MetLife (NYSE:MET), the biggest life insurance company in the U.S., has reported solid results from its operations in the country and in international markets. The company reported a 11% year-on-year increase in operating earnings for the second quarter of 2013, with an 18% surge in both the Americas and Asia regions. MetLife’s stock has also been helped by rising bond yields and has gained 25% in the last three months. Given the current trends and the recent change of reporting structure by the company, we have restructured our model for MetLife and have updated our price estimate to $51, implying a premium of 5% to the current market price.
In the last few articles, MetLife’s Asian Potential Part 1: Japan, MetLife’s Asian Potential Part 2: India And China and A Look At MetLife’s U.S. Operations As We Upgrade Estimate To $51, we analyzed the company’s insurance operations in the U.S. and Asia. In this article, we take a look at the company’s investment strategy and its profitability.
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The premiums collected by MetLife from policyholders are invested by the company to generate returns whilst maintaining policyholder account balances and reserves for future policy benefits. Premiums as a percentage of account balance have been around 12% to 13% in the last four years. The company has to meet stringent capital requirements, which are generally separate for each geography that it is operating in. We expect it to maintain this ratio in the coming years. The company was recently notified that it had reached stage 3 of the process to be named a non-bank Systemically Important Financial Institution or SIFI by the Financial Stability Oversight Council (FSOC).  The Fed is yet to provide clear guidelines regarding the regulations imposed on the non-bank companies deemed to be “Too Big To Fail”, but higher capital requirements and stress tests to ensure their ability to absorb losses are expected.
Nearly 75% of the MetLife’s assets are invested in fixed maturities like corporate and government bonds. Around 70% of the fixed maturity assets are invested in securities designated A or above, of which close to 20% are invested in U.S. Treasury and agency bonds, U.S. corporate bonds and foreign government bonds each.
The returns from these investments are largely linked to interest rates which have been kept artificially low by the government by using programs like the Federal Reserve’s Quantitative Easing program which includes $85 billion in monthly bond purchases. The program involves purchasing assets like long term Treasuries and mortgage-backed securities from commercial banks and other financial institutions, thereby increasing liquidity and reducing long term interest rates. The 10 year Treasury bond yield, which is often used as a benchmark for bond yields, was around 5% before the financial crisis but fell to around 1.5% in 2012.  As a result, MetLife’s fixed-maturities yield fell from 5.4% in 2008 to 4% in 2012.
The Fed has indicated a threshold of 6.5% unemployment rate as a target for the economic recovery before it might start raising interest rates.  Improving trends in the U.S. job market have led to speculation that the Fed might start tapering the program later this year sending bond yields soaring. The unemployment rate in the U.S. has recovered from 10.1% observed during the financial crisis in 2009 and reached a four-year low of 7.5% in April, staying around 7.6% through May and June before increasing slightly in July.  Subsequently, the 10 year Treasury bond yield has climbed from 1.6% in May to 2.8%.
We calculate the annualized spread earned by MetLife on the average account balance by subtracting the interest credited to policyholder account balances from the net investment income. According to our analysis, MetLife’s annualized spread in the U.S. dropped from 4.15% in 2010 to 4% in 2012. We expect a moderate long term increase in the annualized spread as bond yields increase.
Apart from the interest credited to policyholder account balances, MetLife also incurs expenses including policyholder benefits and claims and policyholder dividends, deferred policy acquisition costs (DAC), amortization of DAC and value of business acquired (VOBA) etc. By taking these expenses as a percentage of the premiums earned by the company, we arrive at the loss ratio.
MetLife has maintained an average loss ratio of 144% in the last four years in the U.S., while its pre-tax margins have increased from 9% in 2009 to 13% in 2012. We expect the company to maintain focus on profitability in the coming years by maintaining underwriting discipline. We forecast a loss ratio of around 142% through the end of the decade with higher yields from investment allowing net interest income (net investment income – interest credited to policyholder account balance) to increase to around 44% of premiums. As a result, the pre-tax margins will improve to around 20%.
MetLife’s international loss ratio has improved significantly since the acquisition of ALICO from AIG in 2010. The loss ratio fell from 135% in 2009 to 118% in 2012. However, the company is expect to expand in emerging markets like India in the coming years. According to McKinsey, Indian business margins are the lowest in Asia. Private sector insurers invested around $ 7.5 billion in the Indian market between 2000 and 2011, of which around $4 billion was to fund accumulated losses, mostly to create distribution capabilities. We expect the company to incur higher losses In the coming years, with its loss ratio reaching 120% by the end of the decade, however, higher yields from investments will allow the pre-tax margin to improve from the current level of 15% to around 20% as the net interest income increases to around 32% of premiums.Notes:
- Statement by MetLife on Reaching “Stage 3” of FSOC’s SIFI Designation Process [↩]
- Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury [↩]
- Bernanke Offers Possible Timetable for Tapering [↩]
- U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]