In the Q2 earnings release, MetLife (NYSE:MET) took many investors by surprise, announcing EPS that missed analyst estimates due to headwinds in foreign currency, equity markets, and interest rates. The company also took a $161 million hit relating to the review of actuarial assumptions relating to variable annuities. The annual review process for variable annuities was brought forward, in light of MetLife's plan to separate a substantial portion of its U.S. retail business. On the back of this review, MetLife reported that it would take an after-tax, non-cash charge of $2.0 billion due to a change in customer behaviour along with other economic and other actuarial assumptions for its variable annuities business. This charge effectively reflects the admission that the company mis-modeled, mis-priced and underestimated the true cost of its variable annuity guarantees (not intentionally, of course).
With a variable annuity, policyholders can select their own mutual funds giving them the opportunity to boost their returns if the market goes up. At an additional cost, these products give them optional living and death benefits. This allows them to take withdrawals, and depending on how much they invest, they are then guaranteed to receive a minimum amount annually, even if the market performs poorly, though they could receive more if the market performs well. These withdrawals and/or income payments are based off an amount called the benefit base. The benefit base is not invested in the market and will not be impacted by market declines; sometimes, it will even grow at a set minimum rate if the market is flat or declines. Unfortunately, for MetLife, its interest rate assumptions and behavioural models were inaccurate, underestimating how expensive these variable annuity guarantees really are.
Policyholders have got smarter following a more efficient behavior than what MetLife had modeled. In their own words "adverse behavior changes include lower lapses, lower elective annuitization, and higher systematic withdrawals, resulting in increased annuitization under no-lapse guarantees and increased utilization of enhanced death benefits." It is somewhat ironic that in this instance, adverse behavior relates to intelligent and efficient behavior from its customers, that the company did not anticipate. In such a low rate environment, opting for a dollar for dollar withdrawal, especially at older ages, is preferable than annuitizing, and many "intelligent" policyholders are taking advantage of the embedded optionality; certainly, more than what MetLife's actuarial model was assuming.
MetLife has therefore now i) lowered the percentage of policyholders who elect to receive a fixed income annuity, ii) lowered the percentage of policyholders who elect reimbursement of the initial premiums paid when that amount exceeds their current account balance iii) increase the percentage of policyholders who elect dollar-for-dollar withdrawals, particularly those in qualified plans at higher ages iv) lowered the ultimate lapse rate on certain contracts. Why weren't these assumptions reviewed earlier? Because there is a 10-year deferral period till someone can exercise his optional living and death benefits in such a contract, hence no sufficient historical data was available.
MetLife also lowered its projected interest rate assumptions because of the prolonged low interest rate environment, and lowered its long-term separate account return assumptions, which the company uses to value its variable annuity-related guarantees, both of which reflect changes in economic assumptions. What are the revised assumptions? MetLife has now reduced the long-term separate account return assumption for variable contracts with traditional mutual funds from 7.25% to 7.0%, and managed volatility funds from 7.0% to 6.75%. It also reduced the projected ultimate 10-year Treasury rate from 4.5% to 4.25%, by 2027. Forecasting future returns and interest rates one year ahead is a daunting task - forecasting them 10 years ahead is an impossible one. While the direction to these revisions looks sensible (as they now assume lower returns and lower interest rates than before), the magnitude of them looks a bit rosy, especially when it comes to the returns. This raises the possibility of future reserve charges for the eventually separated US retail business, exposing the uncertainty around its valuation, prior to its spin-off, IPO or sale.
Is MetLife done with the charges? The management has already communicated that the re-segmentation of the business units which will remain at MetLife will result in a GAAP charge to operating earnings in the third quarter of less than $300 million after tax. Some additional pain may also be inflicted to the shareholders near term on the back of the annual review on other assumptions such as mortality and morbidity. While the management has guided that historically, these tend to be more modest, they were shy from providing any real assurance or quantifying the impact. The review of goodwill in Q3 may result in additional charges, and if the above are not enough to make you cautious, management has also guided that the re-segmentation will also have an ongoing adverse impact on projected earnings for variable and universal life business that they cannot quantify till Q3.
MetLife has always been on my radar as a possible candidate to allocate my hard earned capital, but for the time being there are just too many unknowns making me uncomfortable to initiate a position. Better times will come for MetLife when interest rates start normalizing, but the short-term outlook remains bleak with too many headwinds. As Warren Buffett puts it, "We have done better by avoiding dragons rather than slaying them," and in this instance, I'm opting to do the same. I will stick to the easy and obvious (companies like Walgreens (NASDAQ:WBA) and CVS Health (NYSE:CVS)) and be certain of a good outcome, rather than try to figure out where the 10-year Treasury rate will be by 2017 or what the long-term return of a mutual fund will be.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.