Hi, I'm Seth Weiss, Senior Life Analyst here at Bank of America. Pleased to be joined by the team of MetLife, CEO Steve Kandarian, and the CFO, John Hele. Steve has been with MetLife since 2005, where he first served as Chief Investment Officer. Then 2011, took over his reins as CEO. Prior to joining Met, he was the Executive Director of the Pension Benefit Guaranty Corporation. His experience in a regulatory capacity obviously gave Steve valuable perspective when navigating the options MetLife faced after being designated systemically important. John has experience both in the life and P&C side, serving as CFO of Arch prior to joining MetLife. Since taking over as CFO in 2012, MetLife has more than doubled its pace of cash flow generation. Steve and John, thank you so much for joining us.
If time allows this morning, I'd like to cover some of the key topics that investors are focused on from Met. Big ones being improved free cash flow, separation of Brighthouse, regulatory matters, including the pending court case. Then the $1 billion-plus expense initiative that you announced last year. However, before I get into those important topics, I just want to address the large derivative loss that occurred in the fourth quarter, which I know received a lot of investor attention post-quarter. If we look at that derivative loss, I think the fourth quarter, the move seemed a bit outsized relative to past interest rate moves, both moves up and down. During 2016, I'm curious if you added or changed your derivative position to increase your downside protection.
Thanks, Seth, for having us here today. Can you hear me? Is this on yet, or my mic? Yeah, it's a little better. Let me just start by saying that MetLife has used derivatives to hedge its risks for many years, and it's actually provided us a tremendous amount of operating income and downside protection of the interest rate moves, currency moves, credit issues, equity moves, and so on. It's part of our philosophy is hedging our risk. When we had our earnings call for the Q4 period, we mentioned that there was this large derivative loss below the line, and there was a lot of asymmetrical accounting associated with that. There were hedges put in place, and there were offsets in the liability side that don't get marked to market.
We said 94% of this "loss," was the asymmetrical accounting treatment, the GAAP accounting treatment. I should probably mention that FASB is looking closely at this issue right now because it is a big issue for insurance companies in terms of how the accounting works. If you can get hedge accounting on your derivatives, then they go up and down together, and you don't have this noise. If you can't get hedge accounting, and the test is very narrow in terms of getting hedge accounting, you have a lot of this noise going on. When we put hedges in place, we're trying to hedge as closely as possible to those liabilities that we are concerned about in terms of movement changes up or down. We did put some additional protection on in the third quarter of 2016.
It related to a block of business in the segment that we call Brighthouse Financial. I'm sure you know that we have announced the spin-off of that business. It's the ongoing U.S. retail life insurance business that'll be its own stand-alone company going forward. That hedge was put in place as we were going through the analysis associated with the spin of Brighthouse. The key was to make sure that this very important strategic move for us to separate out Brighthouse, put it on its own going forward, was executed as seamlessly as possible. We were protecting the capital in that business. One of the key aspects of separation is making sure that there's adequate capital in Brighthouse on an ongoing basis, making sure it launches off with strong capital positions.
There was a universal life with secondary guarantee block of business, and we wanted to kind of defease, lock in those liabilities in terms of interest rate movements. That was done in the third quarter of 2016. The decision was made early in the third quarter of 2016. A lot of hedges got executed over the course of the quarter. At that point in time, we still had an interest rate environment that was quite low, A, and B, a number of people were concerned about U.S. rates mimicking rates you see in places like Western Europe and Japan, et cetera, i.e., very, very low rates, even lower than we have here in the United States. Zero, even negative rates for 10-year government instruments in some of those countries.
Had that block not been hedged properly and had rates dropped down to those very low levels, we'd be having a lot of strain in terms of capital on the most important strategic move we are making here in the last several years, which is a separation of our U.S. retail business, the ongoing business that we call Brighthouse. We defease those liabilities, we lock them in, and when rates spiked up in the fourth quarter, those positions resulted in losses. They are, again, below the line. They're asymmetrical. The liability also went down in value, but GAAP accounting doesn't account for that. That was the disconnect in terms of the income statement in the balance sheet component. That's really what was going on at that point in time. It was a decision to make sure we protected that capital that we needed for Brighthouse.
Part of our overall plan here, and I think it's important that I spend a little time on this, which is, our philosophy is driving up that free cash flow percentage for MetLife. We've talked about that a lot. We'll talk about it probably later in this discussion. One of the components of that in terms of separation is making sure that when this is all said and done, A, Brighthouse is well-capitalized, and B, we get a dividend back into RemainCo MetLife, that again, will be used for additional capital for many purposes, including dividends, share repurchases, and any M&A activity that makes sense from a strategic and accretive perspective. We're trying to make sure, as we looked at this back last year, that Brighthouse gets separated out seamlessly as well as possible, capitalized, a dividend comes up to the holding company.
All this is part of our strategy, the hedge was to protect, at that point in time, capital for the company overall.
Maybe I should just add that this captive is just being formed. It's mentioned in our first Form 10 filing, we will have many more details of all this, there's some offset to these derivative losses from the value of the liabilities in the captive. We are limited by how much we can tell you because it is a Form 10, we can't speak too much about that until it gets released. It'll be in March, we'll have full details of all this in the Form 10 that will explain all the Brighthouse pieces of it.
How should we think about further balance sheet sensitivity to potential spikes in interest rates?
Well, if rates were to continue going up, you would see these particular kinds of derivatives that are protecting against low rates have some losses. Again, the liabilities they're hedging would also diminish in value. There'd be an offset economically. From, again, a GAAP perspective, there'll be an asymmetrical treatment to that. John, you want to add to that?
It's 94% in the fourth quarter of asymmetrical non-economic derivative losses because the liabilities in true economic terms went down, and net-net, MetLife economically is worth more, has much better present value of future cash flows now than it did previous to this rate rise. It's all good. Unfortunately, accounting is a bit complex when you try to cut through it on a GAAP basis.
Let me just mention one thing, because I've heard some people say, "Was MetLife making an interest rate bet?" It was actually just the opposite. MetLife was trying to lock in margins regardless of interest rate movements on an economic basis. That's the goal with our hedging program.
We focused a lot on the GAAP ramifications. What about the statutory ramifications of this all?
There's also asymmetrical accounting in statutory. The derivatives are held at market, the liability is generally all at book. The changes on derivatives generally don't go through the net income report on a stat base. It just goes right to capital. There is an impact on it. We are looking at this carefully. As we announced on our last call, we are re-looking at our hedging program that we have today. We have a program in place where through a long period of time, we were facing risk of more downward rates, and now we're in a higher rate environment, and we have to rethink how we can manage that as rates keep going up.
Could you comment about your options of how you may modify your hedge position?
Well, it is not simple. That's why it takes some time. It's really almost an optimization program. You're balancing economics, GAAP and stat points of view here. We do want to ensure that we protect as much as we can our free cash flow because it's very important for us to generate free cash flow. You can switch, instead of using swaps, you could buy swaption, which are more like insurance protection, but you pay a fixed price. It's really balancing current cash versus rates going up and having cash. Even if rates do go up, there's many tools that we can use to manage within this. We're working on that, and as we have some more details on it, we will let you know.
Maybe taking a step back from the quarter and now focusing on the bigger picture strategies, free cash flow improvement, as I mentioned in my opening, has been a big theme since you've both taken over your leadership roles. The separation is a big part of this initiative. Can you tell us some other examples, maybe, of steps you've taken to improve free cash flow and maybe some further opportunities you see?
When I became CEO of MetLife back in 2011, if you look at the first full year of my tenure as CEO, 2012, our free cash flow ratio was 26%. Last year, after normalizing for a few factors, including the Brighthouse separation, it was 77%. We've said 65%-75% for the next two years is our goal. That 77% was a high number. You've seen an increase in free cash flow over the last several years at MetLife. That 26% number was not an aberration in 2012. Basically, MetLife, up to that point in time, was running a lot of business that had a lot of capital strength in policies like universal life with secondary guarantees variable annuities that had large income benefits, long-term care policies.
Those businesses perform well in a steady or even slightly higher rising interest rate environment. In a low rate environment, there's more strain put on those kinds of liabilities. You've seen us over the last several years decrease that side of our business and increase other parts of our business. You've seen intentional shrinkage of certain parts of our company and intentional growth of other parts of our company. In net, we're growing slowly over the last several years. There's been PFO growth, top-line growth, but slow growth because you're seeing negatives and positives. At some point, those negatives will wind down and just the positives will remain. If, again, you go look back at those kinds of liabilities, they put a lot of strain on your balance sheet and your free cash flow generation.
We've taken steps to move away from things like we don't sell any longer new long-term care policies. Existing ones still have premiums coming in. We don't sell USG any longer with lifetime guarantees, and we've dramatically modified how we sell annuities in the marketplace going forward. Our IB product's no longer being sold. Those are the major steps we've taken to shift the business.
We also have gone through a very extensive analysis, and John can talk more about this in a second, looking at our business, not just kind of an overall macro point of view, but a micro point of view, kind of market by market, product by product, geography by geography across our entire footprint around the globe and said, how these different products we sell, the different liabilities we put on our balance sheet perform over time from a free cash flow perspective, from perspective of how much capital is necessary to put them on the books, how fast that capital comes back to us and our shareholders, and that is a major driver of our strategy and the kinds of products we are selling going forward.
Yeah. This is a company-wide program that takes a great effort to get through and do. It's a market-by-market, product-by-product analysis, looking, as Steve said, the capital committed, how fast that capital comes back, the IRR that you get on it. Because some products can look really good in GAAP earnings, but they use a lot of capital, and they may have a very long payback. We've incented management. We've had training. We're redoing our company from top to bottom with this strategy. You'll start to see that year by year as you get more capital efficient. We already have the last few years, and that's been helping the overall cash flow. Our goal is not to just get cash flow in any one year because there's many things you can do to get good cash flow in one year.
You can do a reinsurance deal. You could do many things. The real elements have sustained ongoing strong free cash flow. Our target for a RemainCo is strong in the industry, and we are working everything always to generate free cash flow. It's also long-term free cash flow. It's not just doing it in one or two years.
In terms of the 65%-75% target, that's the remaining MetLife. As of now, you're still a consolidated MetLife with Brighthouse. I wanted to address the separation and just get an update on your expectation of timing and what steps need to still be taken.
For the Brighthouse separation?
For the Brighthouse separation.
We said first half of 2017. I'd say the likelihood is the back end of that time frame. We require approvals at the state regulatory level as well as with the SEC. This will be a spin-off. It'll be a separate public company on its own. The structure that we've discussed before that's most likely to be utilized here is a 80.1% tax-free spin-off to existing shareholders, and the remaining stub, 19.9%, being held by MetLife RemainCo. We would anticipate selling that down over time, opportunistically. We'll consider other structures before the final execution occurs, that is the current thinking in terms of how this would proceed. We've talked to a number of our large shareholders.
We've talked to them about different structures, the one that we thought made most sense, there was concurrence between our thoughts and our large shareholders that they would like the benefit of holding that stock and deciding for themselves whether they want to retain or not retain the Brighthouse stock going forward. They would like that decision to be in their hands, the structure provides for a tax-free spin-off. We think it's the right structure, again, there are other options that always remain on the table until final execution occurs.
You can still switch that form of separation. I guess, what are the factors that you would need to consider since you're leaving that option on the table?
Someone makes an offer for $30 billion. Sold to you.
I'll let you know how much is in my wallet. What are the biggest challenges that could delay the separation? You talked about some of the processes and back half of the second half of '17 is most likely. any new developments there that you could share, I think everyone would be interested in.
John, you want to?
Sure. this is a very complex project, as you can well imagine, separating a major piece of a company that's been around since the beginning, almost, of the company. we're well underway on all these pieces. Brighthouse is operating, all but disaffiliated now as a company within a company. In March, their brand will be rolled out and announced, so they'll be operating as Brighthouse. We do have to go through complex regulatory approvals at both the SEC and the state, as Steve mentioned, and they take time. we're working every day with the regulators to work through that.
as it looks right now, the total distribution shares would be really towards the end of the first half of the year, so.
Great. Thank you. The other big, I think, headline with Met has been this court case on SIFI. You won the initial ruling. It's been argued on appeal. Just curious what your expectations or range of expectations are for timing of hearing that appeal ruling.
Sure. Just to recap, we brought suit under Dodd-Frank, which provides in the act for an appeal of an FSOC designation for non-bank as a systemically important financial institution. Following the law, we appealed to the U.S. District Court in the District of Columbia. That case was heard back in 2015. The decision came out in March of 2016, and we prevailed. The judge found in our favor on three of 10 counts that we brought in that suit. On a fourth count, the judge found against us, and the other six counts, she didn't rule. She didn't feel she needed to rule. We won on three of the four counts that were decided by the judge in that case. The U.S. government quickly appealed that case to the circuit court of the District of Columbia. They asked for an expedited hearing.
They were granted that. The filings were made over the course of the spring and the summer. The court case, the oral argument on the case was heard by the appeals court in late October of 2016. There's a three-judge panel that is determining the case, and their decision can come out at any time at this moment. They heard the case, as I mentioned, in late October, we're just awaiting a decision on the appeal that was brought by FSOC and the U.S. government.
Do you have any indication from the Trump administration whether they may decide to drop the appeal?
I have nothing to disclose. There's nothing at this point in time that I can discuss on that point. Obviously, a new administration can look at things differently than a previous administration. The Trump administration has said already through one of its senior officials that they don't feel non-banks should be designated as SIFIs. That's a public statement that was made by a senior member of the Trump administration. We're awaiting resolution of the case at this point in time.
Maybe staying on the regulatory theme, but taking a step back from the court case. President Trump, he's pledged to dismantle and replace Dodd-Frank. You talked about what one of his senior advisors, Gary Cohn, had spoken about a couple of weeks ago. I suppose, what's the range of outcomes or scenarios that you see as possible, maybe most specifically as it relates to the insurance industry?
For us, the first issue is, do we become a SIFI or not? Right now, we are not a SIFI because we won the court case in the district court. If, under a scenario, the appeals court reversed the lower court decision completely, then we would be a SIFI at that point in time, and then there would be rules eventually coming out of the Federal Reserve, under which we would be operating and regulated. That's one end of the spectrum. Those rules still have not been finalized, so we can't really say what the impact would be on our company since the rules are not yet promulgated. Again, the person who was in charge of supervision at the Federal Reserve, Dan Tarullo, announced that in April, he was intending to step down from that position.
As of now, there has not been anyone appointed as vice chair of the Federal Reserve for Supervision. That is a position that was created in the Dodd-Frank Act back in 2010, but never filled formally. It's a confirmed position, confirmed by the United States Senate. It was never filled. Governor Tarullo has been acting in that role in a supervisory capacity. Again, he's announced his departure in April. It would depend upon how the new person who would oversee supervision of the Fed would ultimately come out in terms of rules. We are optimistic that if we were, in a worst-case scenario, to be designated, i.e., the appeal coming out against us, that under the current administration, I am optimistic that the rules would have a certain level of reasonableness from our perspective.
Having said that, we still feel very strongly that under Dodd-Frank, we are not a SIFI. We made that case very strongly to the district court. The district court agreed with us wholeheartedly. If you read that opinion, it was not on the one hand, on the other hand. It was a very strong case in our favor, and we will defend that decision going forward. Right now, it's before the appeals court. We'll have to wait and see how that sorts out. One other thing I should mention, because I am obviously a lot more optimistic right now than I might have been a few years back on this issue of whether MetLife would be put in this bucket as a SIFI and have rules that made it really uneconomic for us to compete in a very competitive industry.
Both the issue of supervision, what the Fed may do going forward under a new administration, with perhaps a new person in that role, but also related to other aspects of how Dodd-Frank might be applied. For example, GE is no longer designated as a SIFI. They basically sold down a large part of the GE Capital business that was targeted for their designation. As we separate out Brighthouse, we will be a different company. Many of the things pointing to in the FSOC decision relate to that part of the business in terms of certain products, certain kinds of derivatives used, and so on and so forth. Certainly it'll be a different company post the separation of Brighthouse.
Simply from a legal perspective, in the worst-case scenario of being designated, that separation would make us a different company going forward for a new FSOC with new members to look at in terms of whether or not MetLife should remain designated as a SIFI if we were, again, to lose the appeal at the appeals court level. Net-net, I'm feeling much more optimistic about retaining our level playing field status, which right now we have. We're not a SIFI, and we're regulated like other insurance companies by the state regulatory system, which I must remind people is a very well-constructed, over many decades, system of regulation for insurance companies. Again, if you just kind of step back and think about what happened during the crisis, the one company that really had issues in the crisis was AIG, but it was not their insurance entities.
It was their financial products group, which was not regulated at the state level. It was regulated at the federal level by the Office of Thrift Supervision, which is no longer in existence. It was folded into the OCC through legislation post-crisis. The remaining part of the life insurance industry, with strong regulation at the state level, came through the financial crisis. We got our bruises like anyone else, but we were not systemic as companies or as an industry. I think the new administration understands that.
Another hot topic as it relates to the change in administration is potential for tax reform. What impact do you think that this could have on Met's overall effective tax rate, and how are you viewing some of the potential positives in perhaps risk factors?
It's very early days. Chairman Kevin Brady from the House Ways and Means Committee has put a blueprint. There really are not details. It's a high-level statement. The key factor there is something called border adjustability, where exports are not taxed and imports are taxed. It'd be a major shift in terms of how taxation at the corporate level would occur in the United States. We don't know whether that blueprint will ultimately turn into law or whether a different direction will occur. I am confident that Congress as well as the President is committed to tax reform, that there'll be a robust discussion about what the ultimate tax bill looks like over time.
Our view at MetLife is we strongly support pro-growth tax reform. I've said in fairly large meetings, not necessarily public meetings like this, but large meetings of business executives, that certainly MetLife will be supportive regardless of the kind of the pluses and minuses of how it impacts MetLife, the entity itself. Caveat, if it's so dramatically impactful to us that our business model is at risk, that's a different matter. If it's plus or minus net a little bit to MetLife, but it's pro-growth, we and other companies, I believe, should be supportive of pro-growth tax reform in this country. If people kind of lock into my little piece of the world here, we'll never get anything done.
This may be a once in a generation opportunity to get true pro-growth tax reform that'll help not only MetLife, but will help workers in this country going forward when job creation gets stimulated. That's the big prize for all of us, people have to keep their eye on that.
I want to shift from some of the big picture thematic things we've been discussing to maybe more of a MetLife specific topic on the expense initiatives.
Okay.
You've announced a $1.05 billion gross expense initiative. It's the second major expense initiative announced in the last five years.
Right.
How are you able to take such aggressive cost cuts without risk of under-investing in the businesses?
John.
Sure. The goal really is $800 million net by 2020. Why the difference? Well, we will have overhead that's stranded. As you separate out Brighthouse Financial, there are costs that have been allocated historically to Brighthouse Financial. It's a pretty big business. We're going to move that allocation to MetLife Holdings, so you can see it isolated there, and do this cost program to get $800 million net of the stranded overhead pre-tax by 2020. That's January 1st, 2020, the run rate would be $800 million. I gave a slide at our public call in our investor day of the saves and how they come in because this will take investment. We have done a cost savings program since 2012.
This is the next one, and this is going to take technology investments across the company in many different aspects. The bottom line impact of the savings less the investments is about $100 million negative in 2017, $200 million in 2018, $400 million in 2019, and then $800 million in 2020. It's quite extensive. Finance is going to be automating a lot as well. We're part of it. Almost every department in the company is part of really investing in some more automation and some new tools to really streamline what we do. More than that, we've designated this a unit cost initiative because our targets will change over time. We are comparing and benchmarking ourselves against key competitors. Those unit costs, if they keep improving, we will also have to improve. This will not be just a three or four-year program.
This would be an annual ongoing program to ensure that we have competitive unit costs across the world and our company. It's much more an ongoing program to always improve year by year with an eye on being competitive on a unit cost basis.
We have about one minute left, so I just want to wrap up with a question on ROE progression, and the way you target your goal, which is a spread over Treasuries. I believe it's eight percentage points over Treasuries in the short term, going to 9%-10% over time. The separated MetLife or the remaining MetLife should be a less interest rate-sensitive business. Why is the historical spread over Treasuries still the right way to think about ROE targets?
You're right. Over time, we'll become less interest rate sensitive. I talked a little earlier about the products we no longer offer that are very interest rate sensitive. That'll take time to roll off. Even with the separation, there's a fair amount that's still in RemainCo through our MIC subsidiary. Even still, even with the kinds of products we'll be focused on in the future, it's still a spread business. You price an insurance policy based upon what you think you can earn on the premiums you take in for that policy. You get a margin, you have a credit shave for defaults on your bonds over time and so on. Ultimately, it is a competitive business. There's a lot of insurance companies out there. We compete on a lot of different measures as well as price.
You look at the risk of the liability, things like mortality, morbidity, credit, and so on. Look at the returns you can get on those assets you're getting for premiums, and that's how you price product, and you're competing against others who are doing the same sort of exercise. Ultimately, if what we're buying in the asset side of things, the bond market mostly, or other fixed income instruments, have low nominal yields because there's low rates, low inflation, versus a different time in history when inflation's higher, rates are higher, reflecting the inflation and so on, the nominal numbers are going to be different. Just for example, if you had a 14% or 15% ROE in a 6% 10-year treasury yield world, that's not the same as having a 15% ROE in a 1% or 2% or 3% 10-year treasury yield world.
It's a very different real economic outcome in those two different scenarios. I think it's important for people just to keep that in focus, even as investors. The expectation for investors, what's the real return on my investments, not what's the nominal return of my investments. That's how we look at our business as well. If we were to chase some sort of artificial, in my judgment, nominal ROE target, the only way to do that is take more risk. You can take more risk on the asset side, and you know what? You'll do great until there's a downturn, and then you'll give back a lot of that in the downturn because you took a lot of risk from that portfolio.
You can take it on the liability side, in which case you'll look great in a GAAP basis because of how GAAP accounting goes for insurance, and then some number of years down the road, I'll be long gone, John will be long gone, but the next group of executives will be cursing us because they took a big reserve hit down the road. We're not going to do that. We're going to run this business on a basis that provides a fair return to our shareholders, a good service, and good products to our customers. We want this company to be a simpler company. We want to be a company that has more predictable, higher levels of free cash flow over time. We want this company to be a company that utilizes technology in a very forward-looking way.
It makes us more efficient, easier to do business with as customers. We want to not only drive up our ROE over time from that real return of 8% to the 9%-10% we're targeting in the future once we get through the separation and the cost efficiencies. We also want to drive down our cost of equity capital because ultimately it's the difference between your cost of equity capital and your return on that equity. It's not just driving out the return on equity. You can do that, but your cost of equity capital, at least over time, once people figure out what you're doing, will also go up if you're taking lots and lots of risk, either on the asset side or the liability side. That's our philosophy.
That makes sense. Well, thank you so much. Appreciate the time.
Thank you.