#333 | Mid-Year Statutory Results Round-up
As tumultuous as the economic environment has been this year, life insurers have shown a surprising level of resiliency. Aggregate surplus across the 18 life insurers in the sample is down just 1.8%, with the Big 4 mutuals up 0.8% and the remaining insurers down 5.1%. Much of the damage to surplus came from unrealized capital gains, primarily derivative losses, that were only partially offset by Asset Valuation Reserve releases. And although life insurers have generally seen the fair-market value of their bond holdings drop from 108% of book value at the end of last year to 91% of book value through Q2, realized capital losses have been small. All in, the life insurance industry is fairing well – with one caveat. Financial engineering is more pronounced than ever. The carriers that use it have balance sheets that are increasingly complex and seem to be producing unintended consequences. The next 24 months will be the true test of whether those structures will stand the test of time.
Earlier this year, I’d planned to write an article summarizing the statutory results for a crop of major life insurers in 2021. The problem is that the year-end statutory results for life insurers usually don’t start showing up until April. By that time, I’d realized that the 2021 year end filings were going to be pretty mundane relative to what would show up in the Q2 filings for 2022.
The first 6 months of year saw the dust settle on both Constellation/Ohio National and Brookfield/American National along with a host of other smaller acquisition and reinsurance transactions. But more importantly, we’d be able to see the effect of both collapsing equity valuations and rising interest rates. The degree to which the generally stellar statutory results over the last couple of years were contingent on realized and unrealized capital gains should become more apparent.
For this analysis, I used the statutory filings for 18 life insurers. Statutory results are often minimized as being inaccurate because they are strictly a cash view of the company’s performance. But at the end of the day, cash is what actually matters. A company that consistently loses money on a statutory basis is really consistently losing money. Granted, it may be losing money in order to put business on the books that will ultimately produce distributable earnings, but the hole they’re creating today is real.
The alternative way to look at life insurer books is GAAP, which departs from Stat chiefly in the way that it handles up-front acquisition expenses, although there are lots of other quirks to GAAP. The joke in the industry is that “GAAP is crap.” The evidence of that is the incredibly deep discount that life insurers trade relative to GAAP book value. Stat, in my view, is the best and most comparable view into life insurer financials.
Why these 18 insurers? It’s always tempting to pull every filing for this sort of thing and I chose to resist that temptation for the simple reason that these 18 life insurers already cover a broad swath of the market, from large to small, publicly traded to mutual holding company to true-blue mutual to private-equity owned, Indexed UL-writers to Whole Life-writers to primarily annuity writers, you name it. They’re a representative sample.
If you were to look at life insurer financials boiled down into a single number, then the number you’d choose is surplus, which is equal to assets minus liabilities. It is the statutory book value of the company. In general, rising surplus means that life insurers are adding value. Falling surplus means they’re chewing through value. This even works within complex life insurance holding companies where a life insurer may have multiple life insurer subsidiaries. How are those subsidiaries held on the balance sheet of the mothership? You guessed it – statutory surplus. Surplus, for lack of a better term, is the statutory value check, the number that encompasses all other numbers.
Compared to Year End 21 (YE21), total surplus across the 18 insurers is down by 1.8%, from $156.8B to $153.9B. All in, that’s an indication of the fundamental strength of life insurers in a very turbulent environment for both equities and fixed income valuations. However, the picture at some life insurers is significantly better and significantly bleaker at others. The Big 4 mutuals make up $90 billion of the $154 billion in total surplus and those companies posted aggregate surplus growth of 0.7% through the first 6 months of the year. The Big 4 have fared exceptionally well over the past couple of years and this year is proving to be no exception.
However, that means the other 14 life insurers making up the remaining 40% of surplus got pummeled to the tune of -5.1%. Take a look at the chart below showing how each company fared:
At the risk of dramatically oversimplifying statutory financials, surplus changes because of two things – realized and unrealized results. Realized results are the actual operational earnings of the life insurer and the realized capital gains that come from actually selling assets and actually reaping the profits. Unrealized results are changes to various reserve accounts, tax assets and, crucially, unrealized capital gains. Ironically, and as I’ve written before, unrealized results have been by far the biggest drivers of surplus growth over the last couple of years. Realized results are a bit mundane. Unrealized results are where the fun stuff happens.
This time around, though, even the mundane is interesting. Aggregate operational earnings across all 18 carriers stood at $3.524B – but if you thought the average was a bit misleading for surplus, consider the fact that Lincoln ($2.7B) and Pacific Life ($967M) account for 105% of the total. On the other end of the spectrum, Brighthouse posted a loss of $691 million, followed by a loss of $391 million at John Hancock, $354 million at Ohio National and $211 million at F&G. Ten life insurers (including all of the Big 4) posted gains, eight posted losses.
Operational gains and losses themselves can be kind of quirky. Life insurance businesses are complex. It’s not always readily apparent why the company actually did well or poorly in terms of operational results. Take Lincoln. For Q2 of 2022, Separate Accounts net gain from operations (Line 5) tallied up to a whopping $3.1B. Offsetting that gain was a net transfer to the Separate Accounts (Line 26) of $1.2B.
The net result of those two numbers is $2.9B, more than the total operating earnings of $2.7B. In 2021, those two line items netted out to negative $800M and Lincoln’s total operating earnings were negative $1.2B. What are those line items? Something to do with Variable Annuities and Variable Life. That much is clear because we see the same effect happening in Brighthouse’s statement. There, these two line items produced a net impact of $1.5B – and Brighthouse still lost nearly $700M on operations. But what’s really going on? It’s hard to tell.
What’s not hard to tell, though, is the impact of challenging market conditions on capital gains at life insurers. The grand total of unrealized and realized capital gains across all 18 life insurers fell by $9.6B through the first 6 months of this year. Only five of the 18 life insurers posted net growth in capital gains through the period and of the four, only Guardian did it to the tune of more than a few million dollars. The remainder of the firms posted reductions in capital gains as large as $1.6B (Pruco). Considering that many of these firms have surpluses less than $10B, swings in unrealized capital gains of a few hundred million to over a billion can materially impact the results.
Something of a ballast to all of these unrealized capital gains swings is the Asset Valuation Reserve (AVR), which is described in Northwestern Mutual’s filing as “a reserve liability for invested asset valuation…intended to protect surplus by absorbing declines in the value of the Company’s investments that are not related to changes in interest rates…increases or decreases in the AVR are reported as direct adjustments to surplus in the financial statements.” It works as intended. AVR releases added $2.7B to surplus against the $9.6B loss, bringing the net reduction in surplus to $7B. And, as you’d expect, the companies with the biggest unrealized capital losses also had the biggest releases of AVR.
Some of you might be thinking that those reductions in capital gains sound small given the incredible size of the asset blocks at life insurers – and you’re right. Recall that realized and unrealized capital gains only hit surplus for non-fixed income assets. Looking through life insurer books, most of the losses this year appear to be related to equity, derivative and foreign exchange assets. Those are all mark-to-market. Bonds are not. Bonds are held at book value. So although there has been much talk about the fact that rising interest rates have absolutely crushed the value of fixed income assets held at insurers, you wouldn’t know it by looking at the statutory results.
That makes sense. Life insurance policies don’t all liquidate at once. Even if they did, life insurers have numerous safety mechanisms. First, they’d use incoming premium to pay outgoing benefits so they didn’t have to liquidate assets with losses. Second, they’d burn up their cash and other short-term investments before dipping into long-term investments. And third, statutory law allows life insurers 6 months to pay benefits, which would give them plenty of time to liquidate assets in as favorable of conditions as possible. There is no real reason for life insurers to hold bonds at fair-market value.
But that doesn’t mean fair market doesn’t matter. Significant gains in fair market valuation over book valuation constitute something of a shadow surplus. They represent financial flexibility to liquidate assets and reap profits, if needed, as some life insurers did years ago when falling rates seemed like a temporary thing. The opposite is true when fair market valuation falls below book value. Carriers have their back against the wall. They don’t want to liquidate assets and it’s a race against time to keep policyholders – and their assets – on the books until the assets mature. It’s risk. Not a big risk, but risk nonetheless.
Fortunately, the risk is spelled out in the statutory filings in the Notes section that shows the book value and fair-market value of the assets side-by-side. In raw terms, bond portfolios at these life insurers are currently worth, on average, 91.5% of the bond book values. How big of a risk does that pose? One way to look at it is to compare the gap between fair market value and book value of the bonds relative to each life insurer’s surplus. Take a look:
In general, life insurers have about 25-50% of their surplus exposed to the gap between fair market bond value and bond book value. Lincoln is the only company that still has a margin in the bank with a ratio of fair market value to book value of 103%. How is that possible? Of Lincoln’s $77B in general account assets (at the life insurer level, not including subsidiaries), 23% is invested in bonds with maturities greater than 10 years and 36% is invested in bonds greater than 20 years. To put that into perspective, Northwestern Mutual stands at 14% and 18% for the same metrics. Lincoln is long. Very long. That makes sense given Lincoln’s liability mix – and that’s probably also why Lincoln still has gas in the tank. Some of those bonds were purchased when yields were even higher. And that would also explain why at the end of 2021, Lincoln had the highest ratio of fair market to book value for its bonds of any other life insurer at 113%.
F&G also makes sense given its liability mix. F&G is by far the largest fixed annuity writer of the bunch as a proportion of its overall liabilities. Fixed annuities are much stickier than life insurance during the surrender charge period. In general, permanent life insurance without secondary guarantees has lapse rates of around 6-8%, at least that’s what I’ve seen in working with carrier clients. Fixed annuities, by contrast, have lapse rates before the end of the surrender charge period that are more like 1-2%. The likelihood of a run on the bank at F&G, where the vast majority of policies still have surrender charges and market value adjustments, is lower than a mature life insurance company where a large part of the business is out (or nearly out) of the surrender charge period.
Finally, we get to the fun part – financial engineering. The first 6 months of this year has been pretty entertaining in terms of M&A and reinsurance activity and the impact those transactions have on carrier balance sheets. Here are some of the highlights.
Ohio National’s surplus was bolstered to $1.9B by an $878M deferred reinsurance gain from selling its participation Whole Life block to Hannover Re. As soon as the dust settled on that transaction, Ohio National kicked up a handsome $325M dividend to its new owners. But if you consider the fact that the deferred reinsurance gain represents an acceleration of future distributable earnings and, therefore, will be gradually amortized into net income (as stated in the statutory filing), then Ohio National’s surplus actually dropped by the amount of the dividend. The net surplus isn’t $1.9B – it’s $1.1B, roughly the same as it was before Ohio National executed a series of complex reinsurance trades to liberate more capital. As I wrote in a recent article, this is the very definition of an insurance company being hollowed out. Let’s hope that Brookfield doesn’t follow suit with American National which, so far, it hasn’t.
John Hancock finally managed to relieve itself of a portion of its VA block courtesy of a reinsurance deal with Venerable for $22B of separate account assets. The result was a pop to the surplus of $465M that was quickly sucked out and sent to Manulife courtesy of a massive $580 million dividend. Securian executed a reinsurance deal with an unnamed party that created a $210M deferred reinsurance gain. And, of course, there are remnants of other reinsurance deals as well, several of which produced multi-hundred million dollar profit line items on derivative positions held by the ceding company to support the block as a part of coinsurance funds withheld treaties.
And, finally, there’s Schedule DB, the gargantuan list of derivatives owned by every life insurer. A few years ago, most life insurers had a Schedule DB that went a few pages. Now, some of those reports span a few hundred pages. That’s an indication of the growing prominence of indexed products and increased hedge sophistication for variable annuities, but also the fact that life insurers are increasingly using derivatives to hedge broader, more macro risks as a part of their business. Because all of these derivatives are held at fair-market value, they are increasingly swinging the balance sheets of life insurers.
For most life insurers, the majority of their unrealized capital gains comes from their derivative positions. For example, Brighthouse held $1.3B of net value in its derivative positions at the end of last year. By Q2 of 2022, those derivatives were worth negative $544 million, a swing of nearly $1.9B in just 6 months and contributing to Brighthouse’s $1.3B decline in surplus from YE21 to Q2 ’22. Over the same period, Lincoln had $2.8B decrease in the fair market value of derivatives.
So where does this leave us? On one hand, life insurers are stronger than ever. Since 2008, life insurers have been banking surplus, building buffers and preparing for adverse scenarios just like today. That effect has been especially accelerated as rates dropped, valuations increased and cost of capital fell. The fact that equity valuations are off by 15% for the year and rates have jumped by several hundred basis points and life insurer balance sheets are largely intact is an indication of the overall strength and stability of our industry.
That’s what the hard numbers say. But after regularly reading statutory filings for a decade now, I’m increasingly coming to see that the life insurance industry is really split into two camps. The first is embodied by the Big 4 mutuals, companies that (generally) have a surplus built with blood, sweat and tears – which is to say, scrupulously producing operating earnings, building (or buying) ancillary businesses that generate long-term value, fanatically limiting product risk and avoiding capital “management” plays that rely on regulatory arbitrage, such as captives. Add Pacific Life, OneAmerica and Securian to that list. Consider that of the $150B in surplus in the 18 carriers on this list, the surplus at those firms account for 70% of the total.
The story for the remaining companies is more complex. Some are exposed to reserve arbitrage structures. Some are so levered that they’d be nearly insolvent on a pure NAIC basis. Some companies have latent economic risk lurking in their balance sheets from products with long-tail guarantees. Some companies have become increasingly reliant on third-party reinsurance for capital management. Some companies use and over-use derivatives to manage macro risks, sometimes with unintended consequences. Some life insurers fancy themselves to be highly sophisticated enterprises and the complexity of their balance sheets increasingly reflect that sentiment.
For those companies, it is incredibly difficult to actually ascertain their financial position. Consider that Prudential just took a $1.3 billion charge for its Guaranteed UL block related to actuarial assumptions. That is not a small bit of money. In fact, it’s big enough that simply the specter of Prudential’s adjustment sent Lincoln’s stock tumbling because Lincoln hadn’t made a similar adjustment – at least, not yet. It’s difficult to look at a complex life insurer’s books and know what’s really going on.
The next 24 months, I think, will be a transformative time for life insurers. The quality and sustainability of some of these financial engineering tactics will be made apparent. There will be winners and there will be losers. But more importantly, there will be firms who didn’t make the bets, didn’t engineer their balance sheets and stuck to their knitting – and I have every confidence that those firms will ride out whatever storm is coming.