Ladies and gentlemen, thank you for standing by. Welcome to the MetLife second quarter 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. If you should require assistance during the call, please press star then 0. 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 companies 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 Incorporated's filings with the U.S. Securities and Exchange Commission. MetLife Incorporated 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'd like to turn the call over to Conor Murphy, Head of Investor Relations.
Thank you, Greg. Good morning, everyone. Welcome to MetLife's second quarter 2010 earnings call. We're delighted to be here this morning to talk about our results for the quarter. We will be discussing certain financial measures not based on Generally Accepted Accounting Principles, so-called non-GAAP measures. We have reconciled these non-GAAP measures to the most directly comparable GAAP measures in our earnings press release and in our quarterly financial supplements, both of which are available at metlife.com on our Investor Relations page. A reconciliation of forward-looking financial information to the most directly comparable GAAP measure is not accessible because MetLife believes it is not possible to provide a reliable forecast of the net investment-related 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 Rob Henrikson, our Chairman and Chief Executive Officer, Steve Kandarian, our Chief Investment Officer, and Bill Wheeler, our Chief Financial Officer. After our brief prepared comments, we will take your questions. Here with us today to participate in the discussion are other members of management, including Bill Mullaney, President of U.S. Business, Bill Toppeta, President, International, Bill Moore, President of MetLife Auto & Home, and Donna DeMaio, President of MetLife Bank. With that, I would like to turn the call over to Rob.
Thank you, Conor, and good morning, everyone. For the second quarter of 2010, MetLife has again delivered strong results across the board. Remember last December at Investor Day, we highlighted our commitment to disciplined growth, margin improvement, and ROE expansion. Well, we delivered on that commitment in the first quarter, and I believe we have done so yet again in the second. Our premium fees and other revenues increased 4% over the second quarter of 2009. Operating earnings grew to over $1 billion, up considerably from both the year-ago period and sequentially. I'm also pleased to report that book value increased tremendously, up 48% over the year-ago period and 10% sequentially, driven not only by our investment performance, but also our strong operating earnings. At the same time, our ROE continued to improve and we achieved excellent underwriting results. Importantly, we remain committed to expense discipline and risk management.
Let me share a few highlights, beginning with U.S. business results. U.S. business generated premiums, fees, and other revenues of $7.2 billion, up 2% over the prior year period. Excluding the impact of lower pension close-out activity, which can vary from quarter to quarter, the top line grew by over 6%. Operating earnings grew by 39%, with significant increases in each of the major business segments, largely driven by strong underwriting results. Within the insurance product segment, premium fees and other revenues grew 2% over the second quarter of 2009, and operating earnings grew 29%. Group life premiums grew 4% and operating earnings were up 56% compared with the prior year period. Group underwriting results were excellent, with the group life mortality ratio at 86.6%. Non-medical health revenues were up slightly, reflecting higher dental revenue, partially offset by lower disability revenue.
Non-medical health earnings were up over 40%, with improved interest and underwriting margins driven by strong improvement in dental. Group disability incidents remains elevated but consistent with plan, while recoveries are showing signs of improvement. Individual life premium fees and other revenues increased modestly, and we had a 6% increase in operating earnings, again reflecting disciplined underwriting and expense management. In retirement products, the top line grew by 34%, driven by sales and higher fee income, and operating earnings were higher at $238 million. Variable annuity sales of $4.5 billion were up 11% sequentially and consistent with last year's very high level. Net flows remain strong. Lapse rates continue to decline, and the success of our new Fidelity product continues to contribute to our strong results.
In corporate benefit funding, premium fees and other revenues were down, driven by less pension close-out activity, which I mentioned earlier, although structured settlement premiums grew by 9%. Operating earnings grew to $238 million, up 54% from the prior year, due primarily to higher variable investment income. Rounding out the domestic businesses, auto and home had another very solid quarter, as did MetLife Bank. Turning to our international business, we achieved another very strong quarter with growth across all three regions. On a reported basis, premiums, fees and other revenues grew 21% over the year ago period. Operating earnings declined by 8%. Strong earnings in Latin America, driven by business growth and expense management, were offset by lower earnings in Japan due to the challenging equity markets. In Latin America, growth in Mexico, Chile and Brazil contributed to its top line growth of 23%.
The Asia Pacific region grew 20%, due primarily to higher sales in South Korea and Hong Kong. In Europe, Middle East and India region, the top line increased by 13%, reflecting continued growth in Europe and India. In a moment, Steve will comment on our investment results, but I can't help but highlight one component of the portfolio. We continue to experience a low level of investment losses, including impairments. This is partly due to the continuing strong performance of our real estate portfolio, where you should note that loan to values actually decreased during the quarter. Our reserve against future losses came down and the percentage of delinquent loans also declined. I think you would agree these are all positive trends. Switching gears, obviously the Alico transaction is attractive to us because of our focus on generating strong, consistent earnings growth, expanding ROE, and increasing shareholder value.
Together, MetLife and Alico teams are working diligently and have achieved several significant integration planning milestones. We remain on track to close in the fourth quarter. As we told you when we announced the deal, we continue to be impressed by Alico's people and how well the franchise has been performing. While we cannot comment on Alico's second quarter financial results, we are pleased with their first quarter performance, and together we are working on defining how we will further accelerate our growth strategy. Our Operational Excellence initiative remains on track to deliver the $600 million of annualized expense savings we promised. It has now been one year since the formation of the U.S. business organization. The team identified several opportunities to take that business to the next level. Over the past year, we've reaped the benefits of combined sales forces with increased cross-selling opportunities.
Secondly, U.S. business is deploying investment dollars across the business in a more efficient way to capitalize on market opportunities. Thirdly, we've identified synergies giving us the opportunity to reduce overall operating costs. We're certainly seeing big benefits already from combining the businesses. In closing, this is a momentous time for MetLife, one that will propel us into the next phase of our long and successful history. As I reflect on the first half of the year, I'm very pleased with our performance. We've been enjoying strong momentum and looking ahead, we are very enthusiastic about our future as a global company. With that, let me turn it over to Steve Kandarian.
Thanks, Rob. I would like to spend a few minutes reviewing the key components of our investment results for the quarter. First, let me start with a comment on variable investment income. Pre-tax variable investment income for the second quarter was $296 million, which is $96 million above the top of the plan range that I provided on Investor Day. This is primarily driven by strong private equity returns. While we expect variable investment income to trend lower for the remainder of the year, we believe it'll still perform within our quarterly range. Now let me cover investment gains and losses for the quarter. Gross investment losses were $253 million. Gross investment gains were $396 million, and write-downs were $172 million. For a net investment loss excluding derivatives of $29 million. Results were largely in line with the previous quarter.
Gross unrealized losses on fixed maturity and equity securities were $7 billion, down from the $10.8 billion at year-end. Gross unrealized gains were substantial this quarter at $14.2 billion, as widening spreads were more than offset by declining interest rates. Overall, the portfolio was in a net unrealized gain position of $7.3 billion at quarter end. Next, let me expand upon Rob's comments regarding our commercial mortgage portfolio. The loan to value of our portfolio improved slightly to 68%, down from 69% last quarter, as valuations have stabilized. Our commercial mortgage valuation allowance declined modestly to $621 million. Total delinquent commercial mortgages decreased from $162 million to $137 million. The decrease in delinquencies was driven by the restructuring of one loan, resulting in a $5 million loss.
As to the remaining two delinquent loans in the U.S. portfolio, one is expected to be paid off during the third quarter with no loss, and the other is a high-quality property that we plan to transfer to our real estate equity portfolio. As I have mentioned previously, we expect limited losses on these loans, as the recoveries are projected to be above the historical average of 75%. Although some challenges remain, we believe the commercial real estate market is slowly improving, and that our portfolio will continue to maintain low loss levels and outperform the overall market. Let me comment on our cash position, which increased from $17.2 billion last quarter to $20.4 billion this quarter. The vast majority of this increase can be attributed to higher cash collateral balances received from our derivatives counterparties.
As interest rates and equity markets decline, the value of our derivative positions increased, and we took in additional cash collateral. Excluding the impact of cash collateral from our derivative counterparties, our cash position is down $4.1 billion since Investor Day, as we reinvested into higher yielding assets. In summary, we continue to see solid results in our portfolio, with variable income above plan, continued low losses, and an improving commercial real estate market. With that, I will turn the call over to Bill Wheeler.
Thanks, Steve, and good morning, everybody. MetLife reported $1.23 of operating earnings per share for the second quarter. As Rob mentioned, this strong bottom-line result represents solid business growth, higher investment income, strong underwriting results, and the impact of our expense management efforts. This morning, I will walk through our financial results and point out some highlights, as well as some unusual items which occurred during the quarter. Let's begin with premiums, fees, and other revenues. Total premiums, fees, and other revenues, which were $8.7 billion in the second quarter, were up 4% from the second quarter of last year, and up 6% when adjusting for closeout sales in both periods. As we have noted before, closeout sales can fluctuate from quarter to quarter. U.S. business premiums, fees, and other revenues of $7.2 billion reflect a 2% increase over the prior year quarter.
This includes a 2% increase in insurance products revenue, largely driven by an increase in group life. Group life premiums are up 4% from the prior year quarter, consistent with our Investor Day guidance. Growth was helped in the segment by a change in financial terms on a large retrospectively rated contract, which resulted in less reinsurance ceded in that particular contract. This change occurred in the fourth quarter of 2009 and was anticipated in the guidance we provided at Investor Day. Revenue and retirement products increased by 34% due to income annuity premium growth, as well as higher separate account fees due to positive net flows and favorable separate account investment returns in prior quarters. Revenue and corporate benefit funding was down 17% from the prior year quarter, driven by lower closeout premiums. Structured settlement premiums remained strong.
International's revenues were up 21% on a reported basis and 13% on a constant currency basis over the prior year quarter, driven by growth in Mexico, Korea, and Chile. Operating margins. Turning to our operating margins, let's talk about underwriting results. In U.S. business, our mortality results were quite strong this quarter. The group life mortality ratio for the quarter was 86.6% versus our estimated range of 90%-95%, which is an excellent result. Our individual life mortality ratio for the quarter was 80.4%, while higher than the exceptionally strong prior year quarter of 74.9%, the results were quite favorable and well below our plan. At 87.8% for the second quarter, the non-medical health total benefits ratio was down from both the prior year and sequential quarters of 88.4% and 91.2%, respectively.
This favorable result was due largely to improved dental underwriting results, in which we continue to see more stable utilization and favorable pricing trends. Disability margins continue to be below plan as incidence levels remain elevated and recoveries continue to be below expectations. However, we are seeing some early signs of improvement in recoveries. Turning to our auto and home business, the combined ratio, including catastrophes, was 95.3% for the second quarter, which was up over the prior year quarter's result of 93.5% due to higher catastrophes. The combined ratio excluding cats was 85.5% in the second quarter versus 88% in the prior year period. A non-catastrophe prior accident year reserve release of $12 million after tax was taken in the current quarter compared to a $3 million number in the year ago period. Moving to investment spreads.
We saw continued strong investment spreads this quarter, driven in part by variable investment income results. For the quarter, variable investment income after tax and the impact of deferred acquisition costs was $62 million or $0.07 above the top end of the quarterly guidance range given at Investor Day. As Steve explained, this was primarily driven by strong private equity returns. Moving to expenses. Our Operational Excellence initiative continues to prove successful. Our expense ratio for the quarter was 22.4%, a solid result, and within the 2010 guidance of 21.8%-22.5% given at Investor Day. Turning to our bottom line results, we earned $1 billion in operating income, or $1.23 per share.
Included in our second quarter results was a favorable market impact of $43 million, or $0.05 per share, as gains from our hedge program more than offset the impact of lower equity markets and interest rates in both the U.S. and international businesses. With regard to investment gains and losses, in the second quarter, we had after-tax net realized investment gains of $767 million, which included derivative gains of $878 million after tax. MetLife uses derivatives in connection with its broader portfolio management strategy to hedge a number of risks, including changes in interest rates and fluctuations in foreign currencies. Movements in interest rates, foreign currencies in MetLife's own credit spread, which impacts the valuation of certain insurance liabilities, can generate derivative gains or losses. Derivative gains or losses related to MetLife's own credit spread do not have an economic impact on the company.
In this quarter, we refined our estimate of expected recovery rates for our insurance subsidiaries within the measurement of own credit as of June 30. This refinement resulted in an after-tax realized investment loss of $621 million during the quarter. Impairments were $112 million after tax in the second quarter, modestly higher than the first quarter of 2010. Our preliminary statutory earnings for the second quarter of 2010 are approximately $220 million, and our preliminary statutory net income is $250 million. Statutory operating earnings were significantly impacted by lower equity markets and interest rates in the quarter and do not reflect the benefit of gains from our hedging program. Statutory total adjusted capital, which is the numerator in our RBC calculation, increased by $1.1 billion. Turning to our holding company, cash and liquid assets at the holding company at quarter end were $3.7 billion.
In summary, MetLife had a very strong second quarter. Our revenue growth was solid, our investment performance continued to improve, our operating margins remained strong, driven by disciplined underwriting and expense management, and our earnings continue to grow. With that, I'll turn it back to the operator for questions.
Thank you. Ladies and gentlemen, with your questions at this time, please press star one on your touchtone phone. We do have our first question from the line of Mark Finely, Bank of America. Please go ahead. Your line is open.
Good morning. Hopefully, you can hear me okay. There's a lot of static. I guess it was a good quarter. You had favorable mortality, good morbidity, good investment results, good expense control across the board. I think if you looked at the core number, it's somewhere in the $1.10 to $1.15 range. I guess what I'm really interested in is how should we think about this level of earnings and whether we should be trending off this number, or whether we should be thinking about a little bit lower of a number, just given the level of favorability in the quarter?
Hi, Mark. It's Bill. Yeah, we did hear your question. I always hesitate to say whether $1.11 is a good run rate or not because that'll give you some sense of the pluses and minuses. You're right, underwriting was very strong, I think a lot of that is sustainable. Some of it was probably just good fortune. I also think, by the way, that the improvements in dental underwriting margin are very sustainable. In fact, they might get better from here. The other interesting fact is disability underwriting margins were roughly flat on a sequential quarter basis, but there's potential for a lot of improvement there as early maybe in the third quarter, maybe not. The guys who are very close to that business are encouraged by some of the signs they saw in the second quarter.
Certainly there are headwinds or there are things which might not be repeatable in the second quarter results, but there are further opportunities. I would also just a couple other things to keep in mind is I think the expense picture only gets better, okay, as Operational Excellence continues to execute, though probably the drop in the equity markets at the end of the second quarter is probably a modest negative as we think about third quarter fees in the retirement business. Finally, I think the low interest rate environment that we're in, though I don't think it will be a very large impact in terms of our operating impact, it will probably slice a little bit off of investment margin in the future quarters. I think it'll be very modest.
That's sort of the color on what's sustainable and what might be in the future. I kind of come away from that little dialogue as that kind of $1.11 current run rate is a number that I think you can think about as a reasonable projection going forward. Could it be a little lower? Sure. Not materially.
Okay.
Okay.
That's helpful. Just finally, I know there's a lot of moving parts with equity markets down, interest rates, I think you mentioned adjusted capital is higher. Is there any update you can give on just the overall capital position?
Well, we don't give out quarterly RBC projections. I just don't think that's a good practice because I think you probably appreciate the actual RBC projection is a very involved calculation. We don't perform it quarterly. We do estimate our RBC every quarter
We don't. It just strikes me as, until you do the real math, you shouldn't put out a number. I think the way to think about this is total adjusted capital, as I said in my prepared remarks, went up $1.1 billion. Well, that's the numerator in the RBC projection, the $1.1 billion. The denominator changes because the balance sheet's a little bigger, and things have changed a little bit. $1.1 billion, you'd think $50 million to $60 million per RBC point, that sort of implies 15 to 20 RBC points in the numerator just in the second quarter, never mind the first quarter, which was another billion-dollar increase.
Right.
We're clearly building statutory capital versus our RBC at year-end 2009, which was 432%. We feel good about our capital levels, and our cash levels at the holding company haven't changed. I guess I feel that capital position is in good shape.
Okay. All right. Thank you.
Thank you. Our next questions come from the line of John Hall with Wells Fargo. Please go ahead. Your line is open.
Good morning, everyone.
Morning, John.
Yeah, just a couple of questions for Steve. I was wondering if you could just give us a sense of those gross losses on the investment portfolio that were realized, where they came from, and I think you sort of indicated along the way that you might be reducing some of your sovereign holdings, and I wonder if any of that activity occurred during the quarter.
Hi, John. Actually, we did not decrease our sovereign holdings. We didn't have very many sovereign holdings. You may be remembering some comments I made earlier when you talked about the Alico transaction. As you know, pre-closing, we don't control how they manage their portfolio. I can't really comment on what is going on that side of the ledger. In terms of gross losses, it's a fairly varied group of sectors that are contributing to that. There's no one item that's sort of jumping out where I can say this sector is underperforming on the realized losses. On impairments, it was more in the area of structured financed assets. There was some in CMBS, some in ABS, and that was the main driver for the impairments.
Great. Thanks. It was clearly a strong sales quarter building momentum around the variable annuity product. Can you give us a sense of how much the Fidelity relationship might have contributed to that? Are there any other new sales relationships that could potentially keep that momentum going?
Hi, John. It's Bill Mullaney. First of all, yes, we did have a good sales quarter in variable annuities. We had about a $4.5 billion level of sales, which we were very pleased with. It continued to come from a broad range of channels. The traditional channels where we sell variable annuities continues to be strong. Rob did mention in his comments the Fidelity relationship, and that has continued to grow and to give us an alternative way to distribute the products. We do look and are in discussions with other potential parties that we would partner with to distribute our VAs through some alternative channels. As those things get finalized, we'll certainly make you aware of them.
All right, great. Just I guess finally on capital, in a sense, have you guys made peace with S&P with the strong quarter and the strong book value growth?
We love S&P. Look, I hesitate, certainly in a public, to speak about what S&P thinks. They put out a research report on us. It was about a month ago, I think. I thought that was a pretty accurate reflection of where they're at. That's sort of, I would say our current state of affairs with them.
Great. Thanks very much.
Thank you. Our next question is from the line of Colin Devine with Citi. Please go ahead. Your line is open.
Thank you very much. Okay, just a couple of questions. One with respect to what's going on in the U.K. I guess a couple of your more legitimate competitors have pulled out with AXA leaving and Aegon putting their business up for sale. Is there any sort of update on your thoughts on the U.K. pension market and where you're at? Excuse me. Sorry. Second, I didn't catch what you said the sales were for the variable annuities through Fidelity. If you could just give us a sense of that would be very helpful. Also with respect to, I guess your two other things internationally, your ongoing discussions, I guess, with Sompo Japan Nipponkoa and where you stand on the JV, if that is no longer going to be a JV.
Can you give us any update on your negotiations with Japanese regulators to start taking capital out of Alico early next year instead of having to wait till 2012?
Colin, it's Bill Mullaney. I'll talk about the first two parts of your question. As it relates to the U.K. closeout business, we had lower U.K. closeout sales this quarter than we had in the first quarter. As we've talked about in the past, closeout sales are lumpy, and they do vary from quarter to quarter. I think you're seeing the effect of that. In addition, though, I do think the low interest rate environment, in particular, is having an impact on the closeout market in both the U.S. and the U.K.
Companies that would be thinking about transferring their pension plans to us are moving more slowly here because of the fact that interest rates are so low. I think that will continue to provide a challenge for us in that business until we see some improvement in the interest rate and in the longer-term interest rate environment. I think that's how we're thinking about the U.K. and the U.S. closeout market. In terms of the Fidelity relationship, you didn't hear the sales number because I didn't say what it was. Because it is a relationship that we have with another company, we don't disclose that publicly. It has become an important part of the overall sales story. I will tell you, it represents less than 10% of our total VA sales. I think then the third question is to Bill Toppeta .
Yeah. Hi, Colin.
Bill.
Just on the Japan JV, we are in the discussions with Mitsui Sumitomo. I would say that the discussions are very positive and moving along well. We don't have any conclusion yet, and as soon as we do, you'll be the first to know.
Okay. Then with respect to Japanese regulators.
Yeah, I'm going to give that to Mr. Wheeler.
Come on.
Come on. The Fed only gets so much air time each call. We have to limit it. With the Japanese, obviously, we explained when we announced Alico that under sort of the general rules, we thought we wouldn't be able to take out regular dividends out of Japan until sort of the 2012 timeframe. It's quite possible that we may get some flexibility on that from the regulator. We haven't really brought that up in great detail with them yet because we've obviously have been doing some other things with them about discussing other issues with them at the moment. I'm hopeful that we might make some progress on that front earlier. There's nothing definitive to say now.
Okay. I guess just a quick one for Rob. You haven't said anything about the New York Attorney General investigation. I can't believe you're going to let that pass without some comment. Perhaps you can update us on your thinking about that.
I just lost a bet. I thought maybe somebody would let it go through and not mention it at all. I forgot-
I knew you wouldn't.
You were on the call. In the first place, I can't really say anything specifically about the Attorney General because even though we've read in the press, just like everyone else, about the certain subpoena activity, we haven't seen anything, nor we've talked to anybody from the Attorney General's office. I really can't comment.
Have you received it?
Pardon me.
Have you received it, actually?
Not to my knowledge. Why? Do you have some other information? No, we have not received it.
Okay.
I would comment just generally. Obviously, we strongly disagree with the misleading and incorrect statements, certainly the initial statements coming from the press. Subsequent to that, of course, those with correct knowledge of the situation including the National Organization of Life Guaranty Association, the NAIC, the ACLI, we and other insurance companies have provided a lot of well-written clarifications. I would say that certainly most of you on the call have made very clear that you understand how the accounts function, and I think you've provided a real public service, quite frankly, for putting together reports that demonstrate very ably your understanding of these. I think that as more comes to light, that's the direction things will go. The beneficiaries have full access to their funds. They earn guaranteed minimum interest rates. They exceed what they could in other money market-type accounts.
Our account holders tell us they love it. It's consumer friendly, on and on. One of the interesting things as you probably know in terms of guaranty funds and whatnot, in the course of business we actually are prohibited from talking about guaranty funds and whatnot in the insurance industry. I think that has to do with moral hazard issues and so forth which we certainly wouldn't disagree with. Since NOLGA did weigh in, by the way, you may recall back in 2008 during the crisis, they clarified the guaranty association coverage, which in this instance goes as if it were any kind of life insurance death benefit. Most states in the U.S., all 50 have coverage. Most are at $300,000. A handful like New York are at $500,000. None of them are below $250,000.
Now I can say that because I'm just commenting on a comment from the Guarantee Fund Association. They came out with a reaffirmation of that just this week. I think there's nothing better than having good, solid, clarifying, correct information when it comes to financial products. That's about all I have to say, but I can't say anything about the Attorney General's office.
Okay, thanks. I think Bill said in the past you have about $3 billion in those accounts. Is that still the right number?
No. There was a report. It's north of that. I don't have the exact figure in my head, but it's north of $3 billion.
Okay. Thank you.
Yes.
Your next question comes from the line of Jamminder Bhullar from J.P. Morgan. Please go ahead.
Hi. Thank you. Good morning. Just to clarify on the previous question, I think isn't the amount close to $10 billion in those accounts, Bill?
Yeah. It's something like $10.
Okay. I had a couple of questions. One is on disability claims. Obviously, your margins held up really well. A few other companies have reported an uptick in claims, and maybe it seems like there is a business mix issue, but what's the possibility that if the economy stays the way it is, that you actually see another uptick in claims over the next few quarters? The second question is on interest rates. With rates like 10-year sitting around 3%, could you maybe quantify a little bit on if the 10-year stays around at this level for the rest of the year, how much of an impact it would have on your earnings? Maybe even if it were to drop another 50 basis points, what sort of sensitivity would you have on your results?
Hi, Jimmy. It's Bill Mullaney. I'll start off by talking about what we're seeing in disability. As Bill Wheeler talked about in his opening remarks, we saw a modest improvement this quarter in disability results relative to prior quarters. Incidence was down slightly. Recoveries improved slightly. That's brought the loss ratio down a little bit. You commented on what some of our competitors are seeing. I can't really speak for them, and I'm not really sure why we saw the impact on our disability business more quickly. As you know, we've been talking about this issue for some time. Some of it may have to do with the mix of business that we have. We have a book of business that focuses on large companies. It's also got a significant percentage of those being financial services companies.
I think when the economy started to turn down, I think those companies acted more quickly in terms of adjusting their workforces. That may have had some impact on how quickly we saw claims coming into our operation. We also have taken some price increases over the last couple of pricing cycles. I think that has helped us in terms of our overall results for the quarter. What I would say just to summarize is that the performance of the quarter in disability was moderately encouraging. I would say as the economy continues to slowly recover, we think that we'll begin to see a recovery in our disability business as well.
Okay.
Jimmy, with regard to interest rates, we have run a sensitivity, or done a little projection, I guess, by saying if sort of the interest rate environment that we're in now with sort of the 10-year roughly at 3% sort of continues for the rest of this year and through 2011, what would happen to our results? I guess I would say the answer is not much in general. By that I mean we would probably see a little lower earnings than otherwise expected in 2011, but it'd be enough to mention, but not that significant. I think some people have talked about impairments of DAC or goodwill or things like that. I wouldn't think that that's likely in this sort of timeframe. You also mentioned what'd happen if we dropped the 10-year to 2.5%?
I have to admit I haven't run that scenario, so I can't give you any real precise answer. I would give you sort of a general response. You've followed us. I think most of the analysts listening to this call have followed us for a long time. We've talked about the low interest rate issues and what we do to protect ourselves. We've said that from time to time, well before, obviously, the current situation. We have a history because this is part about risk management. We've often talked about a Japan scenario and how we protect ourselves against that risk. We buy very long interest rate floors, sometimes with deferred start mechanisms to push out, protect ourselves as long as we can. We have a pretty good portfolio of those.
As interest rates continue down here, those things obviously come into the money and start paying, but obviously they're increasing in value as we speak. Obviously even in the second quarter, we saw an increase in value of those contracts. This is something we've thought about for a long time and have, I think, prepared ourselves pretty well for, and spent the money, frankly, over the last five years to do. I think that's being smart about risk management, understanding where your real risks are. I think we're in relatively good shape here.
Okay. Thank you.
Your next question comes from the line of John Nadel from Sterne Agee. Please go ahead.
Okay. A couple quick questions. Any update on the timing for when you guys might file those pro forma historical financials that show MetLife on a combined basis?
No. There's no update yet. Well, I'm not actually sure when AIG actually announces earnings for the second quarter. I should probably know the answer to that. There's no update yet.
Okay. Sometime after AIG reports.
Well, I said there's no update yet.
Okay. All right. Here's my bigger picture question for you. Your capital levels continue to grow. The investment portfolio is clearly recovering. Showing good strength, very manageable credit-related investment losses and impairments. I guess I'm just curious as to whether we should expect the mix of your financing for Alico to maybe shift a bit from your original expectations when you announced that deal.
It's a good question, John. I think probably the prudent thing for me to say is you'll just have to wait and see. Obviously, this has been a source of considerable discussion for us, and we obviously wanted to get through this quarter. We'll have to just see, I think is the only answer I can really give.
Okay. Fair enough. Thank you.
Your next question comes from the line of Suneet Kamath from Sanford Bernstein. Please go ahead.
Great. Thank you. I guess two questions, maybe both are for Bill Wheeler. First, in terms of some of the normalization adjustments that we talked about last night. In particular, I'm not used to backing out positive earnings in quarters when the equity markets are down, and obviously, that was part of last night's drill. As it relates to kind of thinking about Met's exposure to equity markets, especially considering some of the hedges. Would you consider the second quarter to be particularly abnormal in that you actually did well as markets came down because of some phenomenon in terms of how the markets traded in the second quarter? Or are you at a point where you're so over-hedged right now that to the extent that markets recover in the third quarter, we might actually see a little bit of earnings pressure because the hedges would underperform?
That's question number one. Question number two is, I guess Met's been fairly involved in the FASB-IASB joint accounting project. I think you and your team, Bill, have talked to them about some of the industry's issues and concerns there. Any updates in terms of where we are and what things might look like as we progress through the year? Thanks.
Okay. I'm going to turn it into the accounting expert here. With regard to the second quarter phenomenon of that positive earnings adjustment. We had an interesting situation this quarter, and I'm not sure we've completely diagnosed why it came about because I think it is sort of unique. You had a pretty substantial drop in both equity and interest rates right at the end of the quarter. For most of the quarter, it was on level, we had a pretty big drop near the end or in June. The way GAAP works and when it reflects those sort of macro events, to put it simply, sometimes GAAP sort of smooths results with some things like mean reversion formulas and such. This was one of those occasions where there ended up being a fairly big smoothing.
At the same time, our hedging program, which we use to protect against these sorts of events, doesn't smooth anything. Effectively, we became over-hedged at least on an accounting basis. Certainly not on an economic risk basis. I think that we feel our hedging worked quite well there. It was meaningful enough that obviously we felt we really had to call it out in the financials and talk about it because it represented roughly a nickel overall for the company of earnings per share. The interesting question is, that's sort of what happened. What happens if we get a reversal? It doesn't, I don't think, magically go the other way, and there's been a $0.05 adjustment going the other way. It doesn't work that simply.
I do think that these things do balance out over time because, of course, that's the whole point of mean reversion. It's a smoothing mechanism that will spread out the adjustment over a longer period of time, as much as, frankly, five years. That's how the mean reversion works. It also has to do with the fact that we are very much in the middle of the mean reversion corridor as opposed to being at one end or the other, which is good to be in the middle. I think that sort of has the smoothing impact. You could smooth a little bit the other way, I think obviously if the stock market goes up, we would live with a little smoothing. That's okay. With regard to accounting, you know what?
I'm going to introduce Peter Carlson, who is our Chief Accounting Officer rather than me. I remember what he told me yesterday about what was going on. Rather than me just trying to repeat it, maybe I'll let him speak and talk a little bit about what's going on with these accounting initiatives.
Thanks, Bill. Suneet, I think you referenced the insurance contracts project that's a joint project between the International Accounting Standards Board and the U.S. Board, the FASB. What's happened, the International Board actually overnight did release an exposure draft. They had a July 30th goal, They've released their exposure draft for this project. That would apply to people under international financial reporting standards, which obviously is not what we currently follow. The U.S. Board because there already are existing standards for insurance contracts, we have much more industry-specific guidance here in the U.S., actually is on a little bit slower path and is not expected to release an exposure draft for another month or two, actually may not even do it in an exposure draft. The stage of the discussions are much more preliminary on the U.S. side.
That being said, the boards have recently, in discussions, reached a general consensus between both boards that acquisition costs actually would be considered in
Cash flows. There would be some deferral of acquisition costs, that's been one of the two key issues we've been monitoring as an industry.
Thanks. I guess the bigger issue, at least for me, is this whole marking-to-market of liabilities, which I think could cause your earnings to swing around pretty dramatically for non-economic reasons. Is that still kind of where their heads are? Has there been enough communication with investors, or perhaps they're taking another look at whether or not that makes sense in terms of improving transparency? Any thoughts on that would be helpful. Thanks.
I'm pretty sure there's going to be some. This IFRS insurance contracts exposure draft is going to include some mark-to-market of liabilities. The key is not whether or not they're going to do that. It's how they do it and the kind of discount rates they use. There was some discussion of that they might consider using a risk-free rate. We think that would be a bad idea. We think that the discount rate should really mimic as closely as possible sort of what's going on with spreads or the mark-to-market of the assets so you have them. Ergo, if you're a well-matched company, which we think we are, and others, that would minimize the volatility of marking both sides of the balance sheet together. I think they're a lot more aware of that than they used to be.
There's this whole interplay between what goes on in AOCI and the movements there and also net income versus operating income. I think those sort of distinctions, a lot of the mark-to-market in AOCI, obviously including now liabilities, is now going to just flow through a real income statement. We're going to have to look at operating income, and being able to call that out is just only going to get more important as opposed to sort of the mark-to-market and the balance sheet that goes on every quarter. It'll probably confuse newspaper reporters, but I think the analyst community will get it. Also, one last thing since we're on this topic is our expectation is this isn't going to be sort of the law of the land until sort of 2013 or 2014.
They have pushed this date back a little bit, so we might not be done pushing it back. This is quite a ways out before this is going to hit us.
Okay. Thank you.
Your next question comes from the line of Andrew Kligerman from UBS. Please go ahead.
Hey, good morning. I want to just kind of color in around the edges of some of the questions that we just heard. For example, on the net non-medical benefits ratio, you had an improved 87.8%. I look back to the good old days, which were back in 2006 and 2007, and the ratios were slightly under 85%. The first question is just, is that where we get back to as things improve, and do you kind of have any time trajectory for that?
Hi, Andrew. It's Bill Mullaney. Let me comment on that. First of all, the improvement that we saw in the non-medical health benefits ratio this quarter, as Bill mentioned in his comments, was primarily driven by dental. We saw the increase in utilization in dental claims early in 2009. We took some steps as part of our 2010 pricing, both for new business and renewal pricing, to adjust our prices to make sure that they reflected the higher cost of claims. I think you're starting to see the impact of those pricing changes working into our financial results. As a result, the loss ratio in dental has come down, and that is the primary driver of the non-medical health benefits loss ratio.
That's one of the reasons why we created the new ratio, because the dental business has grown significantly over the past few years, and so relative to the disability business. When you think about comparing the benefit ratio today versus the benefit ratio a few years ago, we have seen a change in the mix of the products that are there, with dental becoming much more significant. That's one of the reasons why we adjusted that ratio in the first place. We still think that we have some opportunities for us to bring that ratio down. As I talked about before, I think the disability ratios continue to be high, reflecting the downturn in the economy, though we are seeing some improvement there. We haven't yet seen the full impact of the dental pricing changes working through into the benefits ratio.
Over time, our expectation is that that ratio will continue to trend down.
Great color. Want to give a little specifics or quantify that or?
I think there's a number of things that will factor into that, including how quickly the economy recovers and how that will impact disability. At this time, I don't think I will get any more specific than what I said before.
Okay, fair enough. Just shifting over to Operational Excellence, Bill mentioned an expense ratio of 22.4%, the low end of, I guess, the guidance is 21.8%. Bill, I guess you had gotten additional $200 million of savings. I think that's all done, give us a sense of when you could get to that 21.8%?
Yeah, you bet. In the first quarter, I think we were at 21.7%. I think that's right. We were right at the bottom of the range. Obviously, it's a ratio, right? You got to look at the numerator and the denominator. In terms of expense control, we're ahead of our plan, we're doing better than our budgets and our plans this year. We're very good about that. What we can control very well is the denominator, which is revenues. Obviously what kind of pop made the ratio go up a little bit this quarter is not because expenses went up, it's because we had less close-out sales, which are obviously lumpy. That smooths over a year period. In the short run, you can have lumpy quarters like the one we just did.
In terms of real expense control, we put out guidance that we raised our Operational Excellence guidance to $600 million at the Investor Day 2009, last December. We're going to exceed that number. It's hard for me to say how much, but as you would hope, a number we put out, we would like to beat. We're doing very well there. Now, of course, after this year, I think we start shifting our focus onto the Alico acquisition and taking costs out of there. I don't know if we'll have an OpEx 2 necessarily, but we're going to be continuing to drive expense control around here. I think that's not just only through Alico, but through the rest of the company. I think there's more good news there to come in the future.
That's interesting. Just lastly, Steve seemed somewhat optimistic about the outlook for commercial real estate. Would love to hear a little color on just the overall environment for that and where you see that affecting Met's ratios, that you discussed earlier.
Sure. We've seen, I'd say, at a minimum, a bottoming out of certain sectors of the commercial real estate market and even a slight improvement. Certainly, there are far more lenders going back into the arena right now, and mortgage rates are coming down fairly significantly. You're seeing activity pick up, you're seeing improving lease-up rates and so on of buildings. I don't want to overstate it. I'm not saying that there'll be other problems coming down the road because there's always a lag in this sector regarding a borrower who eventually can't pay off a mortgage. I'd say the fundamentals of the business itself have improved slightly. I think that where things go from here will be largely driven by what happens in the overall economy.
If we do have a slow recovery here, which I think is our position in terms of the most likely outcome, then you would anticipate that the market overall will improve along with the economy. Were we to go into some sort of double dip, which we're not predicting, then obviously things could get worse.
Great. Thanks.
Andrew, this is Rob. It's hard for me to be quiet on this topic. Steve is absolutely correct in everything he said. I would say, though, that he's reflecting because the question is about our portfolio and our mortgage holdings and so forth. I just wouldn't want to hasten to say that our experience is necessarily reflective of the entire marketplace. It hasn't been in the past, and it won't be in the future. I say that because we have very high-quality properties, an extraordinarily strong real estate history and team. I think he's being a little modest. I would just put it that way. Don't project that as a proxy to the entire marketplace, which is full of a lot of secondary market problems still and might even trend a little bit worse in some of those markets.
It's a reflection of market quality of properties as opposed to just a general. Thank you.
Exactly.
Your final question today comes from the line of Randy Binner from FBR Capital Markets. Please go ahead.
Thanks for letting me on. Just interested in any thoughts we could get on Dodd-Frank bill, specifically related to Volcker and then derivatives. On Volcker, there was a broad carve-out for the insurance industry, but at least we're still not clear on whether or not your holdings of hedge funds and private equity might be affected. Just more broadly, kind of how you think derivatives might carry a higher cost going forward.
Let me sort of provide a little color and commentary, Randy. Last call, I think the one before that I talked about at least it was helpful for me to kind of differentiate thoroughbred racehorses from camels. I made that comment, and at least some of the people down in Washington kind of liked it and said it was actually reflective of what it was all about. Whether or not that's helpful for normal people, I don't know, but it seemed to help people in Washington. Let me just give you a little flavor. As I said all along, the bill passes, and now relative to the insurance companies, the work is far from over, which is a good thing because the bill is full of bank language, full of bank processes, and so forth. The clarifications then work to differentiate the insurance marketplace.
It's literally hundreds of rulemaking and regulatory projects that are go on. To give you an idea, there are 199 separate rulemaking initiatives. There's 68 studies underway. There are 355 issues on which lawmakers have given regulators the authority to issue the regulations, even if the regulations are not expressly required. Keep in mind that some of the studies are done by agencies that do not even now currently exist.
The Financial Stability Oversight Council, the Consumer Financial Protection Bureau, et cetera. There's a lot of work to be done in the details, and because it is so important to us, other people may think that we would relax a little bit, and this is the time that we really have positioned ourselves, both as a company directly and through the ACLI as a resource to all of these rulemaking initiatives and wordings and so forth. When it comes to things like-- this covers the Volcker Rule, it covers derivatives, it covers things like resolution authority, fees, taxes, this and the other. We're all very focused and very active here at MetLife in Washington. That's probably the best way to answer that question because it's very difficult to be more clear than that. We're not discouraged. We like this kind of slogging through.
That's kind of what we do very well.
I mean, the Volcker issue is a real issue, right? With the holdings?
Well, maybe Steve might want to comment on that. The Volcker issue is interesting because keep in mind where it started. It starts with proprietary accounts. The language in the original proposal did not, of course, contemplate nor think about insurance companies. Therefore, the definition of what a proprietary account was not clarified. Of course, if you left the language alone, it would have given us problems relative to the general account itself because if proprietary is everything other than an account owned by an individual, as you know, individuals own contracts and policies with us in the general account. They don't own a specific investment. That was a starting place, and I'll let Steve comment beyond that.
Yeah, Randy, there is carve-out language in the Volcker Rule component of the bill. It's somewhat vague, and there's a six-month study that's been ordered by the bill. We think that when people really work through the analysis here, they'll realize that for us to invest in private equity funds, for us to invest in hedge funds with the capital requirements that are imposed upon us through our existing regulatory regime, certainly still makes sense. There's certainly no evidence to suggest any problems during this last crisis we went through related to these kinds of investments for insurance companies in their general account, again, given the risk-based capital rules that we live under and so on.
My guess is that it will not affect us, but we'll have to wait to see how this six-month study sorts out, and we'll certainly be involved in providing input into that process.
That's very good. Thank you.
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