MetLife (MET) Q2 2013 Earnings Call August 1, 2013 8:00 AM ET
Edward A. Spehar - Head of Investor Relations
Steven A. Kandarian - Chairman, Chief Executive Officer, President and Chairman of Executive Committee
John C. R. Hele - Chief Financial Officer and Executive Vice President
Michel Khalaf - President of The EMEA Division
William J. Wheeler - President of The Americas
Steven Jeffrey Goulart - Chief Investment Officer and Executive Vice President
Christopher G. Townsend - President of Asia
Maria R. Morris - Head of Global Employee Benefits and Executive Vice President
John M. Nadel - Sterne Agee & Leach Inc., Research Division
Yaron Kinar - Deutsche Bank AG, Research Division
Suneet L. Kamath - UBS Investment Bank, Research Division
Thomas G. Gallagher - Crédit Suisse AG, Research Division
Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division
Eric N. Berg - RBC Capital Markets, LLC, Research Division
A. Mark Finkelstein - Evercore Partners Inc., Research Division
Ladies and gentlemen, thank you for standing by, and welcome to the MetLife Second Quarter 2013 Earnings Release Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.
Before we get started, I would like to read the following statement on behalf of MetLife. Except with respect to historical information, statements made in this conference call constitute forward-looking statements within the meaning of the federal securities laws, including statements relating to trends in the company's operations and financial results and the business and products of the company and its subsidiaries. MetLife's actual results may differ materially from the results anticipated in the forward-looking statements as a result of risks and uncertainties, including those described from time to time in MetLife's filings with the U.S. Securities and Exchange Commission, including in the Risk Factors section of those filings. MetLife specifically disclaims any obligation to update or revise any forward-looking statement whether as a result of new information, future developments or otherwise.
With that, I would like to turn the call over to Ed Spehar, Head of Investor Relations.
Edward A. Spehar
Thank you, Greg, and good morning, everyone. Welcome to MetLife's Second Quarter 2013 Earnings Call.
We will be discussing certain financial measures not based on generally accepted accounting principles, so-called non-GAAP measures. Reconciliations of these non-GAAP measures and related definitions to the most directly comparable GAAP measures may be found on the Investor Relations portion of metlife.com, in our earnings press release and our quarterly financial supplements. A reconciliation of forward-looking financial information to the most directly comparable GAAP measure is not accessible because MetLife believes it's not possible to provide a reliable forecast of net investment income and net derivative gains and losses, which can fluctuate from period to period and may have a significant impact on GAAP net income.
Now joining me this morning on the call are Steve Kandarian, Chairman, President and Chief Executive Officer; and John Hele, Chief Financial Officer. After their prepared remarks, we will take your questions. Also here with us today to participate in the discussions are other members of management, including Bill Wheeler, President of Americas; Steve Goulart, Chief Investment Officer; Michel Khalaf, President of EMEA; and Chris Townsend, President of Asia.
With that, I'd like to turn the call over to Steve.
Steven A. Kandarian
Thank you, Ed, and good morning, everyone. We are pleased to report another strong quarter, with most financial metrics exceeding our plan. Second quarter 2013 operating earnings were $1.6 billion, up 11% over the second quarter of 2012. Operating earnings per share were $1.44, a 7% increase over the prior year period, and operating return on equity was 12.3%.
This quarter's results reflect the continuation of our strategic shift away from capital-intensive, market-sensitive products to high-return, lower-risk product lines, as well as our strategy to grow emerging markets. This shift was evident with variable annuity sales down 40% versus the prior year period, while sales rose 28% in our Group, Voluntary & Worksite Benefits segment; 32% in Latin America; and 32% in the emerging markets within our Europe, Middle East and Africa segment. Our investment margins were favorable again in this quarter as a result of good variable investment income, effective asset/liability management and income from derivatives, many of which were purchased in the mid-2000s to protect earnings under a low rate scenario.
In the second quarter, our average investment spread across all U.S. product lines was the top end of the roughly 200- to 250-basis-point range experienced during the past few years. To help you think about the impact of interest rates on earnings, I refer you to the low interest rate stress scenario in our 2012 10-K. We said that the continuation of the late 2012 interest rate environment in the U.S. through year-end 2014 would reduce our operating earnings by $45 million in 2013 and $150 million in 2014 relative to plan.
In late 2012, the 10-year treasury yield was 1.69%. Our plan assumed rates would steadily increase and reach to 2.38% by year-end 2013, and then remain at this level through 2014. In addition, credit spreads were tighter in late 2012 than assumed in our plan. Today, the 10-year treasury yield is approximately 2.6% or slightly above our plan assumption, and credit spreads have widened, which puts them roughly in line with our plan. With a rate environment only slightly more favorable than our plan, we did not assume investment margins will expand as a result of the recent increase in interest rates. To be sure, higher interest rates are a positive development, but the benefits for MetLife are reduced risk of margin compression and balance sheet charges.
Now I would like to provide an update on customer centricity, followed by some comments on the regulatory environment. We continue to expand significant effort on the 4 cornerstones of our strategic plan because they are firmly within our control and critical to becoming a world-class organization. Regulatory outcomes by contrast are only partially within our control, but require no less effort, given their potential impact on our long-term competitive position.
Customer centricity is an important element of our strategy, and while it won't show up in the numbers overnight, it can help create an enduring competitive advantage for MetLife. I have noted in the past that MetLife and the life insurance industry have not done as good a job of delivering exceptional customer experiences as some other industries. Simply put, we are just too hard to do business with. As a result of important simplification work we are doing around the globe, we have early indications that enhancing the customer experience not only increases customer satisfaction but also reduces additional work and ultimately, lowers cost for MetLife. Results in several areas, faster call handling, improved self-service, first-contact customer resolution and streamlined claims processing, bear this out.
In Korea, improved technology has dramatically reduced telephone wait times, with 86% of calls answered in less than 20 seconds today, up from 47% before the upgrade. In the U.S., simple fixes to our website tripled customer use of our online change of address process and virtually eliminated related customer complaints. In the U.S. and Mexico, call center representatives, newly empowered with better tools and technology, are now resolving 60% of customer problems in a single contact, up from 45%. And in Poland, a redesigned claims process, including simpler forms, reduced documentation requirements and proactive status updates to customers, reduced life insurance claim payments turnaround times by 30% from 5.6 days to 3.9 days. There is still much work to be done, but I am encouraged by our early progress on improving the MetLife customer experience.
Now let me offer a few observations on the regulatory environment. As you know, on July 18, the Financial Stability Board designated MetLife and 8 other insurance companies as globally systemically important insurers or GSIIs. Our understanding is that being named a GSII has no legal effect unless MetLife is designated a systemically important financial institution or SIFI by the Financial Stability Oversight Council. If we are designated a SIFI, MetLife would be subject to enhanced prudential standards promulgated by the Federal Reserve. Furthermore, the Fed will have to determine whether to subject U.S.-based GSIIs to additional supervision and prudential rules.
Two days before we were named a GSII, FSOC voted to advance MetLife to Stage 3 of the SIFI designation process. As I said at the time, I do not believe that MetLife is a systemically important financial institution. The life insurance industry is a source of financial stability. Even during periods of financial stress, the long-term nature of insurance liabilities protects against bank-like runs and the need to sell assets quickly.
For pure protection products, the company makes no payment unless an insured event occurs, so there's no way to accelerate the liabilities. For products that include a savings component, there are strong disincentives to surrender and cash out. Not only can policyholders face surrender charges and tax penalties, but they may find it difficult to purchase new policies if they had to be medically re-underwritten. The existence of the state-based guarantee funds provides a further incentive for customers to hold on to their policies. Importantly, state insurance regulators have the ability to halt surrenders in the event of financial distress and have typically done so.
As a practical matter, being moved to Stage 3 means that FSOC can request nonpublic financial information to examine a company's potential for systemic risk. During the process, MetLife is permitted to submit additional information to FSOC, demonstrating that our business does not pose systemic risk. It's unclear how long we will remain in Stage 3 of the designation process. Our only frame of reference from the insurance industry is the experience of AIG and Prudential, both of which spent more than 7 months in Stage 3.
After Stage 3 is complete, a 2/3 vote of FSOC is needed for a proposed determination that a company is a SIFI, including an affirmative vote by the chairperson, who is The Secretary of the Treasury. If a company receives a notice of proposed determination, it has 30 days to request a nonpublic hearing to appeal the decision. FSOC then has 30 days to hold the hearing and another 60 days post hearing to make a final determination, which again requires a 2/3 vote of FSOC, including an affirmative vote by the chairperson. At that point, a company may bring action in U.S. district court, seeking to have the determination rescinded.
The critical question for insurers designated as SIFIs is what the prudential rules will look like. Will they be bank-like capital rules or rules appropriate for the business model of insurance? Senator Susan Collins of Maine helped put this issue in perspective in a letter to the federal banking regulators last fall. For context, Senator Collins sponsored a provision on the Dodd-Frank Act requiring capital standards for nonbank SIFIs to be no less rigorous than those that apply to banks. In her letter, she said, "it was not Congress' intent that federal regulators supplant prudential state-based insurance regulation with a bank-centric capital regime."
We strongly believe that insurance companies should be regulated differently than banks. As I've said many times, if life insurers are subjected to capital rules designed for banks, MetLife's ability to issue guarantees would be constrained. We'd have to raise the price of products we offer to consumers or stop offering certain products all together.
To be clear, we strongly support prudential regulation of the life insurance industry. After all, we are financially liable for insolvencies to the state-based guarantee funds. What is imperative is that the rules be tailored to the business model of insurance. In closing, while the regulatory environment remains fluid, we are delivering strong financial performance today and executing on our strategy to generate increasing shareholder value over time.
With that, I will turn the call over to John Hele to discuss our financial results in detail. John?
John C. R. Hele
Thank you, Steve, and good morning. Today, I'll cover our second quarter results, including a discussion of insurance margins, investment spreads, expenses and business highlights. I will then conclude with some comments on cash, capital and guidance.
As Steve noted, MetLife reported operating earnings of $1.6 billion or $1.44 per share, up 11% year-over-year. This quarter included a few notable items, all in our EMEA region. The first relates to our pension business in Poland. In June, the government of Poland announced 3 proposals, and any one of these 3 would materially change the country's pension system. A change in the system is expected before the end of the year, with implementation occurring sometime in 2014.
We expect that the economics of our pension business will be materially altered in Poland, resulting in either a significant reduction or the elimination of our pension assets under management, which were approximately $7 billion as of June 30. Therefore, we have written off the entire DAC and VOBA balance related to this business, resulting in an after-tax charge of $26 million or $0.02 per share in the second quarter. Going forward, our preliminary estimate is that this change to the Polish pension system will reduce EMEA's operating earnings by $15 million to $30 million annually.
Also in EMEA, we had a couple of onetime tax items this quarter. The first was a tax benefit of $52 million, as we made an APB 23 assertion for the region. This was partially offset by a $30 million write-off of a deferred tax asset related to our U.K. wealth management business due to regulatory changes that made future sales growth and profits less certain for this startup operation. The net benefit of these 2 items was $22 million or $0.02 per share.
Turning to our bottom line results. Second quarter net income was $471 million or $0.43 per share and included net derivative losses of $1.1 billion after tax. The net derivative loss in the quarter was driven primarily by 3 items that we consider to be either noneconomic or a cause of asymmetrical accounting treatment. These are: number one, an increase in interest rates; number two, changes in foreign currencies, principally the weakening of the yen relative to the U.S. dollar; and number three, the MetLife-owned credit impact associated with our VA program. Book value per share, excluding AOCI, was $47.20 at June 30, down modestly from March 31. This slight decline was a function of modest net income due to the net derivative loss and 2 quarterly dividends declared in the quarter.
Turning to margins. Underwriting was generally unfavorable this quarter. The mortality ratio in retail life was 89.7% due to unfavorable experience in both variable and universal life and traditional life. This result was higher than our expectation for the quarter and worse than the 85.6% ratio in the second quarter of 2012. The mortality ratio in group life was 86.5% in the quarter, favorable to the prior year quarter of 87.3% and well within the target of 85% to 90%. The improvement in the mortality ratio was driven by lower Group Universal Life claims experience. As a reminder, a 1-percentage-point change in mortality ratio equates to quarterly operating earnings impact of approximately $2 million to $3 million for retail life and $8 million to $10 million for group life.
The Non-Medical Health benefit ratio was 89.5%, up 210 basis points from the prior year quarter of 87.4% and at the top end of the targeted range of 86% to 90%. The primary driver for the increase in the ratio was weaker underwriting results in long-term care due to higher incidence and to a lesser extent, an increase in the average claim size. However, we are seeing an improvement in disability underwriting results as the overall claims incidence trend continues to be favorable. As a reminder, a 1-percentage-point change in the Non-Medical Health benefit ratio equates to an operating earnings impact of approximately $10 million on a quarterly basis.
In our P&C business, the combined ratio, including catastrophes, was 107.5% for Retail and 97.7% for group. Retail was impacted by higher-than-budget catastrophes in the Midwest. Overall, catastrophes were higher than budgeted in the quarter by $16 million or $0.01 per share. The combined ratios, excluding catastrophes, were higher year-over-year in both Retail and group at 86.1% and 92.1%, respectively. The increase was driven by elevated non-catastrophe weather-related losses and lower favorable prior year reserve development.
Next, let me turn to investment spreads. In our QFS, you will note that the spreads remain strong and are higher versus the prior year quarter across all major product lines in the U.S., driven by higher variable investment income and derivative income. A simple average of the investment spreads in our U.S. businesses were 244 basis points this quarter, which compares to 231 basis points in the second quarter of 2012 and 235 basis points in the second quarter of 2011. This progression illustrates the resilience of our investment margins despite a challenging interest rate environment. In the quarter, pretax variable investment income was $312 million, reflecting strong returns from private equities and hedge funds. After DAC and taxes, variable investment income was $202 million or slightly less than $0.01 per share above the top end of our 2012 -- 2013 quarterly guidance range.
With regard to expenses, the operating expense ratio was 23.5% for the second quarter. Excluding the impact of pension and postretirement benefits and closeouts, the operating expense ratio was 22.8%. This compares favorably to the second quarter of 2012, which had an operating expense ratio of 23.7% and 23.4% excluding pension and postretirement benefits and closeouts. We are pleased with this performance as it reflects progress on our strategic goal to reduce net expenses by $600 million. Through the first half of 2013, gross expense saves were $248 million, while net saves were $173 million after adjusting for reinvestment of $12 million and onetime costs of $63 million.
I will now discuss some of the business highlights in the quarter. Rather than go through every segment, I will focus on areas where our results may have differed from your expectations. Therefore, my comments will be on Retail annuities, Group, Voluntary & Worksite Benefits, Corporate Benefit Funding, Latin America and Asia. Retail annuities reported operating earnings of $368 million, up $142 million or 63% versus the prior year quarter. The earnings drivers were comprised of several factors, including favorable market impact, lower ongoing DAC amortization, lower operating expenses and higher net investment income.
Variable annuities sales were $2.8 billion in the quarter, down 40% year-over-year and 22% sequentially. We continue to target full year VA sales of $10 billion to $11 billion. Effective August 12, we are eliminating sub-pays for all GMIB Max and Enhanced Death Benefit Max products, other than our current product, GMIB Max V.
Group, Voluntary & Worksite Benefits reported operating earnings of $275 million, up 3% year-over-year. As I mentioned previously, underwriting results were unfavorable in long-term care and property and casualty, and this was a case both year-over-year and relative to our expectations. However, improved investments and expense margins were effective offsets to less favorable underwriting margins.
Turning to Corporate Benefit Funding. Operating earnings were $350 million, up 10% year-over-year. The growth was driven by improvements in investment and underwriting margins. Investment margins improved as a result of lower credit interest, primarily on capital markets products, and higher variable investment income. The increase in underwriting margins was primarily driven by a mortality gain in the U.S. pensions business.
In Latin America, operating earnings were $125 million, down 7% year-over-year and 11% on a constant-currency basis due to adverse mark-to-market investment results in Brazil and Mexico, the impact of inflation in Mexico and Chile and higher expenses primarily due to business initiatives in the region. While bottom line results were pressured, underlying business growth in the region drove solid top line performance. Premium fees and other revenues were up 12% year-over-year and 8% on a constant-currency basis, driven by growth in worksite marketing in Mexico, group insurance in Brazil and direct marketing in Argentina.
In addition, total sales in Latin America were up 32% year-over-year, with strong growth in all countries. In Mexico, sales growth was driven by increases in Retail and Group products. In Chile, the sales increase was driven by growth in the agency force. In Argentina, the increase was driven by direct marketing. And finally, sales growth in Brazil was driven by higher accident and health sales.
Turning to Asia. Operating results were $330 million in the quarter, up 18% year-over-year and 27% on a constant-currency basis. Earnings were driven by underlying business growth; higher fee income from the surrender of foreign currency fixed annuity products in Japan; and strong equity market performance in Japan, which resulted in a decline in variable life guaranteed minimum death benefit reserves that benefited operating earnings by $19 million. This quarter, we again saw higher surrender activity in Japan, which was an item we've highlighted on our last call. This is the result of customers harvesting gains in foreign-currency-denominated fixed annuity products, denominated in Australian and U.S. dollars. We believe that customers have shifted assets into equities, which continue to perform very well.
In the quarter, surrender fees in excess of plan contributed $35 million to Asia's operating earnings. We expect that surrender fees will decline significantly in the second half of the year. In addition, as a result of elevated surrenders in the first half of the year, we would expect to see a reduction to operating earnings by slightly less than $15 million annually.
Finally, Asia's second quarter operating earnings were $9 million lower than our plan as a result of yen weakness relative to the U.S. dollar. As we have stated previously, we have hedges for our 2013 projected yen-exposed operating earnings at strike prices at around JPY 90 to the U.S. dollar. These hedges are currency options which provide protection against the yen weakening beyond JPY 90, but allow us to participate if the upside should the yen strengthen. Our protection now extends to the third quarter of 2014, with currency options at around JPY 90 in place for the first quarter, around JPY 95 in the second and in the range of JPY 95 to JPY 100 for the third quarter.
Now I will discuss our cash and capital position. Cash and liquid assets at the holding companies were approximately $6.5 billion at the end of the second quarter. The increase was driven primarily by $1.4 billion of subsidiary dividends, as well as the $550 million release of capital from unwinding MetLife Bank, as we mentioned at our May Investor Day.
Next, I would like to provide you with an update on our capital position. As you know, we report U.S. RBC ratios annually, so we do not have an update for the second quarter. With regards to Japan, our solvency margin ratio was 1,033% as of the first quarter of 2013. Our preliminary statutory operating earnings and statutory net income for our domestic insurance companies for the second quarter of 2013 were $614 million and $176 million, respectively. Statutory operating earnings were up $382 million from the prior year due to improved market conditions, while net income was lower than the prior year primarily due to derivative and joint venture capital losses.
For the first 6 months of 2013, statutory operating earnings and statutory net income for our domestic insurance companies were $1.4 billion and $734 million, respectively. Total adjusted capital for our domestic insurance companies is expected to be approximately $27.4 billion as of June 30, down 6% from December 31 primarily due to subsidiary dividends paid to the holding company. Excluding the dividends, total adjusted capital would have been down 1% for the year due to unrealized losses driven by derivatives.
Finally, let me provide some comments regarding guidance. Considering the outperformance in the quarter and the first half of the year, we now expect to exceed the top end of our 2013 EPS guidance range of $4.95 to $5.35. We believe that our operating EPS will likely be lower in the second half of 2013 relative to the first half of 2013 primarily for 4 reasons: number one, we still anticipate investment spread compression for the balance of the year despite recent increase in interest rates due to our expectation for lower variable investment income and lower core yields; number two, we assume a less favorable market impact for the second half of the year; number three, we expect that surrenders in Japan will return to a more normal level in the second half of the year, which should mean a decline in surrender fee income relative to the first half of the year; and number four, we project higher expenses in the second half of the year, driven by key enterprise initiatives. Partially offsetting these items is the anticipated accretion from the acquisition of Provida, which is expected to close at the beginning of the fourth quarter.
And with that, I will turn it back to the operator for your questions.
Earnings Call Part 2: