When MetLife (MET) failed the Fed's stress test last March, the company and the investment public were outraged. MetLife and its supporters claimed that the company is not a true bank and that it passed the 5% minimum capital ratio. They feel that because of this failure, it will be placed in an uncompetitive position because it will be regulated from the Federal government in addition to the states. However, it failed the test for total risk-based capital, and I think there are real reasons to be concerned about MetLife. One major reason to be worried is that the company had $350+ billion of its assets invested in debt instruments.
Exposure To Long-Term Fixed Maturity Securities
MetLife had about $351 billion of its investment portfolio invested in long-term bonds, $61.3 billion in mortgage loans, and $8.6 billion in real estate related assets, representing 71%, 12.4%, and 1.7% of its total investment portfolio, respectively, at the end of 2011. Assuming the average duration of the bonds is 10 years, a 3% rise in interest rates would cause the bond portfolio to lose over 25% of its value. While no one knows when the Fed will raise interest rates, investors know that this will happen sometimes after the end of 2013. Even at the smallest hint that the Fed is raising interest rates or inflation is creeping up, investors will most likely abandon bonds. This will further depress bond prices and cause strain on MetLife's ability to meet its policy obligations, which will likely rise as interest rates and inflation rise.
While MetLife uses derivatives to hedge interest rate risk, it is not clear what would happen if for example, a counter-party goes into default. In addition, the company does not eliminate interest rate risk entirely as its hedges only a portion of its assets. During the first quarter of 2012, when yields on the 10-year Treasuries rose by about a third of a percentage point, MetLife had derivative losses of $1.3 billion. A steeper rise in yields could have a snowball effect on the company.
MetLife Is Not A Bank (soon)
Some observers claim that MetLife is not a bank. This does not seem correct since MetLife had bank deposits of over $10 billion at the end of 2011. MetLife is in the process of selling its bank assets to General Electric's (GE) financial arm, GE Capital and its warehouse bank operations to Ever Bank. However, the transaction is not completed as of this writing so MetLife is still a bank. In addition to selling its retail and warehouse banking, MetLife will be also exiting its reverse-mortgage business to meet Federal Reserve capital requirements. Details of these two sales are not available but I assume the prices are not favorable, given current market conditions and the speed of the sale.
It appears that if you are an executive at a major financial company you are likely to go and give speeches to the U.S. Congress. We have seen Johnny, Lloyd, Jamie, and a number of other financial executives go to Washington in the past few years. I am sure that they did not expect to be giving testimony to the Senate when they were applying to their jobs. This reminds me of a movie I recently saw, "The Guard," where one of the drug traffickers refuses to help carrying the corpse of a cop he killed because heavy lifting was not in the job description. Recently, MetLife's Vice Chairman gave a statement in front of the House of Representatives' subcommittee on insurance, housing and community opportunity. A day earlier, William Wheeler, another company executive, also presented at a hearing. Both defended the MetLife view that it should not be regulated by the Fed. However, this is quite in contrast to what Stephen Kandarian, then CIO and currently a CEO of MetLife, told Congress in 2009, when memories of the financial crisis were fresher.
In addition to MetLife, there are other insurance companies that could be negatively affected if interest rates rise. These companies include Prudential (PRU), Lincoln National (LNC) and The Hartford (HIG). All of these companies had more than 60% of their investments invested in long-term fixed income securities as of the end of 2011. Lincoln National is the leader with 81% and Hartford had 61% with Prudential in the middle with about 70% of their investments in long-term fixed maturity securities. In addition to high exposure to long-term fixed income securities, these companies have very low stock valuations in common. For example, MetLife, Prudential, The Hartford, and Lincoln National had price-to-tangible-book value of 0.6, 0.6, 0.4, and 0.5, respectively.
In addition to facing a rising interest rates risk, insurance companies, and in particular life-insurance companies could see their costs increase. Life insurance policies are in nominal dollars and in a time of high inflation, people tend to avoid making long-term commitment. The inflation impact on life insurance is well documented in this paper from 1979 when inflation in the U.S. was double digits as well as more recently from this conservative Web site.
MetLife is a leading financial and insurance company and the stock is not necessarily a bad investment. However, the company, similar to other major insurers, has large exposure to rising interest rates and higher inflation. While MetLife shares look cheap, investors should exercise extra caution before buying shares in this and other major insurers. The initial inflation panic is usually most severe and this will be the most difficult period for companies invested in long-term fixed assets.