James D. Wehr – President, Chief Executive Officer & Director
The Phoenix Companies, Inc. (PNX) Credit Suisse Group Financial Services Forum Conference Call February 10, 2011 9:30 AM ET
James D. Wehr
Really what you’re going to hear this morning is a turnaround story. We’re going to talk at a very high level. It’s a turnaround that’s in process. It’s clearly heading in the right direction but not complete so as I think about things from an investor perspective I think that’s an interesting time to understand or start to understand the story and it still gives you an opportunity to get involved as things evolve and continue in the right direction.
I’m going to condense this to just a couple of statements. Today’s presentation may contain-forward looking statements within the meaning of the Federal Securities Laws. Actual results may differ materially from those suggested by those forward-looking statements. I want to note that we plan to release fourth quarter earnings next Thursday, February 16th so results discussed today will be based on third quarter 2011 numbers.
So you can see the headline, “Dramatic transformation since 2009,” I’ve used the words comeback. Let me show you where we were when I took over as CEO in April of 2009 in the midst of the financial crisis and contrast those with where we are today. I think folks in the room know that 2009 was a brutal year. It certainly was for Phoenix, multiple rating downgrades, loss of major distributors which translated into further downgrades, a product portfolio with essentially no market. We’ll talk about that a little bit. Our stock price actually hit, in early March of ’09 a low of $0.21, Sam you should have been involved at that point. Large losses, shrinking capital, it really was a very challenging environment as it was for many financial services companies.
The question was, “Was it an unsustainable enterprise?” And the answer was if we didn’t change things and change them pretty quickly it was. But, we had the confidence and the inherent value of the Phoenix brand and franchise, and felt with the right plan and effective execution we could make the long road back.
Let’s bring it forward to today. Improved really in all the critical areas, ratings we’ll talk about that a little bit, distribution, financial strength, and stock price. We feel that we’re a company on a solid foundation, gaining traction on growth, and an interesting and opportunistic investment given the fact we’re trading at 24% of current book value.
So let’s talk a little bit about, and Sam I think you suggested you were interested in an overview of the company and then where we’re at from a product perspective. I’m not going to spend any more time on the past but I do want to give you that in the context of where we are at currently. So Phoenix today is a growing boutique insurance company. We’re serving the middle market, retirement, and protection needs and we’re selling our products primarily through independent distributors or IMOs.
We have a variety of life and annuity products but most of our recent sales have been in the fixed index annuity space. We have in addition to our current focus on fixed index annuities, a very large enforce life block with $127 billion face amount and about $4 billion of annuity assets under management.
As we look at ourselves in the current environment, we feel that our competitive strengths relate well in the middle market. We’ve found that our brand has translated well in the middle market. A lot of the strengths that we developed as a high net worth company have translated well. Our brand is well known and has been around for quite a long time and is appreciated and our products, particularly the fixed index annuity, is well designed and attractive in that middle market space.
We also have a very long history, dating back to 1851, that speaks to stability, and as I said, a brand that resonates well. So we feel positioned to grow but very cognoscente of pursuing new business in the context of we want to grow, we want sales, but we also know it’s important to manage our capital base and make sure that those sales and that growth is profitable.
When I took over in early 2009 we put together a pretty straightforward strategic plan based on four strategic initiatives or strategic pillars. You can see them on the page in front of you. We really spent most of 2009 focusing on the first three, so the balance sheet, policyholder service, and efficiency. We felt if we were able to manage all three of those well, that would position us down the road to restart the growth engine and to restart sales of new products. So as we head into 2012 the fourth pillar, profitable growth, as become much more important although the first three remain an important area of focus.
The next several pages I’m going to bring you up on where we’re at against each of those pillars. Balance sheet strength, as it is for most financial services companies and particular for us, back in 2009 was the first priority. You can see the progress that’s been made. We’ve compared as of the end of the third quarter 2011 back to end of ’09. You can see that statutory capital has grown by about 50% from $574 million to $864 million and our RBC ratio, which is a measure of capital adequacy has grown or increased by 86 points to 309%.
Driving the improvements in our capital base have been the strength of our investment portfolio and improvements in the portfolio in terms of credit losses declining, market value increasing, much having to do with the strength of the portfolio but clearly being helped by the improvements in market. We’ve taken advantage of our improvement in our financials to build a strong and flexible capital position. In the fourth quarter we completed a reinsurance agreement that added further financial flexibility.
So looking back to ’09 we know how important financial flexibility can be. We’re in a fairly benign environment right now but we know that things will not always be that way so financial flexibility is an important area for us to focus. In the area of financial flexibility, as of September 30, we had a little over $67 million in cash and securities at the holding company. That translates into three times coverage of our annual holding company obligations.
On the other side of the balance sheet, on the liability side, we put significant focus on managing and reducing legacy exposures including a discontinued group accident and health reinsurance business that has largely run off. It’s gone from more than 2,000 active contracts to 150 and liabilities of $45 million as of September 30 so that’s pretty dramatic in terms of the shrinkage there. A block of universal life policies that has a high concentration of older age insureds representing approximately 8% of our gross life insurance in force and this block has shrunk by 23% since 2009.
Persistency of business is how we measure the success of our policyholder service efforts. Our surrender rates, not surprisingly reached a high point in 2009. They’ve improved significantly ever since and have now gotten to levels that are much more normal. It took an awful lot of effort and speaks to the ability of our management team to focus on an important priority and deliver.
This pillar, now that persistency and surrender rates have stabilized, also encompasses all services so not just services but how we deliver that service and our ability to do it cost effectively. So there’s a clear overlap with service and our cost of doing business which is what we’re going to turn to next.
Another area of significant focus back in 2009 was expenses. We knew that since we were going to be writing a lot less business we needed to take expense out of the business and do it very quickly. So we reduced core expenses by, in total, 24% since 2009. The primary driver there was headcount reduction, but we also expanded it to include benefit reductions and sweeping changes to our infrastructure and the way we do business. Really, as I said, it was all designed to align our expenses with the business we had become.
It continues, expense management is never over but we realize that generating profits is not just about managing expenses so while we’re cutting expenses where we can we’re also investing in new business and investing in ways to lower our operating expense going forward. So we’re taking expense out of the business at the same time we’re spending to take expense out of the business going forward or to grow the business.
So really thinking about it, expenses in the context of profitability and to that end we have committed to additional expense reductions of $20 million by year end 2013. So we’re basically thinking $10 million in 2012, an additional $10 million in 2013. To put that in context off of a base as of September 2011 of about $200 million so effectively an additional 10%, 5% in each of the next two years.
Let’s look at the growth side of the business, where and how we are growing the business. Prior to 2009 we were a life and annuity company and we were operating primarily in the affluent and high net worth space. We lost access to that market as a result of credit downgrades in 2008 and 2009 so we had to rebuild the business acknowledging what our current ratings were and acknowledging what we were good at.
Things we were good at included investments, life and annuity distribution, hedging, asset liability management, and we’ve been able to leverage those as we moved into the middle market and focused on primarily an annuity product mix and primarily fixed index annuities, as I said earlier. The fixed index annuities are a product that there’s a lot of demand for, particularly in the middle market.
People don’t have the alternatives, bank CDs, money markets, interest bearing accounts of all mutual funds that they had previously. They’re just not giving them the kind of income so annuities for folks in that space have become very attractive for both middle income pre-retirees and retirees. People talk about the low interest rate environment and isn’t that a challenge for insurance companies, that’s an area where we really think the low interest rate environment is actually playing to our strength from a product standpoint.
There’s quite a bit of demand. It creates opportunity for somebody who is relatively new to the market but isn’t new in terms of the capabilities that it takes to be effective in that market. One of the things that we’ve seen is that our product management, our willingness to change rates, and change product features, to customize product features for new partners in the middle market, has given us a lot of traction very quickly. We basically started at zero in this business in 2009 and we’re now at the cusp of a top 10 player, so kind of right at the back end of the top 10 in the fixed index annuities base.
The other primary growth initiative we have is really, I would say unique, to Phoenix. What we did back in 2009 was we had a very capable distribution capability. That sounded a bit redundant. But, we were very good at particularly high net worth life distribution. That’s something we had done for a long time, we had done through a distribution relationship with State Farm so we had a lot of experience working in other people’s distribution systems.
We knew that given the ratings downgrades that we had been through that we were not going to be in a position to sell a lot of our own product so we focused on this kind of distribution consulting business. We really are doing two things with it today. The first is what we’ve referred to as assisted sales. To give you an example, our distribution company Saybrus Partners is working in the Edward Jones system working with Edward Jones financial advisors effectively as a consultant and representing more highly rated life carrier’s life insurance products in the Jones system.
So you have an Edward Jones FA who may not have the level of expertise in wholesaling high net worth products working with one of our Saybrus folks selling those more highly rated products. It’s gone quite well. Jones likes it because it allows their financial advisors to work with somebody who is experienced and it’s worked quite well also because the Saybrus folks effectively are objective. They’re representing Hancock or [Pack Life products not Phoenix products so I think that translates into a level of objectivity that’s appreciated at the table.
It also allowed us to rent a capability that we didn’t need for ourselves at the time but we knew if we got the business back on track we were going to need that distribution capability. So while it was expensive if we had just funded it on our own without getting the income we’re getting from Edward Jones, Wells Fargo, and others, it really would have been impossible for us to bridge that business all the way through to when we were able to sell our products.
So the fact we were able to rent it to somebody else allowed us to hang on to that capability and as we have now rolled out fixed index annuity product in the middle market, we’re now using Saybrus to work in the wholesaling of those products as well. So Saybrus really is wearing two hats, they’re doing that third party assisted sales and also selling Phoenix product, primarily annuities, in the middle market.
We have set up Saybrus as a separate business with its own P&L and you can see that it has swung from losing money the second half of 2010 in the first half of ’11 but progressing steadily towards profitability. They passed breakeven in the third quarter of ’11 so that is now profitable on a standalone basis.
Rating agencies, that’s really been an important part of our turnaround. Back in 2009 they were a big challenge for us, a big negative and that has swung around as we head into 2012 to be much more of a positive. We had been downgraded, as I mentioned earlier, in 2008, ’09 and into 2010. Outlooks had changed to stable 2010 and early 2011 and now we’ve started to see the outlooks change to positive.
These guys have been a tough critic. They’ve been very hard and very slow, not just in Phoenix’s case to acknowledge turnarounds, particularly in the financial services business. So the actions are important for us, they kind of affirm, they’re an external affirmation of the progress that we’ve made. The comments that they made in the most recent change in outlooks to positive have been very encouraging. Some of the factors they’ve cited are factors that I’ve shared with you already stabilized and improving financial profile, improving capital adequacy, positive earnings, reduced surrenders, good expense management, and continued derisking.
These are really all areas of concern they had back in ’08 and ’09 and things that we worked very hard to address. I think the last comment is probably the one that is most important to us and for us going forward which is that we’re successfully executing new business growth. They’re acknowledging our ability to grow the business.
So what are our priorities going forward? I’m going to start on the right hand side of the page on growth. As we head into 2012 profitable growth, and we’ve always referred to it as profitable growth, we didn’t just want to restart the growth engine but it was important for us that we make money doing it so we were very careful about that and very careful about the alternatives that we pursued and many that we didn’t.
So we want to maintain that fixed index annuity momentum. We’ve set a target for 2012 of $1 billion to $1.4 billion. We had about $270 million in third quarter sales so if you round that up to $275 that would annualize to $1.1 billion. So we’re basically saying the run rate we’ve achieved in the third quarter of 2011 is sustainable and what we’re looking for as we move into 2012. We are introducing select life insurance products. We just announced a new agreement with National Agents Alliance to distribute a redesigned indexed UL product and to continue to focus on profitable growth at Saybrus both through that third party and Phoenix sales.
At the same time the first three pillars are going to continue to be very important so we’re going to focus on the balance sheet. We’re generating capital, we’re planning to continue to do that and we’re really with an eye towards maintaining and growing that financial flexibility that I referred to. On the policyholder service, focus on that persistency that has become more normal so from elevated levels back to more normal and to translate that into more efficient service, reduce cost per policy, and aligning our service model with our growth strategies.
Then finally on the efficiency side, we said that $20 million expense target by year end 2013. We’re going to do that by managing outside services, systems, process improvement. Much less of a focus on headcount reduction and much more about focusing on the way we do our business. At the same time built into that $20 million of expense reduction includes a commitment to continue to invest in growth.
Now I’m going to try and bring it all together in terms of an investment thesis. I made the statement up front that Phoenix was an opportunistic investment. So why did I make that statement? What do we think makes Phoenix compelling? As we all know in the investment business timing is very important, when you get in and out of investments.
So we think the timing is very good. The reasons start with the platform that we built. We talked about that balance sheet repair and you can see it in terms of our statutory surplus growing by 50%, RBC improving from 223 to 309. That ignores the reinsurance transaction I referred to that we executed in the fourth quarter which, when we completed that transaction, we said that with all other things being equal would add about 45 points to our RBC ratio. So effectively if we had that reinsurance transaction in place at the end of the third quarter that 309 would have translated into kind of a 355 type of number so a significant increase there.
The portfolio was in good shape and the rating agencies are now acknowledging that so our below investment grade exposure has declined from just less than 11% to about 7.5%. That’s been done through some selling but also through an awful lot of upgrades within the portfolio so it hasn’t just been selling.
One thing that we did do that I think saved a lot of capital for us was we were under some pressure in ’08 and ’09 because we were seeing the fallen angel affect translating into our fixed income portfolio. It would have been tempting to address that by selling higher risk bonds. The problem is, the prices they were trading at we did not think made any sense so we held on to our below investment grade positions for quite a while, really into 2010.
Once credit spreads made a big move, the stuff that we sold we were able to move out of essentially at a breakeven. So if you netted all of the transactions we did, we took some gains, we took some losses, but the capital gains position or the capital gain result was about a breakeven. That holding company liquidity you can see is about three times our annual holding company obligations of $23 million, our surrender rates for both life and annuity have come down.
We have that solid platform and we’ve used that solid platform in terms of where we’re headed going forward. We’re delivering earnings, through the first three quarters we had operating income of $41 million. I mentioned we’re targeting $10 million each in 2012 and 2013 in terms of further expense reductions. We’re growing the annuity business, it should be north of a billion in 2012 sales, and we’re getting back into the life insurance business and we’re doing it primarily in that middle market space working with people that we’ve developed relationships with through the fixed index annuity business.
So tying it all together, we’ve built a solid platform. That was really the first step and we’re trending in the right direction of profitable growth, yet we’re still trading at 24% of book value. To me, I spent most of my career as an investment professional, not an equity analyst but a fixed income who focused primarily on value and relative value. It just seems like, as is often the case with turnarounds, the fundamentals are out in front of the valuation.
We don’t feel like the market has given us the attention given our capitalization and the understanding given frankly what we are doing is not really a standard playbook. Turning around a life insurance company hasn’t been done, generally when things get bad their either run off or solid so what we’re doing is a bit unproven. I think as evidenced by the rating agencies, people are being cautious in terms of waiting to see how we can deliver on our plan. But to date we feel like we’ve delivered an awful lot and we should be able to deliver going forward.
With that I’m going to thank you for your time. I would invite you to listen in to our fourth quarter earnings either live or to the replay next Thursday and I’d be happy to take questions.
For the index annuity business, what is the ROE profile of the business and what’s the capital requirement profile of an index annuity?
James D. Wehr
The ROE we’re targeting, and again we’re relatively new to this business, mid teens that’s off of an ROA just north of 1% so that translates into an ROE of mid teens as I said. The capital that is required it is a somewhat capital intensive business but we, as you can see, with approaching $900 million of statutory capital we feel that we have more than adequate capital to support that $1 billion to $1.4 billion target we’ve set for 2012.
That number was selling enough business to approach scale. Business that from a competitive standpoint and in the context of the current marketplace we could write profitably, achieve those mid teens ROEs and that we had adequate organic capital in the business to support.
In terms of the lapse rates just for perspective in both products what is your lapse rate goal and what were lapse rates pre ’09?
James D. Wehr
I referred to our 6% to 7% current life lapse rate and that’s really the one given the size of that in force kind of dwarfing all the rest of our business that we’re most focused on and really the closed block within that life business. For us and for the industry 5% to 6% has been kind of a pre financial crisis level both for us and for the industry. So we’re coming down from 10% in the 6% to 7% range currently, so very close to what we would characterize as normal either by industry or our historic experience.
Let me just start with something real basic and get a sense of what is your all’s definition of the middle market that you pursue?
James D. Wehr
I’ll give you some statistics of the folks that we have been selling to in the middle market. Net worth a couple hundred thousand dollars, that’s excluding their home. Income in the $40,000 to $50,000 range, so people that you would say, “Gee, they’re not a significant financial consumers,” I guess would be the best way to put it but given what’s going on with social security, given what’s going on with standard retirement plans, given what’s going on with fixed income alternatives either through banks, or through CDs, or through funds, they have current income needs and future income needs, particularly as they segue into retirement that this product fits nicely.
So if you can get, in terms of your initial – let’s say you take out a $100,000 fixed index annuity, that would be kind of a sweet spot for us, maybe a little less than that in terms of our average face amount. You could get a 6% to 7% annual income stream. Now, that sounds high given that the investing rate we’re investing in currently for new money is 4% to 5% but you have to remember that part of what they’re getting back is return of their capital.
So they’re getting their capital coming back to them, investment earnings that we’re going to earn over time spread over an expected life span that translates into a pretty attractive income stream for somebody that has modest current income which may be declining going forward and doesn’t have a lot of alternatives. It really is a growing sector of the market as opposed to some of the other areas.
Some folks have asked us, “Would you be in this business if you still had your A and AA ratings?” That’s a bit of an irrelevant question for us but I think we well could be. I mean, you’re seeing more highly rated carriers move into this space because it is a growing demographic, that middle market segment and that need is a growing need.
[Inaudible] I think of think of as retiring to an income target and buying on a cash flow target, very stressed in both cases but very needy just as you say.
James D. Wehr
And without a lot of good alternatives.
Without a lot of good alternatives in this low rate environment. 6% to 7% income stream with partial return on capital, without knowing your investment portfolio, I’d kind of guess that maybe you’re crediting about 50 basis points above what you actual make?
James D. Wehr
No. Well, when you factor in the return of principle, they’re actually getting more than 50 basis points above what we’re earning. Again, it’s an actuarial assessment. It’s how old are you so how long are you going to be collecting the income stream? What rate of return do we expect to get? Then that translates into an income stream. But we’re not crediting them – well, I guess we’re distributing to them a rate in excess of what we’re earning but that’s because their principle is coming back to them.
I don’t think that’s necessarily a bad thing to be doing. I mean, we probably share the assumption that we’re at close to a rate trough, if not in a rate trough, why wouldn’t you [smooth] effectively? It makes good sense, especially if you have abundant capital the way that you all have abundant capital at this juncture for new sales.
James D. Wehr
We do. It’s a mid teens ROE business for us, and again, it’s a way for us to kind of turn that lower interest rate environment, which is a challenge for the whole life industry into, it’s really a spot rate product. You price it today based on yields and returns you can get in the market today and you price it out over a period of time, you invest in a duration to match the expected duration of liability, and you give people some of their own capital back.
Given that the alternative for those folks is to sit with effectively dead money, no pun intended, but to sit with dead money or earning next to nothing, it gives them a nice income stream at a point in their life and in a demographic that needs it.
I guess the agencies have given you all a three notch ladder between the operating companies and the hold co. Is there a point – I mean, I wouldn’t expect ratings to go down from here, I think they’re quite low, but is there a point where the independent distributors get really nervous if you were to have a reversal outlook or something like that? Would it be a problem for the product sales?
James D. Wehr
I think given where we’re, the numbers speak for themselves, given where the rating agencies have gotten to, I think they’ve taken a very conservative we’re going to wait to see it and it’s very conservative as you would expect given what they’ve been through over the last several years. They were very patient and very conservative I think in waiting as long as they did. Unless things change dramatically in our business which we’re working very hard to protect against and why we’re in businesses we feel we can manage the risk, why we’ve got a portfolio that’s constructed, we’re still very good at the things we’re doing both with our in force and our new business.
It’s investments, it’s hedging, asset liability management, product management, that skill set has translated from our in force to our new business. So I think the likelihood that we backslide is quite low. Again, assuming things don’t turn dramatically against us and everyone else. So I think there’s potential, if you look at companies that go from downgrade, to negative outlook, to stable outlook, to positive outlook, it’s not hard to anticipate what the next step is. So I think the likely is an upgrade.
I think that gives us some further tailwind in the middle market in terms of the folks we’re doing business with. But we are not, at this point, focused on we need another notch or another two notches to be able to execute some portion of our strategy. Arguably it would make it a bit easier for us, but we’ve established relationships with 25 or so IMOs, with 6,000 to 7,000 agents who are licensed to do business with us, we just signed on somebody else. So our brand and our name is being accepted in the middle market and the IMOs who dominate that middle market.
Ratings improvement would help that but it’s not a contingency or a requisite for us to execute some element of our strategy. We’re not, at this point, saying we want to get back to A rating so we can get back into the high net worth life space. That could happen but I have to say it’s a well down the road event, if it does happen. For now, we feel pretty good about the strategy we’re executing and not just because we have to or it’s the only thing that’s available to us.
It fits with our skill set, we’re making money, we can manage the risk, it’s a growing product. We would like to diversify our product mix a bit, as you can see we’re starting to get back into the life business, kind of putting our toes back into the water again, in the middle market and we’ve got a very large in force primarily life block to compliment to give us that kind of inherent product diversification within the business. Not to knock anybody, but we’re not like a company that is solely in the fixed index annuity or middle market space. By virtue of our legacy we’ve got some benefits on the product diversification standpoint.
You all had to do this very hard thing, you had to find a pathway that you could survive on after what happened. But, how much know how is still in the company after all the restructuring? Do you have the team in place to start moving into ancillary products?
James D. Wehr
Again, we talked about what are the elements of capability or strength that we need to be effective, so what do you need to be good at? You need to be good at investments. We did not take a lot of heads out of that segment of our business. We did outsource a portion of our investment business but that was really based on the fact that we had somebody who we knew very well that is only taking on our public bond segment of the portfolio. So we kept some significant alpha adding segments of our investing business. So we hung on to our investment capability.
Key for us was we hung on to that distribution capability with Saybrus which was really a calculated bet and a somewhat expensive bet. You can see the operating losses we occurred in ’10 so we were funding those operating losses but we really viewed it as an investment in the future, a bridge to the future. So I think if we hadn’t hung on to that – that’s a capability that if we had downsized it we would have felt like we didn’t have enough capacity or the right capacity.
The other things about these folks is they are very talented and very experienced. So just because you laid off 50 wholesalers to go out and hire 50 new ones, you wouldn’t necessarily get the same quality, particularly after you had just laid off 50 a year or two earlier. You can imagine how that might have played out so that was important for us.
Then on the actuarial side we kept the talent we needed and that’s important from an ALM, financial services is all about ALM and when people have gotten in trouble it is because they haven’t done that well. We’ve hung on to our investment folks, we’ve hung on to our actuarial folks, our distribution folks, and our product folks. The 35% or so that we downsized we did in areas like life underwriting, areas where we knew we weren’t going to be writing a lot of business going forward and we knew for the foreseeable future, if not forever, those were capabilities we weren’t going to need anywhere near the level of capacity we had in place.
So we were very selective with that 35%. Some areas were 70% or 80% and some areas were 0% to 10%. We were thoughtful about what we were going to need if we were successful going forward. We’ve also kind of retooled and reallocated people within the business. We were very careful when we hung on to people, we hung on to senior people, experienced people who had a capability of being able to do multiple things. So somewhat of a generalist or utility player and we’ve moved a lot of those folks around in the business to areas that were linked to what they did before but really directly relate to what we’re trying to do now.
I want to thank everybody once again and invite everybody to join us for our fourth quarter earnings call next Thursday at 11 am. Once again, thanks for your time and attention.
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