business CSM, which is a, a strong demonstration of the value that we're driving. I, I agree with you, Mario. It's a little elevated this quarter, but I, I do expect to see strong new business CSM growth in the quarters to come. Steve, you're.

Steven Finch (Chief Actuary)

No, nothing to add. That's,

Mario Mendonca (Managing Director and Research Analyst)

Yeah. Steve, just so we're clear, does, does that mean there was, like, a one-time catch-up this quarter, or is this the new sort of sustainable level of CSM if APE were to be the same?

Steven Finch (Chief Actuary)

There, there was a modest, catch-up, year-to-date catch-up in the quarter on, some PAL methodology.

Mario Mendonca (Managing Director and Research Analyst)

Okay.

Steven Finch (Chief Actuary)

As Phil said, it was still a very strong quarter of growth. The year-over-year growth, instead of 26%, still would have been approximately or north of 20%.

Mario Mendonca (Managing Director and Research Analyst)

Okay, then the other question I have, and this is something we're seeing for all of the insurance companies, this growing disparity between reported and Core earnings. It's definitely not unique to Manulife. We're seeing it across the board. One of the big differences, these expected returns on your assets are just so different from what's actually materializing. What I want to do is think about the ALDA portfolio for a moment. We're looking at about a $53 billion portfolio. If the company were to reduce the expected return on the ALDA, then presumably these differences would moderate somewhat. The trade-off then, of course, is that if you reduce the expected return on the ALDA, then your net investment income would go down.

What I'm trying to understand is, first of all, have I characterized that right? Like, if you reduce the, the ALDA return, there's no P&L impact immediately, it's just the ongoing lower net investment. Is that correct?

Scott Hartz (CIO)

Yeah. Yeah, Mario. Hi, it's Scott. Thanks for the question. That's correct. You know, we've, we've tried to put in a rate of return that we think we can achieve or exceed on a through-the-cycle basis, and we have shown that we've accomplished that in the long term, and we put the additional slide in the appendix this time to show that not only in the long term, but over the last three and five years. There is gonna be variability. I mean, this portfolio is marked to market every quarter. Again, from that slide, you can see that variability quarter to quarter. We think the, the right way to think about the ongoing earnings power of the company over time is, is to look at that return.

If we reduce that return, we would, you know, we would show a, a lower underperformance in the quarters where we're underperforming, but a higher overperformance in the quarters where we're outperforming. So net, we would, we would end up showing, over time, a higher net income relative to core, which we don't think is appropriate. We're trying to, to call it right down the middle and, and end up with, you know, core and, and net income be the same over time.

Roy Gori (President and CEO)

Mario, let me just add that, you know, again, if you look at the last three years, which have been incredibly volatile years, and look at our net income versus core, our net in-income has actually been higher than core for those three years. For us, you know, the assumption itself should be, what do we feel confident we can deliver over a longer period of time? As you've seen from our deck, over 18.5 years, we've delivered against the assumption. We've looked at more recent time periods, which, again, have been very volatile, three and five years, which you see in the appendix. We've also delivered against that assumption. For us, it's about making sure that we've got the assumption that makes sense. Again, in some quarters, we're gonna be over, in others, we'll be under.

That's why we have a core metric, because we don't think that's at the fundamental performance of the franchise.

Mario Mendonca (Managing Director and Research Analyst)

Yeah, that's helpful. I mean, the only people that matter are the investors, and if the investors have lost faith... Again, this is not unique to Manulife. This is true for everybody. If investors are losing faith in this expected versus actual, I mean, it really does lead guys like me to have to just say, "Okay, forget what you're saying, just come up with a number on our own for what investors are focusing on." I guess the bottom line here is: What is your outlook for the second half of the year? Do these differences between core and reported, do they start to attenuate somewhat? Is this sort of the name of the game for the next little while?

Scott Hartz (CIO)

Yeah. Hey, Mario, it's, it's Scott. You know, these questions always come up when ALDA has underperformed its assumptions. We've, we've seen this before, then if you look at that graph, we had sort of 8 straight quarters where we outperformed, and these questions kind of go away. You know, while there is variability, you know, there's value to being in an ALDA portfolio, which, which Colin articulated in, in his opening remarks. I think you asked a good question last quarter when you said, "Well, is that variability worth it?" So that, that was, again, a bit of a motivation for that chart we put in the appendix, to show you exactly what that variability is and what the gross earnings are.

You know, those gross earnings are probably double the earnings on average we would have if we were fully fixed income. Yes, it's up to investors to decide, but I think that given the extra earnings we get versus fixed income is, is quite high. I think it's worth it for that, that variability, and it's, again, why we would have you focus on core in any given quarter. Over the long term, it's certainly fair to compare net income to core, but in any given quarter, it's why we have the core metric.

Mario Mendonca (Managing Director and Research Analyst)

Thanks.

Operator (participant)

Thank you. Our following question is from Lemar Persaud, from Cormark Securities. Please go ahead.

Lemar Persaud (Equity Research Analyst)

Yeah, thanks. I want to stick with that line of questioning on the ALDA portfolio. I understand the point you're trying to make on that Alder slide in the appendix, suggesting that, you know, the returns are solid over the past, you know, three years and five years, so over the longer term. It has been below the expectation for a full year now. I guess, is there, like, a line in the sand that we can draw suggesting that, you know, if expect-- if actual returns are below the expected for, say, let's say two years, then you guys have to revisit the return assumptions? Or could that persist for two years or even three years before you guys have to re-revisit those assumptions? I'll leave it there, and then I have a follow-up.

Scott Hartz (CIO)

Sure, Lemar. It's Scott again, thanks for the question. You know, we revisit those assumptions every year. Every year, you know, my team works with, with Steve's team to look at historical returns, to look at what the market's expecting on these things going forward, and it is a very long-term assumption. Looking at any quarter or any given year is, is not really the right way to look at it. I would tell you, I, I have more confidence in achieving those returns now, after having underperformed over the last year. A lot of that underperformance was driven by higher discount rates on these assets, which does weigh on valuations now, but higher discount rates imply higher returns in the future. Frankly, in periods of underperformance, I have more confidence going forward. It's almost the reverse.

If we outperform for a while because discount rates are down, that's when we start to ask ourselves, should we be bringing down the long-term returns? In this environment, I'm very confident in achieving these long-term returns.

Steven Finch (Chief Actuary)

Lemar, it's, it's Steve. I'll chime in. In the past, a lot of these questions came to me because if there was a change in assumptions, it went through reserves. I wanted to add as well that these assumptions are important for our product pricing, et cetera. Just reinforcing Scott's point, it's a very thorough process that we go through each year to validate long-term return assumptions. I won't repeat what Scott said, but I also have conviction in these assumptions, that they're appropriate over the long term.

Lemar Persaud (Equity Research Analyst)

Okay, thanks. Looking at your slide 17, your average Alder return over the last 18.5 years was 9.1, and on the same slide, you show that the S&P 500 was actually 9.4. Is the right way to think about the value of Alder just being the lower standard deviation of these returns? Because I would expect there'd be an illiquidity premium to being invested in these Alders. Like, how do I answer that question from, from investors? Like, why not just look at the S&P 500 and say, you know, the Alder portfolio is underperforming that? Like, where is the, the value in your, in your opinion?

Scott Hartz (CIO)

Yeah, thanks. A great question, and, you know, the S&P has performed very well over this time period. You look at the TSX, and it hasn't performed as well in other foreign markets. We're invested in public equities in different markets, depending upon where we do business. I, I would say versus more global markets. Our Alder portfolio is a global portfolio, it has outperformed public markets. To your point, the real value is in the lower volatility. You know, it's a, it's, it's a tenet in investing that what you really want to look at is the amount of return you're getting per unit of risk. Over the long term, I think our the volatility has been, as you can see on this chart, less about a third of the volatility of the public equity markets.

In fact, you know, if we redid that chart over the last five years, and had we been invested in the S&P 500, the S&P 500 actually would have outperformed on average, but the volatility was intense. There would've been quarters where we would've lost, like, $6 billion because of the extreme volatility we've seen in that market over the last five years. It, it is the lower volatility that's really the, the powerful part of the portfolio, and that's a function of a very diversified portfolio, in six different categories that are not all correlated, and us staying at the low end of the risk-return spectrum.

Lemar Persaud (Equity Research Analyst)

Thanks. My next question, it wasn't long ago where, you know, we were looking at wealth management momentum in the Core EBITDA margins, and, you know, they were approaching kind of the 30% range. It looks like over the past few quarters, there's, there's been a change. We have to be thinking of more in the kind of below 25% range. I just want to revisit that assumption. Is there a path back to the high twenties and low thirties EBITDA margins, or is that off the table until we see more of a recovery in, in industry trends and wealth management? Thanks.

Paul Lorentz (President and CEO of Global Wealth and Asset Management)

Yeah, thanks for the question. It's Paul here. We're still committed to the 30% margin, and it probably would make sense to give you some context for what we saw year-over-year and then what you're seeing from prior quarter. If we just take a step back to last year, there was a, there was a couple items impacting the year-over-year. The first is we did have some re- repatriation of some seed assets and some alternative assets that were moved into a fundraise. That and the other impact was the step-up acquisition of Manulife Fund Management in China. While that's accreted to earnings, there is a little bit of a drag on the overall margin in the short term, but we do expect that to be a tailwind over time.

The combination of those two would've been about 100 basis points of the decline from last year. The remainder amount was really the combination of muted market growth as we continued to invest in the business. That brings you to a Q1 versus what you're seeing in Q2. In Q2, you're starting to see a lot of that come back for a number of reasons. The primary reason is just the strong fundamentals of the business. There is one more day in Q2 versus Q1. That's worth about 30 basis points. The remainder, you know, close to 200 basis points.

That's really just from the strong fundamentals of the business. You're seeing very strong flows, again, in a very difficult market. We've got a resilient net fee income yield. You've seen some good expense management come through Q2 versus Q1. You've seen the margin come forward, and improve because of that. The other thing worth noting is when you look at the year-over-year comparison, we also did see a relatively significant increase in expenses as markets opened up, travel opened up, and we would not expect that continue. You're starting to see that moderate, where we've been able to really pull that back in from Q2 versus Q1.

We would expect, you know, looking forward, you know, we can't control markets, but, our track record and positive flows, the strong market share, the consistency of, you know, our net fee income yield, positions us well to continue to drive this margin go forward. As I mentioned at the start, we're still committed to that 30% margin, you know, assuming, you know, we get back to, to regular market growth.

Lemar Persaud (Equity Research Analyst)

Thanks.

Operator (participant)

Thank you. Our following question is from Joo Ho Kim from Credit Suisse. Please go ahead.

Joo Ho Kim (Equity Research Analyst)

Hi, thanks. Good morning. Just a couple quick ones here. For the expected credit loss line, the benefit that we saw from parameters and model updates of CAD 50 million in Stage 1, could you talk about the moving pieces in that line? I'm just trying to get a sense of what drove that this quarter, whether it was improved macroeconomic outlook or something else. Thanks.

Scott Hartz (CIO)

Sure, Joo. It's, it's, it's Scott, and thank you for the question. You have that right. The way the ECL works is we, we try to model out future credit losses, and that's a function of both the credit quality of the portfolio and how it's changed, but also the current macroeconomic environment. What goes into that model are things like the volatility of equity markets, equity markets in general, unemployment. All those parameters, or most of those parameters, on balance, got a little bit better, so that led to a little bit of a reduction in the ECL.

Joo Ho Kim (Equity Research Analyst)

Got it. Just last one from me. Similar line of questioning, just on expenses. At the top of the house, when I, when I look at your expense efficiency ratio target below 50%, it was-- it was around, I think, 46% so far this year. When I look at it, even in the prior, it's been under your target for a number of quarters. I'm, I'm just trying to get a sense of, you know, what, what's your good, good performance so far this year, and, and if you would consider lowering that medium-term efficiency ratio target. Thanks.

Colin Simpson (CFO)

Yeah, thanks, Joo. you know, you're right to point out expenses. There is quarter-on-quarter improvement, 200 basis points, actually, down to 45.1% for the quarter. So we're, we're, we're pleased with that trajectory, but, you know, never satisfied. you know, certainly not gonna announce a new target today, but really, the drive for efficiency is really important for me personally and for the organization, and, and we've got a great track record. When you look at the, expense CAGR between 2019 and 2022, it's only 1%. you know, and Phil did allude to it a few quarters ago, a bit of a step up in absolute expenses.

The reality is, as Paul also spoke to, is that we're starting to see a moderation of post-pandemic expense activity, and, you know, expense efficiency is just a real priority going forward.

Roy Gori (President and CEO)

Hey, Joo, Roy here. I'll just add to Colin's comments. I think he hit the nail on the head. It has been a massive focus for our franchise, and we're proud of the progress that we've made, and we're not stopping, if that's the implication in your question. We still feel that there's much more for us to do. We've invested more than $1 billion to digitize our business, and we've seen that come through in our straight-through processing metrics, where they've improved quite significantly. In fact, in 2018, only 68% of the transactions that we processed were digital straight through without any human intervention. At the end of 2022, that got up to 83%, and actually, year to date this year, we're up a further 2%.

Those efforts to digitize our business are really translating into that improvement, and we still think that there's much more opportunity for a scaled operation like ours to continue to digitize, which not only gives us the cost benefits that you highlight, but also translates into better customer experiences, which ultimately leads to satisfied customers and more product sales. This is a journey that we're continuing and committed to.

Joo Ho Kim (Equity Research Analyst)

Got it. Thank you.

Operator (participant)

Thank you. Our following question is from Doug Young, from Desjardins Capital Markets. Please go ahead.

Doug Young (Analyst)

Hi, good morning. Just two kind of maybe follow-up questions to, to earlier questions. First is, Steve, on the unfavorable lapse experience in the U.S. that went through the CSM, can you kind of dig a little bit more into that? Can you quantify it? Where I'm going with this, and obviously a secondary guarantee, UL has been a hot topic and an area of some pressure for some of your peers in the U.S.. Is that where we're seeing the pressure, and why shouldn't that be a concern for us and investors?

Steven Finch (Chief Actuary)

Sure, Doug. Yeah, I'll-- I can dive into that one a little bit more. You know, I'll take you back to just before the pandemic. We had been. You know, as you know, we update assumptions frequently as experience emerges, and before the pandemic, we were up to date on U.S. lapse assumptions. We had strengthened reserves there over the years, which you probably recall. During the pandemic, what we saw almost right away in 2000 was, you know, disconnects in lapse rates on some of our products. Protection products in the U.S. dropped about 20%. We saw a similar phenomenon in Canada, with some similar product design showing drops in lapse rates, drop in lapse rates on variable annuities. What, what we've seen since that time is.

... In Canada, and in particular, in the past couple of quarters, we have seen a trend back to pre-pandemic lapse rates in those product lines, level COI, UL, and seg funds. Also informing my views, which I'll get to, is during the global financial crisis, while it was a different shock to the system, we saw similar types of discontinuities and lapse rates on different products, and over time, those lapse rates trended back to pre-shock levels. That continues to be my expectation in the U.S., is that we will see a trending back to U.S. lapse rates over time, to pre-pandemic lapse rates over time.

Doug Young (Analyst)

Just to confirm, this was related to the no-lapse guarantee UL block. Am I correct in that?

Steven Finch (Chief Actuary)

It would include the no-lapse guarantee block as well, but we also have other protection products where we've seen some similar trends. You-

Doug Young (Analyst)

It's just can you quantify, is it just an immaterial amount?

Steven Finch (Chief Actuary)

It's, this is the, the key driver in terms of the, the CSM experience in the, in the quarter for the U.S. that you can see on the, in the, in the results. Yeah, the, I guess the other thing I'd add, re-reminder here that on this, on these protection products, lapse rates are very low. So we're not talking about a, a change from 5% annual lapse rates to 3%. These are variable... Like, on the NLG lapse rates, those expected rates are below 1, and these are, you know, small changes in lapse rates, but, you know, capitalized over, you know, a long period of time, they can have an impact. You know, we'll, we'll wrap that with my conviction that I do expect those rates to trend back over time.

Doug Young (Analyst)

Okay. Just maybe, Phil, Hong Kong, I think we talked a bit about this, I mean, sales are up 100%, core earnings down 13%. You talked a bit about the mix shift, the margins down. You know, I guess slower amortization for the VFA. Is there anything else that's really putting pressure on Hong Kong outside of those items? Then with the VFA, like, if we see rates start to stabilize and maybe go the other way, is that something that could be a bit of a tailwind? Can you quantify, maybe a better way to think of it: How can you quantify how big the slower amortization of VFA has actually had on Hong Kong or on the Asia business?

Phil Witherington (President and CEO of Manulife Asia)

Sure. This, this is Phil. Thanks for the question. The core earnings in Hong Kong, you, you do highlight the 13% decline relative to second quarter of 2022. I, I will point out the stability, sequential stability with Q1, which is important in the context of the, the point you made in the first quarter that you just highlighted. There is a headwind coming from slower amortization of CSM in response to higher interest rates, and I'll let Steve comment on how we expect that to trend prospectively in a few moments. In terms of other things going on, under IFRS 17, we typically expect stable but growing earnings to emerge as new business is put on the books and CSM builds.

What we've seen over the course of the pandemic is lower levels of new business than we would typically expect, as well as the impact of the macro environment on the CSM balance, the inorganic movements in the CSM balance. That is translating to a headwind in terms of core earnings growth in Hong Kong and across other markets as well. From here, our focus is very much on the underlying commercial drivers of value, and you see that coming through in the second quarter with the new, new business CSM growth, but also the organic CSM growth, 11% annualized in the second quarter, and this will translate to future core earnings growth for the Asia segment. I remain optimistic that we'll see core earnings expansion in future quarters.

At this point, I'll hand over to Steve to comment on the amortization methodology.

Steven Finch (Chief Actuary)

Sure. Thanks, Phil. Yeah, the slower CSM amortization on VFA contracts, that is impacting each of the insurance segments to differing degrees. You know, as noted earlier, the benefits of higher interest rates, so a significant benefit in total for the company of about CAD 110 million pre-tax relative to prior year Q2. Embedded that, in that is a headwind of approximately CAD 60 million pre-tax from the slower amortization. However, going forward, you know, we were looking at our methodology on amortization. We implemented a refinement to our methodology so that going forward, we would expect materially less variability in CSM amortization due to interest rate changes. Q2 of this year is a good run rate going forward that we will grow off of as we continue to write profitable new business.

Doug Young (Analyst)

Okay. That's good, Phil. If I can sneak one more in, just I think they're talking about or have implemented fee caps in China, I forget, but you can kind of correct me if I'm wrong. You know, you've obviously expanded in the wealth management in, in, in China. What implication does that have for the, for the WAM business?

Paul Lorentz (President and CEO of Global Wealth and Asset Management)

Yeah, thanks for the question. It's Paul here. The regulator did impose some caps around on equity funds, the intent of that is to encourage more investors to come into the market, which over the medium to long term, will be good for the industry and for us. From our perspective, it's not material to the Guam business in terms of what they're doing there, it doesn't change kind of our outlook and product pipeline. If you look at our focus globally as an organization, one of our big strengths is global fixed income, particularly Asia fixed income, and we think we're well positioned to capitalize on that in the market.

The team there is, is taking that in and looking at whether it would have any material impact on their product plans, and the answer to that is no. We don't see a, a material impact to us there. We're still very optimistic about-.

... the acquisition of our, our partner there and, and the plans we have go forward and, and the product pipeline we have for the second half of the year, is, is mostly focused more on the fixed income side. We feel good about the, the progress going forward.

Doug Young (Analyst)

Appreciate the color. Thank you.

Speaker 18

Yep.

Operator (participant)

Thank you. Our following question is from Nigel D'Souza from Veritas Investment Research. Please go ahead.

Nigel D'Souza (Senior Investment Analyst)

Good morning. Thank you for taking my question. I had some follow-up questions for you. First, on the commercial real estate portfolio. I think last quarter, you mentioned specific markets that drove the fair value of losses there. I think Chicago was one of the markets you singled out. Were there any specific markets that drove the impact this quarter, or was it broad-based across the portfolio? From what I recollect, I think you mentioned that you didn't expect to take another fair value, I guess, write down here, a loss, unless market conditions deteriorated. My understanding was cap rates were mostly fully reflected or higher cap rates were mostly fully reflected in Q1. Just some additional color there would be helpful.

Scott Hartz (CIO)

Sure, Nigel. Yeah, thanks for the question. It's Scott. In our commercial real estate, we're, we're seeing, you know, broad-based weaker valuations as cap rates rise across the board. I'll remind you that as, as Colin mentioned, over 95% of the portfolio is externally appraised each quarter. We are up to date on our valuations, but the appraisers are still, you know, trying to figure out where this market should settle. They've continued to raise cap rates. You know, office is a little bit worse for sure, but we are seeing pressure across, industrial, across multifamily in all, all the different North American geographies. I would say our Asian portfolio, which is 28% of our, our real estate portfolio, has, has actually held up fairly well.

Really, the question going forward everyone's trying to figure out is, are we done? We do feel like the majority of that raising of cap rates is done, but it may not be fully done, and it will be a function of where long-term rates go. There may be, you know, a little bit of weakness going forward, but we wouldn't expect a similar amount of weakness that we saw in the first half of the year.

Nigel D'Souza (Senior Investment Analyst)

Okay. The second question I had was, circling back to expected investment, earnings. Any, any sizing of the portion of the portfolio that's already rolled over to higher reinvestment yields? Just trying to get a sense of the remaining runway here. You know, comparing that to earnings on surplus, just want to clarify that the reason we aren't seeing a similar earnings on surplus quarter-over-quarter is due to a high interest cost. Just some, color there is helpful.

Scott Hartz (CIO)

Yeah, it's Scott. I'll take the turnover question. I think what you've seen is first of all, you know, we hold, as you'd expect, prudently, a decent amount of cash, and that, you know, earnings rate on that has gone up tremendously over the past year and maybe even a little bit more recently. And so that's always turning over at current short-term rates. For the long-term portfolio, we have a very long portfolio to prudently match our long liabilities. So the vast majority of the portfolio has not turned over, but it's not going to turn over a tremendous amount in a given quarter or a given year. I think the average duration of our portfolio, interest rate duration, is something like 12 years. So that's about how long it takes to turn the whole thing over.

Colin Simpson (CFO)

Nigel, just on your higher interest on surplus, it's CAD 94 million higher year-on-year, but that has been offset by higher cost of variable debt, which is CAD 32 million. You do actually see the number in the core earnings. It's just partially offset by a higher cost of debt.

Nigel D'Souza (Senior Investment Analyst)

Okay. And just quick clarification there, from the comments on the portfolio turnover, am I understanding correctly that it's actually the shortening of the curve that that's benefited that line item over the recent quarters, and there's a greater, I guess, beta to, to the short end of the curve? Or, or am I, am I misunderstanding the dynamic there?

Scott Hartz (CIO)

Yeah. I think, I think the short end going up a lot has certainly helped the cash earnings for sure. That's been a tremendous increase. Rates are up everywhere. While we do long investing and we, you know, as those, as those assets turn over, if we kept them shorter, we could probably earn more in the short run, but that would not be a prudent match against our liability. We do reinvest them long term, and long-term rates are, are a lot higher now than they were before, even though the yield curve's inverted.

Nigel D'Souza (Senior Investment Analyst)

Okay, that's it for me. Thank you.

Operator (participant)

Thank you. Our following question is from Darko Mihelic, from RBC Capital Markets. Please go ahead.

Darko Mihelic (Managing Director and Senior Analyst)

Hi. Thank you. Good morning, and I promise I do have a long-term view on stuff, but I'm going to focus a little bit on the short term today. And I thought I heard somewhere in prepared remarks that... My first question is around commercial real estate values dropping by about 30% in the U.S.. I think I heard that correctly. Trouble is, I'm not a, I'm not an expert, so I'm looking for a little bit of color around that. In other words, you also just mentioned it was 95% externally appraised. So is 30% kind of in line with what we're seeing, at, at most other places? Is there any benchmarks you can provide, even internally? You know, how does that compare to your Canada, Asia portfolio of commercial real estate?

Maybe lastly, a little bit of color, you know, around that would be: Would that mark also include own use commercial real estate? Just looking for some color that tells me... You know what? You, you absolutely are conservative on the CRE portfolio would be helpful. Thank you.

Scott Hartz (CIO)

Sure. Thanks, Darko. Yes, you heard correctly Colin's opening remarks, that our U.S. real estate portfolio, U.S. office real estate portfolio, which is only 5% of the overall portfolio. It was a much higher % if you went back post the GFC. We sold over $3.5 billion worth of North American office in the last 5 years, so we really have dramatically reduced it. Still, when it drops 30%, that's gonna hit your income a bit. Yes, we do have over 95% of the portfolio appraised externally each quarter, so we think the valuations are absolutely up to date, but that doesn't mean there could be additional pressure going forward.

As I said earlier, I do think the pressure we're seeing at this point is more broad-based, in terms of rising cap rates as opposed to an asset class where people are concerned about higher vacancies going forward, which was certainly the case for U.S. office. We do have a diversified portfolio. 28% of the portfolio is in Asia, the balance is in the U.S. and Canada. In Asia, there aren't the same pressures on office. There, you know, people are continue to go into the office, and so we haven't seen much of any valuation drops in Asia and would not really expect to going forward. In fact, we've seen in certain markets like Singapore, actually increased appraisals, given the dynamics there.

Yes, this office and that 5% of the U.S. would include, you know, the stuff that we occupy. So, that's probably down a little bit less given that you wouldn't expect big vacancies there going forward. You know, rental levels are down because vacancies are up and our businesses will benefit from that. We will charge them, you know, lower rents as rents come down, and that gets capitalized into the value of the real estate. It does include the whole office real estate. I guess finally, you know, we are using external appraisals. We think that's largely what people would say. They would expect U.S. office broadly to be down about 30%.

I think if you look at some of, some competitors out there, it's maybe down a little bit less than 30%, but, you know, I don't know if they've all used external appraisers and are completely up to date. We feel like we're, we're, we're very up to date on that. Doesn't mean there couldn't be further weakness, but we feel we're up to date.

Darko Mihelic (Managing Director and Senior Analyst)

Okay, that's, that's really helpful. Thank you for the extra color. A follow-up question is with respect to the lending that you do against portfolios of commercial real estate, and specifically office, not small, in your portfolio. The reason why I'm asking this question is, you know, we cover banks, and we're all under IFRS 9 accounting, and if I really wanted to, every quarter, I can look up the stage two reserve, so to speak, or, you know, it, it would be more broadly based, but I can look at it. Banks offer up LTVs on that portfolio. They offer up delinquency movements in stage two.

So I'm surprised when I see the expected credit loss basically being nothing overall this quarter, for the company, considering that there's, there's some stress in that portfolio, or at least as an outside observer, I think there's some stress. Can you speak to maybe the stage two reserve you have against that portfolio, delinquencies there, LTV, anything else that you could offer on the, the, the direct mortgage portfolio that has office exposure, and, and how well reserved you are and, and what that portfolio kind of looks like right now?

Scott Hartz (CIO)

Yeah, thanks. It's a really good question. Obviously, real estate and office in particular, is under pressure. Now, our commercial mortgage portfolio is 7% of our overall portfolio, and office loans are only 2% of the overall portfolio, so it's not a very large exposure. I would say, you know, when you compare insurance companies to banks, we tend to be, as an industry, pretty conservative lenders. I would expect, and you saw this in the GFC, you would expect insurance companies to do better than the CMBS market, which is a more aggressive lending market in the banks. If you look at our portfolio, it's currently... We've revalued all the properties, we're doing that now on a quarterly basis.

It's at a, at a 59% loan to value, so, you know, on average, it's in good shape. There can be pockets of weakness in different markets, certainly office. You know, if you look at our office alone, it's a 64% on average. Still a very comfortable number, but there are pockets of stress. At, at the, at the end of June, our reporting period, we didn't actually have any delinquencies in the portfolio, but I do expect those to arise, and so we have put up some impairments, some stage 3 impairments and some stage 2, which is more. Stage 2 is more a downgrade. Stage 3 is where you're putting up a specific provision. You know, we did, in the 1st quarter, put up some. We put up some in the 2nd quarter as well.

That was then, then the, the modeling, which we talked about earlier in the model inputs, reduced that back to about a, a net nil. I think we've been prudent in trying to get ahead of what's coming at us by putting up some impairments in that portfolio, even though we, we, it did not have any delinquencies. And it will continue to be under pressure. You know, I guess my final message is, both as, as an industry, the insurance industry and, and us specifically, we, we are conservative lenders in a market that is having a little bit of stress.

Darko Mihelic (Managing Director and Senior Analyst)

Okay. That's also helpful color. Thank you.

Operator (participant)

Thank you. We have no further questions registered at this time. I would now like to turn the meeting over to Mr. Ko.

Hung Ko (VP, Group Investor Relations)

Thank you, operator. We'll be available after the call if there are any follow-up questions. Have a good day, everyone.

Operator (participant)

Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.