Life, we're pleased to have John Hele, CFO of Met, join us. John has experience both on the Life and the P&C side. Prior to joining MetLife as CEO in 2012, he worked as a CFO at Arch Capital as well. Moving over to MetLife and the financial side of the equation, Met has doubled its pace of cash flow generation within the last three years under John's leadership as CFO. Within the process, also undergoing other significant changes, most significantly announcing the separation of its U.S. retail and annuity business, and also navigating through potential federal regulation. With that as an intro, I'd like to start on the cash flow story, which has been very core to the message of MetLife in recent years. You've gone from 25% in 2012, and you've more than doubled that, north of 60% in 2015.
Can you just walk us through what's changed and how you've improved your cash flow generation?
Sure. Thanks, Seth. MetLife, up until 2012, when Steven Kandarian unveiled the new strategy, free cash flow was not, I would say, top of mind. In fact, since the demutualization in 2000, I think the average was about a 25% free cash flow generation for that whole time period, up to and including 2012, when I arrived. Steve had unveiled the strategy early that year and said he wanted to make free cash flow a major focus of how we thought about the firm. We did some structural changes. We brought our variable annuity captive onshore and merged it into other legal entities, which helped reduce needs for cash and last-minute needs for cash at year-end. I call that a structural change.
We created much more focus on free cash flow throughout the whole company and everyone really thinking about it, really making it a top priority throughout the firm. We also had a recent change in the New York dividend law just at the end of last year. New York State, which is our largest legal entity, had a lesser of rule. In other words, your dividend capacity for the following year was the lesser of your statutory earnings or your 10% of your statutory surplus. This was about $700 million the last few years that was not coming out if we were greater than state. Most states are greater than. You get the greater of your statutory earnings or 10% of your surplus. New York had always been a lesser than state. Now you could get the money from the state.
You'd have to go and apply and ask for an extraordinary dividend, but you're never certain exactly that you might get it or not, and you have to have approval. We were very pleased to see New York changes late last year. Now with their greater than state, that's going to have more predictability for free cash flow going forward from our largest entity. We've gone from the 26% in 2012 to 35% in 2013, to 44% in 2014, and over 60% in last year, and our guidance now is between 55%-65%. We think that's a major progression that we've done throughout the firm, and this is a very important metric. GAAP earnings are very nice, but if you don't get cash out of it, you can't do anything with those GAAP earnings.
That's a major focus for how we think about the firm. There's always a trade-off between the cash generation you get from a statutory entity and growth. If you stop writing all new business, of course, you have higher free cash flow. It's a balance of growth and free cash flow that we're trying to work on.
With regard to the New York dividend rule change, in your prior target, prior to December when the rule changed, had you assumed some level of extraordinary dividends before and this improves your predictability, or does this actually improve the cash flow yield as well?
We had been assuming we would get extraordinary dividends paid out within that. It's really the predictability that we have, but we just got better cash flow generation throughout the whole firm now to get up to these higher numbers.
In December, you laid out an initiative called Accelerating Value. Laid out actually before December, but I think you named it in December. What does this mean for future free cash flow improvement, and what does it mean beyond cash flow improvement?
What we've done is, we call it Accelerating Value because it's really accelerating how we think about implementing the strategies laid out in 2012. It's not a change in our strategy. It is a way to really do it better. We focus on the three Cs, we call it. Cash, which is net present value of cash generation, how much capital is being consumed by products, how soon you get it back, what's the IRR, all on a statutory basis. Competitors and markets, not just how are we doing, but how are others doing in their cash generation and consumption of capital and return of capital and earnings. Then also customers. Which customers have the most value, and which customer pools are the best ones to be working at? This is a very long-term journey.
It's a great deal of work to do it well because we did it thoroughly throughout the world, essentially an embedded value type calculation as the Europeans do, with a lot of discipline and cross-checking. It really is a chance to take your pricing. Typically, everyone thinks they get a 15% internal rate of return. There's this study done every year by, I think, Towers Watson, and of all the actuaries in the U.S., and they say, "What do you price at?" They all say, "We price at a 15% return." If you look at the industry, it doesn't get 15%. There's a gap. What our calculations do, we take pricing, but we check it every year versus an in-force valuation. If you buy or sell a company, you always do a full actual valuation. That's essentially what we're doing.
It's a check and understanding the dynamics of the generation of how much capital are you consuming in a year for your new business, all the other changes that affect your in-force block, and then how much flows off after that. As you can imagine, it's a great deal of work to get this done. It took us over a year to get our first phase of it done, and we are there now. We're now working more on the customer side, but it's been very insightful wherever we've done it. It led us to find products, often that looked good under GAAP, but had long payback periods. We said, "Do I really want to wait that long to get my money back?" Also, we always run sensitivities when we do this, particularly to low rates or declining rates. That led us to pull some products.
We had a product in Japan, a single premium accident health that looked good on GAAP, nice GAAP earnings, but it was a longer payback and was very sensitive to interest rates. We actually stopped selling that product last year. We took a GAAP hit, if you want to think of it that way, in order to have better cash flow and predictability of cash flows. The other major area that it led to was thinking about the retail business. That, I'd say, was one of the biggest changes that we've put through. The foundation of it came from thinking about the cash flows of those businesses.
Obviously interested in talking about the separation of retail. One question before we move on there on Accelerating Value, how do we measure success? I assume you're still going to report GAAP earnings on a quarterly basis. I hope so for the value of my job.
Yes. I think I'm required to do that for the value of my job.
There is a lumpiness of cash.
Absolutely
not the way to measure cash.
No.
How do we view success in Accelerating Value?
We'll give you annual components of it, and we have been improving our disclosure of this in our 10-K. You can actually see the components of what we call free cash and exactly what's happening to it year by year. We're going to do some more even expanded disclosures on it this year in our 10-K and trying to give people more insight into the statutory earnings of all of our entities. Having our variable annuities inside of a statutory entity, you can see all the derivatives, all the components of it. You can truly see what's going on with that, and that's a published Blue Book. We believe we have to give the investors more transparency on these components, and that's exactly what we're doing. You can see what we're doing as we go along.
As I said, it's a function of free cash flow and growth. As we get more work done on Accelerating Value, and use it more internally, we're using this as an internal tool. We will ultimately give some more components of it to the investment community.
Moving on to the separation, a huge strategic shift. Biggest since at least ALICO, perhaps since the demutualization. What's the primary objectives of separating U.S. Retail Life and Annuities?
There are two fundamental drivers of why we wanted to take a portion of our retail business and pursue separation options. The first was the Accelerating Value initiative that I said, that if you think about the cash flows and generation, use of capital for the type of business in the retail business, the variable annuity, the life insurance sales that are done today in the retail business, they can have a nice return, but those cash flows are more volatile than the rest of our business, which is more predictable, more protection business or pension closeouts. There's much more predictable cash flows from those businesses. We had a more volatile but a good return business with a more stable business.
We started to pursue thinking about, would it be better to have the investors have the choice of having two stocks as an option or maybe someone might want to buy it. We're looking at that line of reasoning. The other reason or driver behind this, equally as important, was the regulatory risk that the products mentioned having the most potential for higher capital charges. Now we don't know what the capital charges will be. The Federal Reserve's indicated yesterday that they may be out soon. In discussions both with the Fed and on the international front, they've said that variable annuities are a more risky product and might have a higher capital charge. By a separation and the size of our separation business, we believe would not be a SIFI.
It would be slightly smaller than Lincoln National, just a little bigger than Voya, neither of which have been named a SIFI. We think that the products sold then would not have the risk of this higher capital charge. If it stays within MetLife, because we are a SIFI, would have the risk of higher capital charges. Both the Accelerating Value initiative and the regulatory initiative, we believe it made sense to make this announcement. We get asked, why did you make that announcement in early January? We had been doing a lot of work on this, as you can well imagine. It's quite involved to really take it to its ultimate conclusion without involving a lot of people in the company.
We didn't want to have rumors start and get out of hand, so we decided to announce a plan to pursue separation of the business. We still are doing a great deal of work to sort it all out and think through all the various options that we have to do, but we want to get the announcement out there so that we can control the communications and work with the various affected employees throughout our firm. As you can imagine, it does affect quite a few people. We don't have it all sorted out yet. We are still working on that. As such, we have work underway that could be considered to be material and non-public information. We get asked after our last call, why did we not re-up another share buyback system?
Is it because you need to build capital to do the separation? That's not the case. We believe based on current market conditions, that we have enough equity capital to pursue the various options of separation, and still have an appropriate buffer of capital, that we need to be a SIFI. It's just that we have this material information as we sort all this out. Under securities laws, you really shouldn't be buying back shares if you're in possession of this type of information. It's just basic securities law, and it will take time. The timing is not exactly perfectly certain. If one of the options is to do an IPO, you probably want to be doing one in this current market, so you may have to wait timing.
We're not sure exactly of the timing of all these things, so I have that caveat on it. Over the whole time period, however long it takes us to separate, we believe that we have sufficient equity capital.
Lots to sort out in terms of the structure of it, obviously it hasn't been decided. Who do you need approval from in order to do the separation?
We'll need a number of regulatory approvals for intercompany agreements back and forth. We still have a large piece of retail, which is in MetLife Insurance Company, which is a New York company. We are retaining that. That will go into runoff, and we have to have services agreements back and forth on how this is done. We don't see any major obstacle in doing this. We are looking to separate MetLife USA, which is a standalone statutory entity, a Delaware-based company. There'll be some other smaller companies that go with it. It's an easier separation than some other companies have had to do before because MetLife USA is already a 10-K registrant. It has a Blue Book, and that's the core piece of the business going.
As opposed to having moving blocks of business back and forth that require a lot of approvals, take a long time, be very complex, we have a very good business today in retail. They're together in Charlotte, North Carolina. This is a manageable separation, we believe. We haven't seen any showstoppers. It's why we're comfortable making the announcement, we have a lot of details to sort out for any separation that has to happen.
From the approval side, it sounds like it's from the state-based statutory type approvals. At this point, is there any need from approval from the Fed?
The Dodd-Frank Act, nor Federal Reserve regulations require us to get approval from the Fed on this.
Moving on to federal regulation, your team was just in court yesterday. The separation plan that you laid out, does this impact the lawsuit against FSOC in any way?
It's actually quite separate. We do not believe that MetLife in total is a systemically important financial institution. We do not believe that FSOC made a case against the criteria as laid out in the Dodd-Frank Act, to name us a systemically important financial institution. We have said that from the beginning of the whole process. Under the Dodd-Frank Act, you're allowed to have an administrative appeal, which we did, and then we got our final designation. We had 30 days in which to decide. Under the Dodd-Frank Act, you have the right to appeal to the courts, and that's what we've done. We filed a lot of briefs back and forth all last year, ended last fall, and the judge held a hearing yesterday to ask questions and probe. It's not really a trial. Each side doesn't get up and testify and cross-examine people.
It's an opportunity for the judge to ask questions and get clarification on various aspects that she is reviewing. We're pleased. The judge is thorough. We have to wait and see what her decision is. In addition, the loser will have the right to appeal to another level, and then it could even go to the Supreme Court if the Supreme Court were to decide to hear it. This can be a long process in going through it. The decision on the retail separation, we took that into account that this could be a long process underway on our appeal against FSOC.
Is management's goal to strip MetLife of SIFI status, or is the separation plan mainly to make SIFI status more tenable?
Well, we don't believe we are systemic, as I said. We don't think we meet the criteria. We don't think our business is systemic really in any way. As big as MetLife is, we believe that if we were to fail, we would not bring down the U.S. financial system. We've done a lot of work on that and filed that with the government. That's our fundamental tenet. Now we are SIFI today, and we have to live, and we fully cooperate with our regulator, and we're proactively working on creation of capital rules, both on a federal level and on the international front. We're fully engaged in this whole process, and we have to be.
We have to do this dual track process, and we hope that the capital rules that come out are tailored for insurance companies and will be reasonable and will have an ability to really understand how you can optimize within those capital rules. We get asked a lot of questions, what should you do and how would you make it work, which products? Until we see the capital rules, and you can run it through a stress testing process, you really won't know. The banks didn't really know until they got those capital rules out and really got through a stress test as well, when you really understand what the implications are from these capital rules.
We haven't seen anything from the Fed. I've heard, "Don't go play poker with the Fed," is the piece of advice everyone tells me. What we have seen is some initial guidelines from the IAIS, and you alluded to this in terms of separating out annuities or secondary guaranteed life contracts in terms of non-traditional products. The remaining MetLife, how are they positioned relative to the IAIS view of non-traditional insurance products?
The International Association of Insurance Supervisors have come up with a framework where they've developed a basic capital rule that applies to the nine globally systemic insurers, of which we've been named one, and then created an additional capital buffer called Higher Loss Absorbency, HLA add on, that would be added to what they call non-traditional insurance products or non-insurance activities. If you did some banking business or something on the side. They've asked for comments on the process and what they've done. We've submitted a paper where we suggested you shouldn't really label things non-traditional insurance. You should instead look at what is driving systemic risk and how you manage systemic risk as opposed to labeling a product. This labeling a product, it might be or it might not be. It could be how you run it might not be systemic.
It could be if you wrote derivatives from a sub, that could be systemic. If you own a derivative to protect against risk, that might not be systemic at all. We've filed a paper on that because they've asked for comments. Today, we live under a framework of non-traditional insurance products, of which variable annuities are named as one of those products. How this impacts the Federal Reserve, and the only way it would impact us as a GSI is through your national regulator. The IAIS has created a set of rules, almost like the Basel Committee creating a set of rules for banks, but it's applied through your national regulator. The Federal Reserve will look at the international rules and decide when it creates rules, how it will apply this thinking to the companies that it regulates.
AXA is one in France, how the Bank of France will apply these rules to AXA. It's up to the national regulator. These are just guidelines. It is important that the variable annuities have been named as this, and RemainCo will far less variable annuities. 75% of living benefit guarantees are going with the separated company. The other activities that have been named, things like securities lending, we believe are very manageable and we can fit within that. Even if these capital market activities were to be onerously have capital charges on, we can wind those down. The duration is less than three years. They're not putable to us. We would just stop them and just let them run off if we needed to. It's a very manageable risk for us as a firm.
GICs and securities lending, even the longest duration guarantees is three years.
It's a three-year duration.
Oh.
some going out. They're all matched. They're not really putable to us. If you just said, "I'm going to run these off," they would just run off, and we have matched assets and liabilities to all these.
Right. At that point, you could just do the math in terms of the capital needed for it versus the earnings contribution.
Exactly
decision.
When we know the rules, we can do the analysis, and we can take appropriate action.
Moving to corporate benefit funding, which is a market that a couple of years ago you categorized potential demand, or not demand, but maybe the pipeline of $800 billion of pensions that could have characteristics that could be ripe for a closeout. How do you see both near-term and long-term pipeline?
We've been selling about the same amount for years in this. We tend to sell to the smaller size pension closeouts. I think the market's $10 billion-$12 billion a year in terms of total sales, roughly, except for the couple large jumbo deals done a few years ago. The potential is, as we said, $800 billion. I think others in the industry have mentioned this as well. What actually drives firms to actually get there? It's hard to say. It's a variety of factors, but we think this is an industry market. We'll be happier when we know the capital rules that apply to this type of business. We do think about it. We have done, using the Accelerating Value framework, thought about the predictability of cash flow in this. We like plans that have retired lives in. It's closer cash flows, it's more predictable.
If you have a lot of pre-retirees, it's much further out, and you take more interest rate risk. If it's really far out, then it's harder to immunize against it. When we bid on plans, we take this into account, to think about the capital consumed and then how fast you get that capital back. As an appropriate amount of business, we actually allocate a capital budget to this business line and say, "You have so much capital to spend this year, and optimize within that." We do think about this, and I think that's one of the big changes of Accelerating Value. It's not go out and sell as much as you can. It's, Mr. Business, you have a certain capital amount and optimize within that and get the best return.
Talking about this topic in terms of triggers of that $800 billion coming to market, I think with the last couple of years, rising interest rates was sort of viewed as a trigger, right? The liability amount getting closer to zero, and at that point, the corporates being willing to take on the expense. Are we seeing perhaps a change in sentiment where if there's not an assumption that rates rise anymore, maybe that actually is also a trigger to spur sales?
It is hard to figure out what goes on in the corporate world that has these pension plans because there's a lot of different factors within it. How they view it on their balance sheet, how well it's funded, how they view future rates, how they view returns. I've heard both that could be triggers. Rising rates could be triggers, declining rates could be triggers. The two larger jumbo deals that were done were done at lower rates. Maybe that is a trigger. We'll have to wait and see, I think there will be a steady flow for a period of time, and we think it would be a good business within that.
Moving to your international business, a big rival in Japan has pulled out some capital through reinsurance of old medical blocks there. Is there an opportunity to do that at Met?
Well, clearly, if you think about you've capital and you have a flow of cash coming off of that for the future, you can wait and get that cash in over time and dividend out from Japan. You could do a reinsurance transaction and get some of the future cash flows today. Reinsurance is not free. If you do a reinsurance transaction, the reinsurer will make money in that charge. If you need the cash or you need the capital today, it is a useful capital management tool, but there's a cost to it. We weigh the cost of doing that versus waiting. We are seeing better dividends come from Japan as we build better earnings. The Japan statutory framework is conservative, you have to take that into account.
That's actually the first place we piloted our Accelerating Value work was in Japan, to really get them thinking much smarter about how much capital they're using and consuming. They've optimized better even by age, by product, having different riders. We pulled the single premium product. Really optimizing their portfolio to be smarter about every U.S. dollar of capital they use, the timing of how fast that comes back. There can be products that are shorter, there are some products sold in Japan that are really long. Those are the products we're selling less of or not selling anymore, trying to direct the business to be a faster payback for every U.S. dollar of capital that we spend. Over time, that will make a real difference to our business there.
If we need some capital, you always can do these reinsurance transactions. We believe that for the shareholder, it is sustainable improvement in free cash flow is the driver of value. It's not just a one-time transaction and getting money today or having a reinsurance deal or some one-time transaction or I've got a nice free cash flow number this year. It is sustainable free cash flow, a good number with growth. We think if you net present value that back, that's the value of a company. It's the value of company in any business, is the net present value of future cash at a discount rate to reflect the risk of the business at your cost of equity. That's how we think of it, and that's what we're building our whole system around.
I want to take a sec to survey to see if there's questions from the field.
There's one of them.
Here we go.
Can you talk a little bit about the reaction of your distribution to the separation and how they feel about selling products that may not have the Met name on it going forward?
We have, of course, met with our major distributors, both our own sales force and the independent sales force that we deal through. We are keeping all the same people and all the same products. It's been sold out of this legal entity all along, it's not like a change in that. There will be a transition time, I would say people are pretty excited about the opportunities that we will have by having a dedicated group and a focus group on this business, we think there'll be good opportunities.
I'm sorry. They don't feel in any way that they're buying from a company they don't know anything about, whose ability to guarantee their products may be very different than the company they're separated from?
Right now, of course, they're still buying from MetLife. All the products sold are within our framework.
When will they know?
Well, products are sold from a legal entity. They're sold from MetLife USA or from Metropolitan Life Insurance Company, which are the separate legal entities. That's how it works. We're very clear on how we disclose that. We have not yet announced, because we're still working on this, the exact form and structure of a separated company. Until we have that.
What about your brand? I mean, it has the name MetLife.
Yes. There will be a new brand for the separated company. Just as Voya separated from ING and had a new brand and a name, the separated company will have a new brand and name. Yes.
Hi. I was wondering how negative rates affect your capital allocation and sustainable free cash flow calculation. What discount rates do you use in this kind of environment, especially as it relates to, say, Japan, but it really is potentially spreading now to more developed countries? Thanks.
I think, the world of negative rates is something that has come to the forefront of people's minds, I think, just recently. We had been running sensitivities in Japan already because rates are pretty low. Down, I think the 10-year is just above zero right now as I saw today. You have to rethink products and the guarantees you make. Yen products, we've already done some actions already. We'll be reviewing more items that we may have to do. We have a long-term portfolio, so the fact it goes down right now, we have the investments. We have a very long-term business. It's much more how we adapt for future sales than for our in-force book. This all has an impact, but we're not just in treasuries as well.
We have a very broad investment portfolio, with a lot of other loans that we have, both in the U.S. and across the world. We've been diversifying for some time. You have to look for other alternatives other than just being in pure governments, and that's, I think, what the market's telling you.
Great. We're going to have to end it there. John, thanks so much for joining us.