Description

Recommendation: Short Brighthouse Financial (BHF)

“I work in the insurance industry because, as a balance‐sheet guy, there’s a lot of junk you can play with... The fun you can engineer into an insurance company’s balance sheet is a lot more fun than some others.” – Former Assured Guaranty CEO, as quoted at the 2018 Sohn Conference

Brighthouse consists of the majority of Metlife’s U.S. annuity operations and was spun-off in August 2017. Brighthouse appears cheap because it trades at a substantial discount to current, stated, book value, yet 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 (GE’s insurance spin-off from 2004) for its entire existence and drove some of GE’s recent $6bn charge which was 14 years after GE spun Genworth off). 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. Many market participants wrongly believe annuity writers do well in up-market environments and that increases in interest rates help them; 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, and volatility spikes are especially bad as their hedging programs are more likely to malfunction, potentially causing substantial economic impacts. Simply put, many market participants incorrectly believe annuity writers are ways to play higher equities and higher rates, which is true in linear first-order moves, but 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. Several of the readings in the folder linked below should help explain how the business works in more detail. As noted in the BHF 10-K, 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 the economic cycle is likely peaking, it seems more likely than not that this won’t be the case from current levels – i.e., if the cycle turns, the stock market likely will not perform at those levels and interest rates will go lower once the curve inverts and the fed adjusts monetary policy to support a weaker economic environment.

Probably the biggest concern with BHF is if the capitalization is in fact adequate given the volatile 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)      Took a $2bn dollar 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

2)      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) 

It is also notable that Metlife has talked about the impact of tax reform potentially meaning about 65 points for their RBC capital ratio vs. ~650% RBC capital ratio (so a potential 10% impact); in the most recent earnings call, BHF seemed to suggest the impact on its capital position from the tax cut would be about 100 RBC points - i.e., the difference between “well in excess of 600%” and “well in excess of 500%” per management’s comments.

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 they don't want to have to reserve to, 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). 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. 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 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.

One other interesting item is that 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 – 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 – 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. Here you have a book of business that is almost 80% equity-exposed (variable annuities + ULSG 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).

While everything has a price, and that may pre-dispose investors to the view that at ~.5x 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. 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 implemented a loss cap such that they would not cover losses above a certain level (management comments on Cigna call 2/4/2013). I think this is instructive in terms of the level of margin of safety required to underwrite variable annuity business.

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%.

Additional Readings:

https://www.dropbox.com/sh/zpsi2y1q0k4sc77/AAC6ZYFvf2N-sn-NxyR1C-T3a?dl=0

Catalyst

1) capital emerges worse than expected

2) VA utilization emerges worse than expected

3) equity market correction

4) interest rates fail to rise to levels BHF has unerwritten