2023-10-27 12:22:08 ET
Summary
- Brighthouse Financial appears cheap to me, but it is cheap for a reason. The company has not found a consistent and reliable way to turn itself into a profitable business.
- Building name recognition in the insurance industry is a top priority for BHF.
- BHF's best strategy is to excel in a specific life insurance niche and organically grow into other product areas.
- The company is well-capitalized, and management prefers share repurchases over dividends.
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Investment Thesis
I would recommend a "Hold" position on Brighthouse Financial (BHF). Although the company has effectively sustained a robust capital position and maintained a healthy risk-based capital level, it has encountered challenges in achieving consistent quarterly profitability. In my view, this fluctuation in the bottom line is likely going to diminish as BHF further consolidates its product offerings. It is essential to recognize that the management of BHF is committed to a longer-term strategy, emphasizing gradual progress rather than expecting immediate, rapid results.
Company Overview
In 2017, MetLife separated its U.S. retail business from its operations, creating the independent entity known as Brighthouse Financial. BHF operates autonomously, completely separate from MetLife. Eric Steigerwalt, who currently serves as BHF's CEO, previously held the position of EVP in MetLife's U.S. Retail segment. Despite its historical ties to MetLife and its relatively short presence in the stock market, BHF can trace its origins all the way back to 1863.
At present, the top three shareholders of BHF are Dodge & Cox Inc (13.7%), Vanguard Group (10.4%), and BlackRock Inc (10.3%). BHF's stock performance has lagged behind the broader insurance and financial sectors, as well as the overall S&P index since its inception. BHF has been actively working to raise its name recognition among investors.
Business Trends
BHF's major lines of business include annuities, life insurance, run-off, and corporate & others. Annuities segment is the most crucial part of BHF's business. Their annuity products include variable annuities, index-linked annuities (Shield), fixed deferred annuities, and income annuities. Life insurance products only account for 10% of the total Assets Under Management ((AUM)). The run-off segment consists of products that are no longer actively sold and are separately managed. As the graph below illustrates, the annuity segment is clearly the most dominant among the four segments.
The composition of each segment within its portfolio has remained largely consistent, and there have been no clear signals from the senior management team indicating a departure from this trend in the future. I think this trend will most likely persist in the next five to ten years. While there are a few potential benefits typically associated with a balanced mix of both annuity and life insurance products, I believe the company should pursue a further simplified and consolidated business line as it pursues greater industry recognition.
On the flip side, we've witnessed a gradual decline in assets under management ((AUM)) within separate accounts, contrasted with a consistent expansion in AUM within general accounts. Separate account AUM has retreated from nearly $120 billion to $85 billion, while general account AUM has grown from $82 billion to $109 billion.
The key distinction between separate accounts and general accounts lies in the types of investments they hold, the associated risk levels, the policyholder's control over these investments, and their respective purposes within the insurance company's overall operations. Separate accounts are typically linked with variable insurance products, offering greater investment flexibility but accompanied by higher risk. Conversely, general accounts are earmarked for traditional insurance products, providing more stable and guaranteed returns. The decline in separate account AUM is directly related to BHF's reduced exposure to the variable annuity market.
The graphical representation below illustrates that the annuities segment forms the predominant component of BHF's business. To be precise, as of the close of 2022, the annuities segment constitutes a substantial 72% of the total AUM. Given this pronounced weight, it is crucial to conduct a more comprehensive dissection of the annuities segment to gain a nuanced understanding of BHF's business dynamics.
In 2013, when it was still a part of MetLife's U.S. retail division, BHF initiated a strategic shift in its business mix . This involved a transition towards fixed products with lower guaranteed minimum crediting rates and variable products with reduced exposure to risky living benefits. Simultaneously, BHF amplified its focus on the MetLife Shield product, an index-linked annuity offering. To gauge the extent of this business exposure and its long-term implications, we'll utilize insurance liabilities as a key metric. Looking at variable annuity future liabilities, we observed a notable decline, plummeting from $115 billion to $83 billion, marking a 28% reduction. In contrast, the Shield annuity category experienced remarkable growth, nearly doubling from $13 billion to $26 billion. Furthermore, the exposure to fixed deferred annuities gained even more significant traction, surging from $5 billion to $19 billion in terms of future insurance liabilities.
BHF's strategic efforts to diversify its sales across the three primary annuity sub-markets are quite evident. This signifies a deliberate move by its senior management team to simplify the intricate nature of its business, which was inherited from MetLife. Notably, shortly after the spin-off from MetLife in 2017, the company's CEO publicly stated the goal of having "simplicity as part of the DNA of the company" .
Life segment on the other hand is completely dwarfed by annuities, equivalent of approximately 10% in comparison to annuities as measured by total AUM. While BHF's in-force book reflects a broad range of life products, the management is currently focused on term life products and an indexed universal life product with long-term care benefits with a concentration on enhancing rider features and profitability over sales volume. I believe the management primarily views its life segment as a natural means of diversification and a hedging tool to support its annuity business, rather than treating the life segment as an independent source of revenue.
Balance Sheet
According to the company's balance sheet , a substantial 48% of its total assets are allocated to investments which mainly consist of fixed maturity securities measured at fair value and mortgage loan securities. This pronounced exposure to fixed interest asset classes makes BHF susceptible to the Federal Reserve's forthcoming interest rate policies. To mitigate this interest rate risk, BHF has actively increased its holdings in interest rate derivatives, including instruments such as interest rate swaps, options, and forwards. The total notional value of interest derivatives within the company's macro interest rate hedging program expanded significantly, rising from $21 billion to nearly $48 billion throughout the calendar year 2022. So far, the company has demonstrated resilience in navigating a high-interest environment and managing uncertainties amid the Federal Reserve's rate decisions. Another 38% of total assets belongs to separate account which is predominantly invested in equity securities ($88.1 billion out of $88.4 billion) due to the less conservative investment nature of variable products.
Author
On the liability side, separate account liabilities match exactly with separate account assets at $88.4 billion. Additionally, two other significant components of total liabilities encompass policyholder account balances and future policy benefits. In terms of debt, the long-term debt-to-equity ratio currently stands at 63%, signifying a healthy level of debt exposure when compared to peer levels. LT debt is sufficiently covered by cash/cash equivalent, $3.2 billion vs $3.7 billion, according to BHF's latest 10Q.
LDTI Consideration
In August 2018, the Financial Accounting Standards Board (FASB) issued new guidance pertaining to long-duration contracts (Accounting Standards Update 2018-12, Financial Services-Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts, referred to as "LDTI"). LDTI became effective for fiscal years commencing after January 1, 2023. Under this guidance, guaranteed benefits associated with variable annuity and specific fixed annuity contracts will be classified and reported separately on the consolidated balance sheets as market risk benefits ("MRB").
Market risk benefits within insurance contracts encompass various guaranteed minimum benefits, including guaranteed minimum death benefits (GMDBs), guaranteed minimum income benefits (GMIBs), guaranteed minimum accumulation benefits (GMABs), and guaranteed minimum withdrawal benefits (GMWBs). It's noteworthy that these benefits were previously accounted for differently. In 2Q23, BHF's MRB amounted to $9.8 billion, a minor decrease compared to 2Q22. This decline is primarily attributed to the influence of changes in fund returns.
It's important to highlight that MRBs are measured at fair value, as prescribed by LDTI. Consequently, their valuation is significantly impacted by actuarial assumptions such as mortality rates, morbidity rates, lapse rates, and policyholder behavior patterns. BHF's management typically reviews these assumptions on an annual basis.
Earnings Trend
Let's delve into how BHF generates earnings. In the first half of 2023, the primary revenue sources, in descending order of volume, were investment income, universal life and investment product policy fees, and premiums. On the expense front, the majority of the company's expenses were allocated to policy benefits and claims, along with interest credited. The decrease in the pretax income can be attributed to the unfavorable impact of losses stemming from variable annuity guaranteed benefit riders. Notably, BHF utilizes derivative instruments, and changes in estimated fair values are recognized in net derivative gains (losses). In the most recent quarter, there was a net derivative loss of $1.8 billion, compared to a net derivative gain of $2.0 billion year-over-year. This variance resulted in a nearly $4 billion reduction in revenue.
BHF acknowledges that factors like net derivative gains (losses) and net investment gains (losses), whether positive or negative, can introduce unwanted market volatility and potentially distort trends. As a result, the company employs adjusted earnings to reflect its core business operations and assess operational success.
Author
The overall adjusted earnings have seen an increase, rising from $144 million in 2Q22 to $271 million in 2Q23. While fee income and net investment spread registered slight upticks, the most significant contributors to this positive adjusted earnings outcome were the reductions in insurance operation costs and other expenses. The lower net costs associated with insurance-related activities were attributed to several factors, including reduced liabilities in the Universal Life and Investment Product (ULSG) business due to the impact of new reinsurance agreements established in the previous period and a decrease in income annuity underwriting margins. On the other hand, the decline in other expenses primarily resulted from the resolution of a reinsurance-related matter in 2Q22, partially offset by increased deferred compensation expenses and decreased ceded cost of insurance expenses.
Insurance-related costs are expected to experience a slight uptick as inflationary pressures persist. In 2023, the Federal Reserve raised the target range for the federal funds rate to a range between 5.25% and 5.50% . These target range increases have contributed to a decrease in the net unrealized gains within BHF's investment portfolio. Any additional target rate hikes could further contribute to these decreases. As of June 30, 2023, the company's overall investment income boasted a net yield rate of 4.21%, in contrast to 4.06% on June 30, 2022. These investment income yields are calculated as investment income as a percentage of the average quarterly asset carrying values.
Other key factors
Distribution Channel
Over the years, BHF has gradually reduced its reliance on independent financial planners and increasingly utilized banks and financial institutions in the distribution of its product sales. This shift is expected to lead to higher commission expenses in the future. However, working with larger institutions offers the advantage of enhanced advertising capabilities and the potential for increased sales through their wholesale distribution approach. In the insurance industry, distribution channels play a pivotal role in nurturing a customer base and establishing brand recognition, particularly for a relatively new entity like BHF. Leveraging its strategic location in Charlotte, North Carolina, BHF is capitalizing on its proximity to the second-largest banking center in the nation, surpassed only by New York City. In my view, this strategic location allows BHF to foster relationships with banks and financial institutions, further strengthening its distribution network.
Risk-Based Capital
Risk-Based Capital ((RBC)) serves as a regulatory framework employed by insurance regulators to evaluate the financial stability and solvency of insurance companies. The RBC ratio is determined by dividing total adjusted capital by risk-based capital, which is adjusted for reserve requirements. If the RBC ratio stands at or exceeds 200%, it signifies that no regulatory intervention is necessary. However, if the ratio falls below this threshold, interventions can vary, ranging from the submission of action plans to regulatory takeovers of company management. When the ratio dips below 70%, regulators are mandated to take control of the company's management. Currently, BHF maintains an RBC ratio of approximately 440%, which falls within the upper range of its target range of 400% to 450%. This indicates robust statutory capitalization and a strong capital position. Upholding a strong RBC profile is of utmost importance for BHF, as it safeguards and enhances its credit rating, which is presently rated A+ by S&P . To provide context, the industry average RBC ratio for publicly owned life insurers stood at 415% at the conclusion of 2022.
Share Repurchase Program and Dividend Policy
During the six months ending June 30, 2023, and June 30, 2022, BHF repurchased 2,684,792 and 5,152,415 shares of its common stock, respectively. These repurchases amounted to $126 million and $259 million, respectively. As of June 30, 2023, BHF still had $167 million remaining under its common stock repurchase program. Currently, the company has no plans to declare or pay dividends on its common stock. This dual commitment to its stock repurchases program and its zero-dividend policy signifies that BHF's share price is potentially undervalued. This conclusion can be further supported by examining its valuation multiples.
Stock repurchases can communicate to investors that the company perceives its stock as undervalued, which can boost investor confidence and attract more shareholders. Conversely, the absence of dividends may be seen as a sign that the company prioritizes maintaining flexibility to adapt to changing market conditions and investor sentiment over a rigid schedule of dividend payments.
As BHF is relatively new to the investor market and holds substantial cash reserves, it appears to be making a judicious decision by avoiding dividend expectations. Instead, the company is enhancing its capital flexibility, bolstering investor confidence, and boosting earnings per share by opting to repurchase shares rather than paying regular dividends. It's evident that increasing investor confidence ranks high on the list of priorities for BHF's senior management team.
Valuation
Ben Graham, as noted in his renowned work "The Intelligent Investor", extolled the concept of book value as a conservative estimate of a company's intrinsic worth . It provides a foundational or "floor" value for a stock, which proves invaluable in assessing the margin of safety for an investment, even though it doesn't prognosticate a company's future performance.
BHF's P/B ratio currently stands at 0.64, indicating that the stock trades at just 64% of its book value. In essence, if one were to liquidate the company's assets, satisfy its obligations, and distribute the remaining equity to shareholders, they would receive more than the cost of the stock. This aligns with Graham's concept of a significant margin of safety.
Another widely accepted metric for evaluating an insurance company's performance is the Return on Equity ((ROE)). BHF's ROE is significantly in the negative range given the negative net earnings on its most recent income statement. This adverse bottom line primarily stemmed from fluctuations in net derivative gains in the most recent quarter. BHF opts to exclude these derivative gains from its adjusted earnings as they can introduce unwanted market volatility and distort trends. The impact of net derivative gains and market risk benefits is closely tied to BHF's future operations, particularly in both the variable annuity and index-linked annuity segments. As BHF reduces its exposure to the variable annuity market, it's plausible that future bottom-line variance on the income statement will diminish.
Combining the above pictures, the message here is clear: BHF is cheap but it's cheap for a reason. The company has not found a consistent and reliable way to turn itself into a profitable business.
Comparable Analysis
To gain a deeper understanding of BHF's performance relative to its industry peers, I conducted a comparable company analysis. I examined key valuation multiples of BHF in relation to a select group of life insurance companies, including Lincoln Financial Group, Jackson National Life, MetLife, and Prudential Financial. The rationale for including Lincoln and Jackson was straightforward, as they are direct competitors in the annuities market. In the case of MetLife and Prudential, they are notable for their substantial market shares and dominant positions within the broader life insurance industry.
BHF and Lincoln National Corporation (LNC) share a significant emphasis on the variable annuity sector, with notable exposure to the fixed segment as well. In contrast, JXN predominantly concentrates on variable annuity sales. BHF has a much lower market cap at $2.9 billion compared to both LNC and Jackson Financial (JXN) at $3.6 billion and $3.2 billion, respectively, partly due to lower level of debt it carries. All three insurers have Price/Book (P/B) ratios below one signaling consensus undervaluation by the market. However, BHF's 0.85 P/B ratio is much higher than that of JXN. Both BHF and LNC reported very negative Return on Equity ((ROE)) figures, largely due to the influence of net derivative settlements. These settlements tend to distort performance trends and introduce unwelcome volatility. However, for JXN, the negative impact of derivative settlements is offset by a larger reduction in market risk benefits, an expense category, as the company recorded more sales in variable annuities. In my opinion, name recognition is the most crucial task for BHF's management currently and in order to be recognized as an attractive investment, BHF needs to come up with effective ways to retain consistent positive bottom-line growth. So far, JXN has found considerable success in business line simplification as evident by a more robust Q2 earnings result. I think BHF can learn a lesson or two from their success. When compared to MetLife (MET) and Prudential Financial (PRU), BHF's performance is even more sensitive to market changes. Going forward, this level of volatility in earnings is likely going to persist for the next few years as the company is undergoing transformation to focus on quality over quantity.
In terms of its share price performance, BHF has exhibited notable fluctuations within the range of the low $40s and high $50s. This significant price swing reflects the company's inconsistent operational performance and the prevailing market uncertainty regarding its future prospects. Based on my analysis, I anticipate that the BVPS is poised to experience an uptick, potentially reaching approximately $60. This projection is substantiated by the company's ongoing share repurchase program, while the total book value is likely to remain relatively stable as there have been no indications of plan for overall business expansion. I also think BHF's P/B ratio currently appears to be relatively higher compared to its closest industry peers. I expect that this ratio will likely converge toward the industry's 0.6 peer average. Assuming a scenario where BVPS reaches $60 and the P/B ratio stabilizes around 0.65, our analysis suggests that the share price is poised to hover around the $40/share mark in the near future.
However, there exists an alternative scenario in which BHF successfully executes its strategic vision and demonstrates its prowess in dominating specific insurance product markets and gradually expanding into additional business segments. In this optimistic scenario, I am confident that the BVPS may surpass the $70 milestone. A more robust bottom-line trajectory will translate into a solid and consistent P/B ratio of 1, using MET and PRU as reference points. Such an outlook would signify a share price in the vicinity of $70. The key to escaping the potential value trap lies in the successful execution of operations within the annuity market.
The insurance industry is highly competitive and capital-intensive, therefore I believe it's not financially or strategically feasible for a smaller insurer like BHF to compete on every front against larger firms. BHF's most viable strategy is to become a leader in a specific subfield and organically grow to acquire the capital needed to diversify into additional product lines. Currently, it appears BHF is on the right track but it will take some time to see the results.
Risks
Because BHF maintains most of its assets in both regular investment portfolio (invests heavily in investment-grade bonds and treasury bonds) and separate account portfolio (predominantly in equity securities), it's clear that the company's near-term operation is going to be considerably influenced by the benchmark interest rate. More specifically, interest rate sensitive liabilities include long-term debt, policyholder account balances related to certain investment-type contracts, and embedded derivatives in variable annuity contracts with guaranteed minimum benefits. The management is fully aware of the company's exposure to the interest rate risk and is therefore using derivatives including swaps, caps, floors, forwards, and options to mitigate the risk.
Furthermore, the company's earnings are highly contingent on the alignment of actual claims experience and benefit disbursements with the actuarial assumptions employed in pricing the products and establishing provisions for future policy benefits and claims. These actuarial assumptions, which hinge on policyholder behavior, particularly with regard to the selection and utilization of embedded guaranteed options within the products, are inherently intricate to model. Any divergence of actual experience from these actuarial assumptions can yield significant fluctuations in the company's financial performance. While the management typically conducts an annual review of these actuarial assumptions, given the current high market volatility, I advocate for more frequent, quarterly assessments. This approach will enable the company to promptly adjust its assumptions and reflect the latest market dynamics, thereby ensuring agile risk management.
Conclusion
Investors should recognize that BHF is not in direct competition with insurance giants like MetLife and Prudential, as such a challenge is currently both financially and strategically unfeasible. Instead, BHF has been pursuing a pragmatic approach to rationalize its product lines by focusing predominantly on its annuity business. It's also transitioning from more complex products, such as variable annuities with complex riders, to simpler and more appealing offerings like index-linked annuities and fixed deferred annuities. This ongoing trend will have huge implications on its future stock price movements. Regarding the life segment, BHF doesn't seem inclined to proactively expand it. Instead, I think it uses the life segment mainly as a natural hedging tool for its annuity business. In the near future, the company's earnings will be influenced by the Federal Reserve's interest rate policy. A substantial portion of its assets resides in the investment portfolio and separate accounts, which primarily invest in equity securities. While investment returns currently contribute significantly to revenue, the core insurance operations have not proven profitable. In my view, this trend will need to be reversed if BHF intends to build a more robust earnings stream and bolster investor confidence. Additionally, BHF maintains a well-covered RBC ratio at 440%, underscoring its strong capital position and dedication to meeting statutory requirements. The company opts to use its capital for share buybacks rather than dividend payouts. By repurchasing shares instead of paying dividends, the company gains flexibility in capital allocation and reinvestment choices. In conclusion, BHF's primary strategic focus now is on building name recognition and generable reliable and consistent profits. The management's strategy of simplifying and consolidating its business appears to be a step in the right direction but it's likely turn out to be a marathon instead of a sprint in my opinion. Therefore, I recommend a "Hold" rating.
For further details see:
Brighthouse Financial: Recommend Hold At This Time But Long-Term Prospect Remains Good