Ladies and gentlemen, thank you for standing by, and welcome to the MetLife third quarter 2015 earnings release conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. As a reminder, this conference is being recorded. Before we get started, I would like to read the following statement on behalf of MetLife. Except with respect to historical information, statements made in this conference call constitute forward-looking statements within the meaning of the federal securities laws, including statements relating to trends in the company's operations and financial results and the business and the products of the company and its subsidiaries.
MetLife's actual results may differ materially from the results anticipated in the forward-looking statements as a result of risks and uncertainties, including those described from time to time in MetLife's filings with the U.S. Securities and Exchange Commission, including in the Risk Factors sections of those filings. MetLife specifically disclaims any obligation to update or revise any forward-looking statement, whether as a result of new information, future developments, or otherwise. With that, I would like to turn the call over to Ed Spehar, Head of Investor Relations.
Thank you, Greg. Good morning, everyone, and welcome to MetLife's third quarter 2015 earnings call. We will be discussing certain financial measures not based on Generally Accepted Accounting Principles, so-called non-GAAP measures. Reconciliations of these non-GAAP measures and related definitions to the most directly comparable GAAP measures may be found on the investor relations portion of metlife.com, in our earnings release, and our quarterly financial supplements. A reconciliation of forward-looking financial information to the most directly comparable GAAP measure is not accessible because MetLife believes it's not possible to provide a reliable forecast of net investment and net derivative gains and losses, which can fluctuate from period to period and may have a significant impact on GAAP net income. Joining me this morning on the call are Steve Kandarian, Chairman, President, and Chief Executive Officer, and John Hele, Chief Financial Officer.
After their prepared remarks, we will take your questions. Also here with us today to participate in the discussions are other members of our management team. After prepared remarks, we will have a Q&A session. In fairness to all participants, please limit yourself to one question and one follow-up. With that, I'd like to turn the call over to Steve.
Thank you, Ed, and good morning, everyone. Last night, we reported third quarter operating earnings per share of $0.62, which included a pre-announced non-cash charge of $0.70 per share related to the tax treatment of a wholly owned U.K.-based investment subsidiary. This and other notable items, operating earnings per share were $1.36 in the quarter, which compares to $1.51 on the same basis in the prior year period. Adjusted for notable items, operating return equity was 10.7%, and tangible ROE was 13.1% in the quarter. While operating EPS adjusted for notable items were down this quarter, our nine-month results on the same basis were up 3%, with an operating ROE of 11.5% and tangible ROE of 14.2%. Macroeconomic factors, foreign currency, equity markets, and interest rates explain the year-over-year decline in third quarter operating earnings per share, adjusted for notable items.
Broad-based strength in the U.S. dollar reduced operating earnings from international businesses by $0.09 per share, with significant weakness in the Mexican and Chilean pesos, the Aussie dollar, and the euro. Equity market performance relative to the prior year quarter hurt operating earnings by $0.04 per share. Most of the negative impact was in retail annuities, but poor equity market performance also hurt the co-investment related earnings from AFP Provida. The persistent low interest rate environment remains challenging and reduced operating earnings adjusted for notable items by $0.03 per share relative to the third quarter of last year. Investment margins have been resilient in recent years as a result of effective asset liability management, low interest rate hedges, and variable investment income.
We face ongoing headwinds from new money yields that are 100 to 150 basis points below the portfolio yield and from the gradual expiration of derivative protection. From a balance sheet standpoint, we believe low interest rates are a manageable risk. For example, we completed our annual actuarial assumption review in the third quarter, and the negative impact from low rates on net income was less than $180 million. A key driver of this charge was an assumption change on how long it will take for the 10-year Treasury yield to reach a normalized level. We are now assuming it takes 11 years for the 10-year Treasury yield to increase to our normalized assumption of 4.5% versus three years previously. Turning to regulatory issues. We recently received the clearest indication to date regarding the Federal Reserve's thinking on capital rules for federally regulated insurance companies.
In a speech delivered in late September, Federal Reserve Board Governor Dan Tarullo commented on the importance of a liability side of an insurance company's balance sheet when constructing capital rules. He said, quote, "Traditional insurance liabilities argue for lower capital requirements than might be required for a hypothetical bank holding a similar portfolio of assets." Unquote. These are welcome comments made possible by the enactment of the Insurance Capital Standards Clarification Act in December of last year. At the same time, Governor Tarullo said the balance sheets of many large life insurers contain liabilities that he does not consider traditional. Our takeaway is that while the Fed clearly recognizes the difference between the bank business model and the insurance business model, we still need to see draft capital rules before we can draw any firm conclusions about the impact on our business.
On a parallel track, international regulators are developing capital rules for global systemically important insurers. Here too, the news is mixed. On October 5th, the International Association of Insurance Supervisors released its proposal for higher loss absorbency capital requirements, or HLA. While MetLife holds capital comfortably above the levels prescribed by the IAIS, we have two concerns with the methodology. The first is that the required capital levels in the international framework are pro-cyclical and potentially volatile, because they are based on a mark-to-market approach that ignores the ability of insurers to hold assets for the long term. The second is that the IAIS proposes to apply higher capital charges to so-called nontraditional non-insurance activities. Certain products with guarantees, such as variable annuities, are deemed nontraditional, while other products with similar guarantees sold by competitors elsewhere in the world are deemed traditional.
This highlights the risk that MetLife has consistently identified in determining what is systemic, that regulators will inadvertently pick winners and losers in the life insurance industry. The good news is that the IAIS has said the higher loss absorbency rules will be subject to revision before the target effective date of 2019. In fact, the IAIS is launching a review this month of the definition of nontraditional insurance and has said that any changes will flow through to the HLA rules. Another regulatory issue MetLife is following closely is the Department of Labor's proposed fiduciary rule. As drafted, the rule would make it significantly more difficult for life insurance companies to sell variable annuities. MetLife has shared its concerns with the DOL in comment letters, and a majority of members in both the House and Senate have asked the department to make changes to the rule.
In addition, several members of Congress are beginning work on a legislative alternative to the DOL proposal, which underscores the growing awareness that the proposal will harm consumers by reducing choice and limiting access to financial education and investment advice. I would now like to comment on cash distributions to shareholders. As you know, on September 22nd, we increased our share repurchase authorization from $261 million to $1 billion. We are comfortable with this authorization given our current capital position, which we continue to maintain above historical levels because of uncertain capital rules. Since the announcement, we have repurchased $261 million of stock, including $107 million in the third quarter, and we plan to remain an opportunistic buyer of our shares. In the first nine months of 2015, our total payout to shareholders was $2.3 billion, with roughly an even split between share repurchases and dividends.
This total payout equals approximately half of our nine-month operating earnings, adjusted for notable items, and is in line with our guidance of a 45%-55% ratio of free cash flow to operating earnings. MetLife's philosophy remains unchanged. Excess capital belongs to our shareholders. In my annual letter to shareholders this past March, I said that free cash flow generation has become an enterprise-wide imperative for MetLife, one that will inform all of our major business decisions in the months and years ahead. As mentioned during our second quarter earnings call, we have undertaken a granular analysis of the cash and capital characteristics of our business. This ongoing work is helping us improve our capital allocation process, which we expect will drive more value for shareholders over time. In closing this morning, I want to provide an update on the management structure of our Americas region.
MetLife is taking a deliberative approach to finding the right leadership for the Americas. While our search continues, we have named Eric Steigerwalt as interim head of the U.S. business, reporting to me. In addition to retail, Eric will oversee our other U.S. businesses, group, voluntary, and worksite benefits, corporate benefit funding, and U.S. Direct. Oscar Schmidt will continue in his role as head of our Latin America business, also reporting to me. Both are strong leaders focused on generating long-term value for MetLife's shareholders. I will now turn the call over to John Hele to discuss our financial results in detail. John?
Thank you, Steve, and good morning. Today, I'll cover our third quarter results, including a discussion of insurance margins, investment spreads, expenses, and business highlights. I will then conclude with some comments on cash and capital. Operating earnings in the third quarter were $705 million, or $0.62 per share. This quarter included five notable items, which were highlighted in our news release and disclosed by business segment in the appendix of our quarterly financial supplement, or QFS. First, we had a previously announced non-cash charge of $792 million or $0.70 per share, related to the tax treatment of a wholly owned U.K. investment subsidiary of Metropolitan Life Insurance Company. Second, as a result of our annual actuarial assumption review and other insurance adjustments, we had an after-tax charge to operating earnings of $92 million or $0.08 per share.
The total after-tax charge to net income was $210 million. Retail accounted for $228 million, partially offset by modest positive earnings impact in Asia and EMEA. The impact in retail was mainly due to the change in our assumptions to reflect the persistent low interest rate environment, and our current view that rates will remain below normal levels longer than we had originally assumed. As you heard from Steve, we are now assuming that it takes 11 years for the 10-year treasury yield to reach 4.5% versus three years previously. We've also lowered our long-term earned rate assumption for annuities from 5.25% to 5%. Our long-term earned rate assumption for life insurance is unchanged at 5.75%, and our long-term separate account return assumption remains 7.25%.
Third, variable investment income was $174 million after taxes and DAC, which was $37 million, or $0.03 per share below the bottom end of our 2015 quarterly guidance range. Fourth, we have favorable one-time tax items in the Americas, which increased operating earnings by $72 million or $0.06 per share. Finally, we had lower than budgeted catastrophe losses and favorable prior year reserve development, which increased operating earnings by $21 million or $0.02 per share. In total, notable items included in operating earnings were $828 million or $0.73 per share. Turning to our bottom-line results, third quarter net income was $1.2 billion or $1.06 per share. Net income was $492 million higher than operating expenses, primarily because of derivative and investment portfolio net gains. The derivative net gains were driven by lower interest rates and strengthening of the U.S. dollar against certain currencies.
The investment portfolio net gains were mainly the result of real estate sales. The difference between net income and operating earnings in the quarter included a favorable impact of $568 million related to asymmetrical and noneconomic accounting after tax. Book value per share excluding AOCI other than FCTA was $51.11 as of September 30th, up 3% year-over-year. Tangible book value per share was $42.21 as of September 30th, up 6% year-over-year. With respect to third quarter margins, underwriting primarily in the U.S. was less favorable than the prior year quarter by $0.03 per share after adjusting for notable items in both periods. Retail, Life and Other, and P&C were the main primary drivers of the year-over-year result. Retail life's interest adjusted benefit ratio was 53.4%, excluding a 4 percentage point impact from the actuarial assumption review.
The ratio was less favorable than the prior year quarter of 51.0% on a comparable basis, but within the expected range of 50%-55%. Average net claims from large face policies were higher than the prior year quarter, but within the normal range of expectations. The group life mortality ratio was 86.1%, or toward the low end of the expected annual range of 85%-90%. The ratio was favorable to the prior year quarter of 87.8% due to better claims experience. The non-medical health interest adjusted loss ratio was 80.7%, approximately in line with the prior year quarter of 80.5% and within the targeted range of 77%-82%. In P&C, the combined ratio, including catastrophes, was 90.9% in retail and 97.7% in group. The combined ratio excluding catastrophes was 84.0% in retail and 92.7% in group.
Overall, P&C underwriting was unfavorable versus the prior year quarter. We experienced higher non-catastrophe claim costs, primarily due to higher frequency and severity in our auto business, as well as higher catastrophes. Turning to investment margins, the average of the 4 U.S. product spreads in our QFS was 202 basis points in the quarter, down 28 basis points year-over-year. Pre-tax variable investment income was $267 million, down $157 million versus the prior year quarter due to weak hedge fund performance and lower prepayment income. Product spreads excluding variable investment income were 172 basis points, down 13 basis points year-over-year. Lower core yields accounted for most of this decline as a result of the low interest rate environment. With regard to expenses, the operating expense ratio was 24.2%, unfavorable to the prior year quarter of 23.0%.
There was an interest-related component of the non-cash tax charge that flowed through expenses. Excluding this item, the operating expense ratio was 21.4%, or 160 basis points better than the prior year, primarily driven by strong pension closeout sales. I will now discuss the business highlights in the quarter. Retail operating earnings were $523 million, down 33% versus the prior year quarter, and down 10% after adjusting for notable items in both periods. Life and Other reported operating earnings of $183 million, down 50% versus the prior year quarter, and down 14% after adjusting for notable items in both periods. The primary drivers were lower expense margins, less favorable underwriting, primarily in P&C, and lower recurring investment income. Life and Other PFOs were $2.1 billion, down 3% year-over-year as growth in the open block was more than offset by runoff of the closed block.
Core Retail Life sales were up 36% year-over-year, primarily driven by whole and term life. Annuities reported operating earnings of $340 million, down 19% versus the prior year quarter, and down 8% after adjusting for notable items in both periods. The key drivers were less favorable initial market impact, higher expenses, and taxes. The separate account return was negative 6% in the quarter. Total annuity sales were $2.4 billion in the quarter, up 20% year-over-year. We continue to see good momentum with our index-linked annuity, Shield Level Selector, and we expect this product to exceed $1 billion in sales this year. Also, our new VA Guaranteed Minimum Withdrawal Benefit rider, FlexChoice, continues to gain acceptance in the market and drove VA sales to $1.8 billion this quarter, an increase of 15% year-over-year.
Group Voluntary and Worksite Benefits, or GVWB, reported operating earnings of $238 million, down 1% versus the prior year quarter, and essentially flat after adjusting for notable items in both periods. Business growth in the quarter was offset by less favorable underwriting in P&C, primarily in the auto business. GVWB PFOs were $4.4 billion, up 2% year-over-year. Sales were down 12% year-over-year as we continue to see an impact from increased competition in life and dental. Sales of voluntary products increased 24% due to growth in property and casualty. Corporate Benefit Funding, or CBF, reported operating earnings of $326 million, down 17% versus the prior year quarter, and down 13% after adjusting for notable items in both periods. The key driver was lower investment margins. CBF PFOs were $1.7 billion, up significantly year-over-year due to strong pension closeout sales in the quarter.
Excluding closeouts, PFOs were down 15% due to lower structured settlement sales. Latin America reported operating earnings of $176 million, up 44% from the prior year quarter, and 100% on a constant currency basis. After adjusting for notable items in both periods, primarily Chile taxes, Latin America operating earnings were down 4% on a constant currency basis. The key drivers were less favorable underwriting and unfavorable market performance, partially offset by growth in the region. U.S. Direct, which is included in Latin America's results, had an operating loss of $7 million versus $15 million loss in the prior year quarter, reflecting lower expenses. Latin America PFOs were $940 million, down 18%, and essentially unchanged on a constant currency basis as growth in Provida and Argentina was offset by lower single premium immediate annuity sales in Chile.
Total Latin America sales increased 3% on a constant currency basis, primarily due to direct marketing across the region, partially offset by lower Afore sales in Mexico and single premium immediate annuity sales in Chile. Turning to Asia. Operating earnings were $338 million, up 9% from the prior year quarter, and up 26% on a constant currency basis. Adjusting for notable items in both periods, operating earnings were up 22% on a constant currency basis, driven by favorable business growth, $21 million of investment income from a loan sale, and an unusually low tax rate. Asia PFOs were $2.1 billion, down 13% from the prior year quarter, but up 3% on a constant currency basis, driven by higher A&H in Japan. Asia sales are down 10% on a constant currency basis due to two large group cases in Australia in the prior year quarter.
Excluding these cases, sales were up 6%. A highlight in the quarter was a 23% increase in Japan A&H sales as we continue to benefit from a refurbished product portfolio. EMEA operating earnings were $66 million, down 15% year-over-year, but up 14% on a constant currency basis. Adjusting for notable items in both periods, operating earnings were up 25% on a constant currency basis, driven by business growth, particularly in the Gulf and the U.K., and favorable tax items. EMEA PFOs were $618 million, down 15% from the prior year period and down 1% on a constant currency basis. Excluding the impact from the conversion of certain operations to calendar year reporting in the prior year quarter, PFOs were up 4%.
Total EMEA sales declined 8% due to strong employee benefit sales in the Middle East and the conversion of certain operations to calendar year reporting in the prior year quarter. Adjusting for these items, sales were up 3%, driven by A&H, partially offset by lower than expected life and retirement sales. I will now discuss our cash and capital position. Cash and liquid assets at the holding companies were approximately $5.5 billion at September 30th. The decrease from the previous quarter was driven primarily by the payment of our quarterly common dividend, interest expense, and share repurchases. Turning to our capital position, we report U.S. RBC ratios annually, so we do not have an update for the third quarter. For Japan, our solvency margin was 959% as of the second quarter of 2015, which is the latest public data.
For our U.S. insurance companies, preliminary third quarter statutory results are an operating loss of approximately $900 million, and a net loss of approximately $700 million. As previously disclosed on a statutory basis, the non-cash tax charge was $911 million in the quarter. Of this charge, $972 million went to the statutory earnings and $119 million directly into surplus. In addition, earnings were negatively impacted by the stock market decline in the third quarter. Our strategy is to underhedge for smaller market moves and accept the resulting volatility while ensuring we have sufficient hedges to protect against extreme shocks. We estimate our total U.S. statutory adjusted capital was approximately $29 billion as of September 30th, which was comparable to December 31st. In conclusion, third quarter operating earnings had several notable items that negatively impacted results, and market factors were unfavorable relative to the prior year.
However, quarterly volatility is to be expected. While we were short of analyst expectations in the third quarter, we exceeded expectations in the first two quarters of the year. We are striving to create long-term sustainable growth in value, and improvement in our free cash flow generation and material increase in distributions to our shareholders highlight this commitment. With that, I will turn it back to the operator for your questions.
Thank you. Ladies and gentlemen, if you'd like to ask a question, please press star then one on your touch tone phone. You will hear a tone indicating you have been placed in queue. You may remove yourself from queue at any time by pressing the pound key. If you're using a speakerphone, please pick up the handset before pressing the numbers. Once again, if you have a question, please press star one at this time. One moment, please, for the first question. Your first question comes from the line of Thomas Gallagher from Credit Suisse. Please go ahead.
Good morning. Steve, I'd like to start with the comment that you made about, I guess it was a backward-looking comment, how you were indicating you've returned roughly 50% of normalized GAAP earnings to shareholders through buybacks and common dividends. Is that a reasonable expectation going forward from here? Because you obviously still have uncertainty with regard to the lawsuit with the government and SIFI rules, is the plan in place that you have and the expectation that we should have that 50% type distribution while you're in this state of limbo?
Tom, I'm going to answer you in one second, John just wants to make a quick correction to his comments. Yes, as I was going through my script, I said one number slightly backwards. Of the statutory charge in the quarter, of the $911 million of the charge, it's $792 million went through statutory earnings. I believe as pointed out to me, I said $972. It's $792 went through statutory earnings and $119 went directly into surplus. Tom, things obviously are moving around as we hear from policymakers in Washington around the capital rules. As of now, there's no draft capital rules out for us to look at and consider with respect to our business.
While we thought these rules would be out well before now, we're still waiting, our decision a couple of years back was to begin returning capital to shareholders, excess free cash flow. We've built up what we believe is a good buffer, again, it's uncertain, and we don't know how this will all play out. Right now, it's a little bit of a judgment call. We are, in this year, looking to return to shareholders the free cash flow that the business generated. I think if nothing changes in the external world, that'd be the pace we'd be on going forward in 2016 as well. I have to put some caveats in here because there could be a change in the environment that we learn about at some point in the future. That is our current thinking.
Okay, the 50%, if nothing else changed, let's say it continued to be delayed for whatever reason, you'd be comfortable with the 50% based on what you know today?
We'd be comfortable with what we're generating in terms of free cash flow. We are targeting at the 45%-55% level. Assuming we achieve that would be a fairly good number to think about. If draft rules come out next year, that could impact our thinking of course.
Okay. The changes or the charges that you had this quarter related to both the tax item as well as the change in RBC coming from some adjustments to the on-shoring of the variable annuity business. The impact from that, would that affect the way you're thinking about returning capital and cash flow or no?
Hi, this is John. Our guidance of the 45-55 is still within the RBC and the tax charges that we've already spoken about.
Okay, one last one, if I could sneak it in. The cash flow project, can you comment on what should we be thinking related to this? I presume the goal is to move it higher, but are we talking about from the 45-55? Are we talking about potentially moving it meaningfully, or do you think it's going to be very marginal in terms of where this might go?
Tom, we're in the process of finalizing our analysis on this, it's too early to say how that number would be impacted. The goal, clearly, is to raise the number. We're looking at all of our businesses by product, by geography, by customer. There's a great deal of very granular analysis that's ongoing, and we're looking at a number of factors as we think of our businesses, including quicker paybacks on our products. The goal here is to improve free cash flow. I should mention that companies that have undergone this process in the past, and primarily in Europe, took a number of years to go through this process. We are trying to condense that to a shorter period of time, but it's not an exercise that one could go through in a couple of quarters.
We'll have more to say about it, clearly next year. You can be assured that we're working very hard on driving higher our free cash flow ratio. As we learn things along the way here with our analysis, we're making adjustments on an ongoing basis.
Okay, thanks.
Your next question comes from the line of Jimmy Bhullar from J.P. Morgan. Please go ahead.
The first question I had is just on your spreads. Even if we exclude the variable investment income, spreads came down a lot, especially in the corporate benefit funding business. I think they were 117 basis points versus almost 150 in the second quarter and the third quarter of last year. What drove the decline, and is this a normal base that you're looking to grow off of, or was there something abnormal in the second quarter that would have pressured your results beyond just the variable investment income impact?
Hi, Jimmy, this is John. Yes, CBF spreads, as you look in our quarterly financial statement, do bounce around quarter to quarter. We had in December 14 on our guidance call said our spread outlook would be between 150 to 170 basis points with 30 to 40 basis points from VII. If you look at it for the nine months, we're at 173 with 39 from VII. The third quarter was at the low end at 149 with 32 from VII. You can see how this moves around quarter to quarter. A lot of VII. Second quarter, you remember we pointed out an accounting change that we did that also gave a boost to the second quarter of CBF. We think this guidance still makes sense for the 150 to 170.
On the $900 million stat charge from foreign tax credits, I think you mentioned previously that the impact on your dividend capacity for 2016 would be around $90 million. Should we assume a commensurate impact in future periods as well beyond 2016?
No. Well, this is a one-time charge. You remember statutory dividends-
Yeah
Statutory dividends are determined a year after the fact. The reason why it's not a larger impact is we're up against the lesser than rule of the New York, which is dividends are the lesser of 10% of surplus or your earnings in the year. This did affect, as I said, our statutory earnings, but it did not affect the dividend capacity for next year because we're bumping up against the 10% number, the 10% limitation.
Okay, thank you. Just lastly, on variable investment income, the weakness this quarter, I'm assuming it's hedge fund driven and maybe the other private equity and prepayments were somewhat normal, but maybe if you could give us some color on what drove the downside this quarter.
Hi, Jimmy, it's Steven Goulart. In looking at variable investment income for the quarter, most of the decline relative to plan and our range was in hedge funds. I think if you just look at what's happened in the market, hedge funds had a pretty weak quarter, and we saw it come through. I think John mentioned prepayments in some of his remarks, but prepayments were still in line with plan. It's really all about hedge funds and VII. As we look forward to the fourth quarter, we're comfortable that we'll be back in the range that we have set out, the $325 million-$425 million per quarter that we gave originally.
Okay, thank you.
Your next question comes from the line of Suneet Kamath from UBS. Please go ahead.
Thank you. Just a question, John. I was writing down numbers pretty quickly. Could you just go over the statutory earnings in the quarter again on an operating basis?
Yeah, happy to. Let me just flip to that page. For our U.S. insurance companies, our statutory results are an operating loss of approximately $900 million and a net loss of approximately $700 million. Of course, this has the non-cash tax charge was $911 on a statutory basis, $792 went through statutory earnings and $119 million directly into surplus.
If we think about that $900 loss, you get $792 of it from the charge, there's $108 loss beyond that. Essentially, are all the stat earnings being offset by the fact that you've under-hedged on the equity side?
Yeah, that was one of the major impacts in it. It's not under-hedge. We don't fully hedge on smaller market moves, but we have a macro hedge that protects against larger market moves. We're trying to be cost-efficient in how we do this. We're willing to take some statutory volatility quarter-to-quarter to have an economical return on this product line, but we're well-protected if larger shocks kick in.
Okay. My second question for Steve, I guess, is in the press release, you talk about the ROE ex AOCI and other FCTA of 10.7%. I know you don't give guidance on ROE. As we think about the trajectory of this, does it feel like the ROE is sort of bottoming at this level, or could we see some continued pressure on that ROE?
Yeah, Suneet, obviously, the external pressures on us are significant, and we've discussed that. I'd say in the near term, given current interest rates and the macroeconomic factors in that high 10%-11% range is probably what we're looking at.
Okay, thanks.
Your next question comes from the line of Seth Weiss from Bank of America Merrill Lynch. Please go ahead.
Hi, good morning. Steve, I wanted to return to your comments regarding Fed regulations, specifically Tarullo's comments on non-traditional activities. I know earlier in the summer, you spoke about funding agreements, commercial paper, securities lending, and guaranteed investment contracts in terms of an area that the Fed may be looking closer at. If these were deemed non-traditional and were holding you up for the SIFI designation, how quickly would you be able to exit these businesses, and would you consider doing that if it would have a substantial regulatory benefit?
Seth, those are shorter duration businesses and liabilities, so we could move pretty quickly. What we would do is once the capital rules came out, we would look at the costs and benefits to the company overall, and we'd have to make a decision based upon that analysis. Until then, it's hard to say what we actually would do. End the day, it'd end up being a fairly straightforward analysis for us.
Okay, great. Regarding variable annuities, do you have any hints if this is something the Fed considers non-traditional, similar to how the international regulators are looking at it, or is this something that the Fed has perhaps shown some comfort around?
Hi, Seth, it's John. The Fed has given no guidance as to what they're considering to be weighted in different ways. They're looking at all aspects of the insurance business, and the industry is in discussions with them, but they really have given us no indication at this time as to how they will view any line of business.
Okay. Thanks for the comments.
Your next question comes from the line of Jay Gelb from Barclays. Please go ahead.
Thank you. With regard to the pushing out the long-term 10-year treasury rate assumption to 11 years from three years, what are the implications on that for future margins? It seems like it would be less of a drag going forward.
Hi, Jay. When we say less of a drag, it's just the slope takes longer. We take a GAAP charge in that today, as you can see, and then the earnings flow through over time. I guess maybe I could follow up. You clarify your question a little bit?
Sure. It seems that if the assumption was previously it was going to be three years to get there, and now we're talking 11 years, there might be less additions to reserves going forward. Am I thinking about that the right way?
Well, it would be now set. If interest rates go up exactly according to this slope, you just have normal profits coming through and no changes to DAC amortizations. This is primarily a DAC change. You have less profits in the future, you need to adjust your DAC today, the patterns go out in a consistent manner.
Okay. On the follow-up on the ROE comment, if I plug in 11% return on equity, I get to around $6 in earnings
Next year, that seems to be perhaps a little bit less than consensus was expecting. Any potential offsets to that we should be thinking about?
Hi, Jay. Well, as I'd like to remind you, we don't give forward guidance. We've given you our views, I guess you can do your calculation. Thanks.
Thank you.
Your next question comes from the line of Ryan Krueger from KBW. Please go ahead.
Hi. Thanks. Good morning. I had a question on the higher P&C auto claims. It seems like you're experiencing the same issues some others in the industry are going through. Is this something that you'd expect to, I guess, recur for a period of time before you can get rate increases pushed through?
Hi, it's Eric. Well, we probably are. I think it's fair to say we're experiencing reasonably what the rest of the industry is. You've heard from other companies that they've been talking about more miles driven. As a result, higher accidents. You heard John say that overall, our results, frankly, in both group and retail, is slightly higher frequency and severity. We're not sure if this is going to continue for quarters and quarters and quarters. We are all over price increases. When we feel we have to take them, as we have in this year, we will. Over time, we'll let you know what our- and other factors. I can't predict where interest rates will be at the end of the year, and that's one of the most sensitive points.
Okay. All right, got it. Thanks.
Your next question comes from the line of Erik Bass from Citigroup. Please go ahead.
Good morning. Thank you.
That overall guidance that we've given.
Okay, thanks. Then on Japan, just one question. You mentioned the third sector sales being up 23% this quarter. Can you comment on the competitive trends in that market and how long of a sales cycle you see for the new products that you've introduced?
Yeah, sure. It's Christopher Townsend here. We introduced those new products in the beginning of the fourth quarter last year. As you can see, we've had pretty good growth right through the first three quarters of this year. Overall, third sector was up 23%. We've got a tough comparison coming up against the fourth quarter of 2014. I think overall, the prior guidance we've given you in terms of sales to third sector was that we would grow it mid to high single digits this year. Given the performance we've had so far, we can lift that guidance now to a full-year outcome of about 10%-12%. The new products are progressing really well. They give customers good choice. They're simple products. They've got segmented pricing. All four of our key distribution channels are up.
We feel pretty good about that third sector right now.
Thank you.
Your next question comes from the line of Yaron Kinar from Deutsche Bank. Please go ahead.
Good morning. I actually want to follow up on Eric's question on the assumption review. Looking at this $3 billion present value that you had talked about in the past from the low interest rate environment forever and comparing to the $180 in losses we saw this quarter. I was under the impression in the past that you had expected to see a lot of the charges coming in the first three to five years. In that sense, I was a little surprised to see a relatively small impact from the new assumption this quarter, and just wanted to square the two.
I think what we had said before when we gave this guidance about the $3 billion, most of it is in DAC, and as you change your assumptions, that tends to be immediate, of course, on your DAC amortization. There's also a U.S. GAAP loss recognition testing that if you need to increase those, that's done over time. What I had said was, I didn't expect to change assumptions immediately to go right down to flat 2% forever. It would take some time for us ever to change our view on that as the world might change. For 10-year treasuries to remain at 2% forever means either no inflation or very little growth in the U.S. economy. We don't believe long-term that that is the case, but we now believe it will take a lot longer to get there from where we are today.
That's the assumption change, and as I said, the calculations we have done are consistent with the prior year guidance that I've given.
Okay. That's helpful. Turning back to P&C for a second, I was just wondering what was causing the more elevated or the greater deterioration, I guess, in group P&C versus retail, bearing in mind the industry trends that we're seeing in frequency and severity.
Yeah. We didn't quite hear your question. Are you talking about the differential between group and retail?
Yeah.
Was that part of your question?
That's right.
Yeah. Buried in there is we had a little IBNR change. That's why the subtlety of my previous answer might have been missed. If you think about it, if I were to normalize that IBNR change, I would say that the hit to group and retail was roughly the same and completely driven by, as we already said, miles driven, both frequency and severity in both businesses. That's a little bit more of a normalized answer there.
Okay. I appreciate it. Thank you.
Your next question comes from the line of Michael Kovac from Goldman Sachs. Please go ahead.
Thanks. With the equity market volatility, clearly saw the impact in the annuities segment for you and your peers. I'm wondering if you can discuss some of the moving pieces, particularly around how managed volatility products and your hedge program performed in the third quarter versus both your expectations and maybe some other market downturns.
Hi, Michael, this is John. As I said, the separate accounts were down about six percent. Our managed vol funds actually did a little better than that but were still negative. They were just around four and a half percent, was about the amount for the target vol funds. Target vols are supposed to be better but to react in a quick quarter like this, it's harder for these. They did perform a bit better than what the S&P did, which was down about seven percent, and our separate account returns in total were down about six percent, but not flat or anything. It was a pretty rough quarter for the equity markets.
As you think about variable annuity sales going forward, I know you'd guided to 50% and 20% and this quarter came in about 15%. Any thoughts on the outlook?
Yeah, this is Eric. The number that I've been looking at, you're quoting the pure variable annuity number. When I look at VAs and our Shield product, in the third quarter, we were up 26%, and that's quite a good result. Our Shield sales continue to increase quarter over quarter after quarter sequentially, and I think we're going to see the same thing generally in VAs. As we moved from 2014, frankly from the 2012 through 2014 period of decreasing sales, 2015 was that inflection point, and honestly very hard to project. We're below what we had thought we would be able to do. There's a number of reasons for that. This quarter, volatility in the equity markets, state approvals throughout the year play a big part. Certain key states came a fair amount later than we had thought they would.
At this point, sales are looking pretty good. The Flex product continues to take hold both in our captive channel and in all of our independent channels. I'm confident going forward that we'll see good sales results, certainly double-digit sales results.
Your next question comes from the line of John Nadel from Piper Jaffray. Please go ahead.
Hi. Good morning, everybody. A lot of questions asked and answered. You have a wide range for the loss expected for the corporate segment for the whole year. I think if we make all of your normalizing adjustments, you're around a $420 million loss, but you have a range of, I believe it was $550 million-$750 million. Can you give us some help on one end of that range or where in that range you expect to end the year, given we've got just a few months left?
Yeah. I'd still stick with that range. We have timing of preferred dividends now. We refinanced one of our preferred dividends, and there's a gain this quarter because it's now a semi-annual dividend, and it'll hit the fourth quarter. There's going to be some bumpy timing as you look quarter to quarter now. The old preferreds that we took out were quarterly dividends, so it was smoother. The new piece that we did, it's a net savings to us by doing this, but it'll be more bumpy.
Okay, that's helpful. I wanted to think about on a normalized basis, the Asia segment has seen a reasonable amount of volatility in earnings for a business that I think should generally versus more of your capital market sensitive businesses, I would expect to be a bit more stable and predictable. That range is pretty wide on a quarterly basis. Thinking about second quarter and third quarter here in particular, which one of those normalized numbers do you think is a better true indication of the earnings power of that business if you annualized it?
It's Christopher Townsend here. We gave some guidance previously in terms of the range. It was high single to low double digit earnings growth on a constant rate basis for Asia, and we're still sticking with that in terms of the year for 2015. If you look at this quarter, for instance, obviously last quarter we had that very high one-off tax issue in Japan, which threw the numbers out. For this quarter, the constant rate growth is 26%, and there's three main items in that. One is business growth, which accounts for about 11% or 12% of that. One is a favorable investment income of $21 million, which is about 7%. There was a couple of one-off tax items. You should probably think about $310 million-$320 million ±5% as the sort of average run rate for the Asia business.
That's very helpful. Thank you, Chris.
Your final question today comes from the line of Eric Berg from RBC Capital Markets. Please go ahead.
Thanks very much for including me at the end here. A couple of quick questions. The increase in the number of years that you expect the 10-year to reach four, I think in a quarter from three to 11, strikes me as a major change. At least it strikes me that way. My question is this something that you have decided recently that you haven't been thinking about for a while? Given that interest rates have actually risen this year, Treasury yields are flat, but credit spreads have widened. As you think about what has happened in the world, what has prompted you to make what would seem to be such a dramatic change in your outlook for interest rates? Thanks.
Thanks, Eric. This is John. Obviously where interest rates go long-term is very important for us in how we price, how we think, and how we account for our business. We spent a lot of time thinking about is four and a half still the correct long-term assumption. When I say long-term, we're putting liabilities on the books today that may last for 100 years given life expectancies of young people. It's a very long-term assumption. We think about that, and the question is how fast will we get there?
I would say currently, we would talk to a lot of economists and academics on this and looked at the global economy. I think given this year compared to even a few years ago, where there was much more optimism about the recovery of the world economies, we see a much slower growth for now and for the foreseeable future. That's why we put a longer slope going out on the Treasury rate, which is the risk-free rate. When it comes to credit spreads, we really normalize those over the entire credit cycle, and the fact they're up in a quarter or down in a quarter doesn't really impact our thinking over a very long-term cycle. We study credit spreads over decades, and that's how we set these long-term assumptions.
We're lucky we have experience of credit cycles over decades and have very good experience in this. That's sort of our thinking and behind how we set these assumptions.
Thanks, John.
There are no further questions.
Okay. Well, thank you very much for joining. Have a good day.
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