Brighthouse Financial (NASDAQ:BHF) consists of the majority of MetLife's (NYSE:MET) U.S. annuity operations and was spun off in August 2017. Since it began trading independently, the stock has pulled back significantly, making Brighthouse appear cheap - especially since it trades at a substantial discount to current, stated, book value. However, book value for an annuity business is largely mark to model, and, in severe cases, liabilities can end up being worth multiples of what they are marked at (this has plagued Genworth (NYSE:GNW) - GE's (NYSE:GE) insurance spin-off from 2004 - for its entire existence and drove some of GE's recent $6bn charge, 14 years after GE spun Genworth off).
I'm expecting further downside to BHF shares due to one or more of the following potential catalysts:
A decrease in book value due to possible reserve charges that BHF will need to take.
An improvement in policyholder behaviour efficiency also leading to reserve charges which will lower book value over time.
An equity market correction in the next few years.
An interest rates path that diverges from what BHF has modeled for.
Before digging deeper into Brighthouse, it would be instructive for readers to familiarize themselves with what has happened at Genworth Financial.
The Genworth Story:
I would encourage those interested to review the Genworth story as a cautionary tale in the dangers of investing in insurance businesses at a discount to book value (especially when that book value is based almost entirely on management estimates and assumptions) - there were people who believed Genworth was cheap given the huge discount to book value as the stock went from a local peak of ~$17 to its current price of $3. Instead of price converging to book value, book value ended up converging to the stock price over time - reserve results were worse than expected in almost every quarter.
See this recent article for some history around the GNW/GE situation:
Industrywide, insurers have taken billions of dollars of charges over the past decade. Genworth, which was spun off from GE in 2004, has tallied losses from its older long-term-care policies of $2.5 billion since 2006.
The example of Genworth clearly shows that insurers trading at a discount can continue to deteriorate.
Comparing Brighthouse To Genworth
The main similarity between Genworth and Brighthouse lies not in the products being sold; Genworth sold Long-term Care Insurance (which was seriously undone by healthcare costs rising much faster than their models predicted and people living longer than expected), while BHF is largely a collection of financial guaranty products linked to equity markets and interest rates. The key similarity lies in the belief that actuaries are able to precisely predict variables with massively divergent potential outcomes decades into the future.
Genworth was predicting the cost of long-term care over decades. Brighthouse sold policies throughout much of the 2000s with assumptions on future equity market performance and interest rate levels in the decades to come, as well as assumptions around the percentage of people that will behave inefficiently and fail to properly utilize the benefits they have purchased.
Overview Of Brighthouse Financial's Book Of Business:
The vast majority of the book is variable annuities (61%), with 14% in fixed and fixed-index annuities, 19% in universal life secondary guaranty (similar in many ways to variable annuities in terms of economic exposure - see Exhibit E for some additional information on how they work), and 6% in vanilla life insurance.
Do Annuity Writers Simply Benefit From Higher Rates And Higher Equities?
Many market participants believe annuity writers do well in up-market environments and that increases in interest rates help them, but that is only part of the story. In reality, only a slow and sustained increase in equity markets/interest rates moving along the forward curve used in the actuarial models is good for them; most other market environments are some degree of bad for them. Volatility spikes are especially harmful as the company's hedging programs are more likely to malfunction, potentially causing substantial economic impacts.
Many market participants incorrectly believe annuity writers are simply ways to play higher equities and higher rates (which is true in linear first-order moves). However, given they are negatively exposed to a range of convex outcomes for equities, rates, and policyholder behavior, annuity writers' economic exposure much more closely resembles selling puts with limited ability to reprice vol over time (see Exhibit B below for a more in-depth explanation of the economic risks of variable annuities to the insurers). Several of the exhibits below should help explain how the business works in more detail.
See this paper for an explanation on how the different variables can impact variable annuity writers.
We also find that, while the impact of the level of interest rates on the effectiveness of the modeled hedging program is rather low, a higher volatility level has a distinct adverse effect on the hedge effectiveness, leading to a further increase of risk-based capital requirements.
Should volatility rise, I believe Brighthouse would be vulnerable.
Brighthouse's Model Assumptions
As noted in the BHF 10-K (page 30), the company's economic model assumes in the base case that equity markets appreciate at 6.5% per annum from current levels and the 10 Year Treasury Yield normalizes to 4.25% over the next ten years.
Given my assessment that the economic cycle is likely peaking, these seem like unlikely scenarios looking forward. If the cycle turns, the stock market likely will not perform at those levels and interest rates will go lower when the curve inverts as a result of the Fed adjusting monetary policy to support a weaker economic environment. In my opinion, this is not really that far-off - the treasury curve has already come quite close to inverting, and it seems to be a matter of time before it fully inverts. This is particularly problematic for Brighthouse as they are most exposed to the long end of the interest rate curve due to the long-duration nature of their liabilities.
Brighthouse Sensitivity to Interest Rates and Equity Markets:
The following table from March 2018 BHF presentation illustrates the inherent volatility in the VA Capital and cash flows:
One important note is that the cash flows above do not account for capital and use what I would consider an overly conservative discount rate (4%) given how risky and volatile this business is (from the 10-K, page 31: "The table below presents, under these five scenarios, the present value over the lifetime of the existing variable annuity block at a 4% discount rate of anticipated revenues net of all expenses and hedge costs, without reflecting the effect of capital and reserving requirements on the cash flows of this business.")
Brighthouse Sensitivity To Policyholder Behavior:
Beyond just the risk factors of equity markets, interest rates, and market volatility in general, Brighthouse also has substantial exposure to the general level of policyholder inefficiency in the decades to come - simply put, the more efficiently people behave with respect to their financial decisions, the less well Brighthouse does economically.
Here's an excerpt from the above Moody's article:
"US life insurers' inability to predict policyholder behavior including lapse rates led to mispricing that continues to be a weak spot for the industry, says the rating agency."
Variable annuities and many other life insurance products are sold with the assumption that a substantial portion of the customer population will either forget or neglect to properly utilize the benefits they have paid generously for. From the 2017 Brighthouse 10-K:
Additionally, we make assumptions regarding policyholder behavior at the time of pricing and in selecting and utilizing the guaranteed options inherent within our products (e.g., utilization of option to annuitize within a GMIB product). An increase in the valuation of the liability could result to the extent emerging and actual experience deviates from these policyholder option utilization assumptions. On an annual basis we review key actuarial assumptions used to record our variable annuity liabilities, including those assumptions regarding policyholder behavior. Changes to assumptions based on our annual actuarial assumption review in future years could result in an increase in the liabilities we record for future policy benefits and claims to a level that may materially and adversely affect our results of operations and financial condition which, in certain circumstances, could impair our solvency.
One of the reasons I think this is a big risk factor is because many of these assumptions have never actually been tested over an extended period of time. Many of these products were sold in the early to mid-2000s, and the liabilities can last 30+ years, so there is no real experience data use for predictions. Additionally, the preponderance of financial advice and tools on the internet make it likely that over time people will more be more efficient as it pertains to their financial decisions. I expect this to be especially true with respect to variable annuities given they often represent a very material portion of the customers' net worth.
Brighthouse Capitalization And Reserves:
The biggest concern with Brighthouse is probably whether the capitalization is in fact adequate, given the volatile and risky business mix. There have been several historical capital issues with the Brighthouse business while it was a part of MetLife where they had to take material capital charges with almost no notice and with no clear explanation as to why (key recent ones below):
1) MetLife took a $2bn charge to strengthen reserves in the VA business in 2Q16 - this type of move on a quarterly basis is very material relative to the size of the business at ~$12bn of equity ex. AOCI.
From the August 2016 MetLife Earnings Call:
Following these reviews, we have strengthened our VA reserves on a GAAP basis to reflect changes in our lapse and benefit utilization assumptions, resulting in an after-tax noncash charge of $2 billion. This action clearly had a large impact on our reported GAAP net income of $64 million in the quarter.
Seth M. Weiss BofA Merrill Lynch, Research Division:
John, I want to dig into the charge a little bit more. And it sounds to me like, at a high level, that the charge could be split between partial what's in assumption review, but also moving from this accounting standard of the insurance SOP 03-1 to the embedded derivative convention. So if we try to bifurcate that $1.5 billion of policyholder charges between what's assumption changes and what's a change in the accounting standard, can you help us think how we would split that?
John C. R. Hele CFO and Executive Vice President:
It's a great question, but it's very difficult to do because we have changed several assumptions. So if you lower annuitization, which we did, and increase dollar for dollar, that's an assumption of what people are doing, but then the accounting changes it as well. And so it's interrelations between all these. The actuaries call it the cross effect, and it's a pretty big number. So if I give you one piece, but there's a big cross effect in how they all add up, and we can't reattribute the cross effect to it. So it's a little misleading to just look at one piece of it. They're all interrelated as you do all these. And so in the end, it's really the total number that we have to communicate."
2) MetLife also took a $400mm charge in the Brighthouse business in 2Q17 right before the spin-off as part of a review of the reserves, after they had already planned for the capitalization of the spin-off (so a surprise move).
From the 2Q17 MetLife Earnings Call (see also this document)
MetLife filed an 8-K disclosing that Brighthouse Financial would need to increase its reserves by approximately $400 million due to refinements in legacy actuarial models. As a result, the size of the dividend MetLife expects to receive from Brighthouse Financial will be reduced from $3.4 billion to $3billion. John Hele will discuss this matter in greater detail.
Potential Negative Impact Of Recent Tax Reform:
Unlike banks which are not allowed to include deferred tax assets as part of the risk capital, life insurance companies are allowed to include deferred tax assets in their capital based on certain allowances ascribed by the NAIC (National Association of Insurance Commissioners). While Brighthouse is still unsure as to what the ultimate impact on its capital position from the recent tax reform will be, it is likely to be meaningfully negative. In its 1Q18 earnings call, the company stated:
The industry and the NAIC are starting to work through how and when the NAIC will modify the RBC methodology to reflect the new tax environment. We estimate that our preliminary combined RBC ratio as of year-end 2017 would have been well in excess of 500% if the tax rates used in this calculation were changed from 35% to 21% at the end of the year.
Explanation Of CTE/BHF's Approach:
From the Form 10 (See also page 26 here):
Conditional tail expectations, which we refer to as "CTE," is a statistical tail risk measure used to assess the adequacy of assets supporting variable annuity contract liabilities. In general, under applicable NAIC guidelines, the amount of assets required to support statutory reserves and capital for variable annuity contracts is substantially influenced by the outcome of 1,000 stochastic capital market scenarios and the Standard Scenario. Although the NAIC does not specify these scenarios, the 1,000 scenarios we select for purposes of our stochastic modeling must comply with guidelines promulgated by the NAIC. Under current NAIC guidelines the total amount of assets required to support the statutory reserves and capital relating to our variable annuity contracts, which we refer to as the "Statutory Total Asset Requirement" or "Statutory TAR," must be at least equal to the greater of (a) the average amount of assets needed to satisfy policyholder obligations (or, the greatest present value of accumulated deficiencies) in the worst 10% of these 1000 scenarios and (b) the total amount of assets required under the Standard Scenario. The result of averaging the worst "x" percent of the 1,000 scenarios is commonly described as CTE100 less "x". Accordingly, the NAIC prescribed worst 10% is commonly referred to as CTE90. Our internal target is based on the worst 5%, and is referred to as CTE95.
One oddity with how MetLife chose to capitalize the spin-off is that they are doing CTE 95 + a $3bn buffer, which they say is innovative, and they claim that is economically equivalent to CTE 98 to CTE99. There likely are some very ugly scenarios in that worst 1-2 percent of scenarios that would make the required capital levels overly volatile, which would explain why they choose to reserve to something that is "equivalent" to those levels but not at them (i.e., they prefer to retain more flexibility in their reserve levels because they are concerned about volatility in the tails of the scenarios). Many peers use CTE98 as it is more conservative and give more weight to the potential negative impacts of extreme market environments. Lincoln National (LNC), which many consider to be the best in the life insurance industry at managing variable annuities, uses CTE 98 for its reserves.
From the LNC 3Q17 Earnings Call:
Alex Scott Analyst, Goldman Sachs & Co. LLC
Okay. All right. Thanks. And I guess a couple of your peers have made tweaks to the CTE-95 levels that they're sort of managing to, so I was just interested if you guys made any adjustments and just an update on sort of where you stand relative to your CTE target level?
Randal J. Freitag Executive Vice President, Chief Financial Officer & Head of Individual Life, Lincoln National Corp.
Alex, yeah. Thanks for the question. So we cap, we price for and capitalize our Annuity business, our available Annuity business, using what I call a greater of approach. It's the greater of CTE-98 and a percent of account value. We use CTE-98 because I think that you really need to move deep into the tails to understand the risk profile on this business. So I don't necessarily believe that CTE-95 is deep enough into the tail for the true profile of this business to emerge, and we use the greater of approach bringing in the percentage of account values because this business is one of those ones that can be countercyclical. It would be account values and as the risk comes out of the business you keep sucking capital out of it right before the capital markets decide to move against you and then you need to shove capital back into it. So I think that greater of approach along with the deep in the tail CTE-98 measure is what is prudent approach to running this business and it's what we do. It hasn't changed at all, Alex.
See this paper from the Boston Fed for some additional explanation of how variable annuity capital works.
The data in the form 10 suggest the reason management has been so conservative about any potential capital return is the peak capital required to support the business is not until 2026, and the business likely needs to build substantial capital before then to be adequately capitalized, and that is without any kind of market shock to rates or equities (from the form 10 from June, 2017: "Based on our Base Case Scenario, we believe the Variable Annuity Target Funding Level for our VA In-Force will continue to increase over time until it peaks in approximately 2026"). That is also without any mis-estimation of policyholder behavior. BHF's book of business has very little surrender charge protection compared to competitors, and this could be problematic under some market conditions. People long shares of BHF seem to believe there is some potential that management's capital plans are too conservative and that there is a chance capital returns will begin earlier than anticipated - I think the opposite is true and capital will likely emerge worse than expected over time.
Recent Voya Transaction As C Comp:
One other interesting item is that in December 2017, Voya recently sold its annuity unit to Apollo and affiliates, which included its run-off VA unit, and they likely sold the VA business for near zero or potentially a negative price (tough to know precisely because the deal included the run-off business and the rest of the annuity operations, but if the non-run-off annuity operations were valued anywhere close to where the comps trade, the VA business was likely ascribed very little or negative value). One analyst explicitly asked if the VA business was sold for a negative price and management declined to answer and effectively said it was important to focus on the overall transaction - the read-through of this transaction for BHF's book of variable annuities is negative.
From the VOYA conference call announcing the transaction:
Ryan Joel Krueger Keefe, Bruyette, & Woods, Inc., Research Division:
"Okay. And then, I guess, maybe it doesn't matter at this point, but if I think about the $1.1 billion of total value, I guess, does that -- would you view yourself as having received a positive price for the CBVA block? It's a bit tough to tell given the Fixed Annuity involvement."
Michael Scott Smith Executive VP & CFO:
"Ryan, I think we're really looking at it as a package in total. The values we received for both blocks were at least within the range of the actual revaluations that we received. We're very comfortable with the overall package and maybe to your point of, it doesn't matter. I think it focuses us on this more capital light, higher return, higher growth set of businesses with a lot less risk and a lot less tail exposure. So I think, that's the way that we are thinking about it and that's the way we'd encourage you to think about it as well."
To the extent some of the BHF longs believe that it will be a repeat of the Voya situation, I think this is unlikely to the be the case: Voya worked out well because the asset management business was attractive enough to offset the closed block VA segment (CBVA) - the recent transaction indicates that the marks on the closed block VA segment were likely far too generous, even after substantial write-downs over time. So, the rationale that the CBVA was being unfairly penalized by the market was incorrect - it was actually worse than expected, but the overall business was attractively priced, given the asset management segment is a solid asset.
On a related note, an important consideration in analyzing BHF's book of business is there is really no good component to the business - in my opinion, it is effectively MET's "bad bank" - it is very different from Voya where there was an annuity business and a higher ROE, capital light, asset management business. With Brighthouse, you have a book of business that is almost 80% equity-exposed (variable annuities + Universal Life Secondary Guaranty in the run-off portion of the business), and the remainder is vanilla annuities and life insurance which is still on average a 10-12% ROE business assuming similar business quality as the peers (which is likely generous given MET's history with the annuity business).
What Buffett's Deal With Cigna May Tell Us About Valuation
While everything has a price, and that may pre-dispose investors to the view that at ~.45x price/book ex. AOCI, BHF is "cheap", it is helpful to consider the price level Warren Buffett seemed comfortable with when he reinsured variable annuity business from Cigna (NYSE:CI). In this transaction in 2013, Cigna transferred over the $250mm in capital backing the business, as well as an additional $200mm in cash; additionally, Berkshire (NYSE:BRK.B) implemented a loss cap such that they would not cover losses above a certain level.
Excerpt from the above Marketwatch story on Buffett/Cigna:
" Through the reinsurance deal, Berkshire is assuming 100% of Cigna's exposure, up to $4 billion in future claims for the Guaranteed Minimum Death Benefits and Guaranteed Minimum Income Benefits business. This amount is "significantly in excess of current projections of future claims for this business," Cigna noted, while adding the chances for exceeding $4 billion is "extremely remote."
I think this is instructive in terms of the level of margin of safety required to underwrite variable annuity business given the volatility and risk in the extreme scenarios.
Target Price And Valuation:
It is difficult to really come up with a precise valuation for BHF given the complexity of the business, and the fact that there is no way to model the cash flows out since the business is in many respects a "black box". I believe a range of 0.2x price/book ex. AOCI to 0.25x price/book ex. AOCI is appropriate given I expect the economic assumptions underlying the base case scenario for BHF to fail to come true in a material way. This would suggest a price target of ~$20-25/share, or ~50% below the current trading price.
1) Capital emerges worse than expected over time - I expect that, over the next few years, BHF will have to take reserve charges which will decrease book value over time.
2) VA utilization emerges worse than expected over time - I expect that policyholders will behave more efficiently than BHF's economic models assume, and this will also lead BHF to have to take reserve charges which will lower book value over time.
3) Equity market correction in the next few years - I am not alone in the belief that is likely the stock market will experience a correction of some magnitude over the next few years, given we appear to be in the late innings of one of the longest bull markets in history.
4) Interest rates fail to rise to levels BHF has underwritten - recent economic data seems to suggest the global synchronous growth is slowing, while inflation is continuing to ramp up - this suggests the cycle is likely peaking - related to point 3 above, if we enter into an economic contraction, yields on the long end of the interest rate curve will decline substantially, thus harming BHF's economic value.
1) Equity markets compound at 6.5% per year in a smooth fashion over the next few years, with limited volatility, and the 10 year rises to the 4.25% level BHF has modeled in a smooth fashion - i.e., if the next few years all look like 2017 - in this case, BHF will likely receive a more generous multiple of book value from the market.
2) BHF executes a buy-out program to try to de-risk their variable annuity exposure - oftentimes when insurance companies take on liabilities that later turn out to be imprudent, they look to buy their customers out with lump sum offers - Voya used this strategy to an extent, but given the size and scope of BHF's book of business and what I believe the likely economic magnitude of the issue, it seems unlikely this would move the needle.
3) VA Capital Reform that is very favorable to the industry - the NAIC is currently working on reforming VA capital - the market currently believes this will likely make annuity writers worse off, but if, for some reason, regulators end up with a solution that substantially benefits the industry, this would be a positive for BHF.
Hedge Benefits And Trading Dynamics:
One additional note on being short BHF as part of a broader portfolio - I think BHF is a great broader market hedge because in most scenarios where the market performs poorly, BHF will perform even more poorly. Since it has started trading, BHF has been down an average of ~3.5% on days where the S&P 500 is down more than 1.5%.
In terms of borrow cost, Interactive Brokers has 1.3mm shares available for 0.3% borrow cost so the shares are fairly easy and cheap to borrow (as of 6/1/2018).
BHF (which is largely a portfolio of very risky liabilities MetLife was interested in shedding) appears cheap because it trades at a substantial discount to book. However, as I have shown, book value is largely mark to model and not to be relied upon as liabilities can (and do) end up being worth multiples of what they are marked at. GNW is a cautionary and similar tale of the dangers of investing in what appears to be an undervalued insurer when the book value is based almost entirely on management estimates and assumptions. A number of realistic downside catalysts creates a path to a re-rating ~50% lower.
Exhibit A - Form 10 for Spin-off From MetLife
Exhibit B - Historical Market Share Tables for VA Sales:
Exhibit C - Papers on Variable Annuities and Their Risks
From the insurers' perspective, however, minimum return guarantees are long-dated put options on market risk that are difficult to price and hedge. Imperfect hedging creates risk mismatch that stresses risk-based capital when the valuation of existing liabilities increases with a falling stock market, falling interest rates, or rising volatility. In fact, the Hartford Group was bailed out by the Troubled Asset Relief Program in June 2009 after significant losses on their variable annuity business. Given their size and potential risk, variable annuities are an essential piece of the puzzle for understanding the insurance sector more broadly.
Exhibit D - MetLife Risk Management Presentation from 2009:
Exhibit E - Universal Life Secondary Guarantees: What's the Real Risk?
Reuters article on the Potential Reform.
Disclosure: I am/we are short BHF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.