The Fed doesn’t understand insurance: MetLife edition

by R.J. Lehmann on March 14, 2012

MetLife Inc. is a financial company that wears a lot of hats. It is the largest U.S. life insurer, and also a big player as an asset manager, provider of dental, disability and supplemental health insurance, and even as a fairly significant home and auto insurer, particularly in the Northeast.

But thanks to its ownership of MetLife Bank, the company is regulated as a bank holding company, the only significant insurance enterprise with this form. It’s always been a somewhat odd situation for an insurer to be regulated by the Federal Reserve, and it’s made even stranger by the fact that, as one of the 19 largest bank holding companies, MetLife must participate in the Fed’s Comprehensive Capital Analysis and Review process, better known as the “stress tests.”

Late March 13, the Fed released the results of its stress tests and, in what has to be considered quite a surprise, MetLife – notably, the only one of the 19 BHCs that didn’t take any money from the Troubled Asset Relief Program – was also the only one to fail.

While this news has prompted something of a sell-off of life insurance stocks early March 14, one should see it as more a result of the Fed improperly applying banking metrics to the insurance industry, rather than any actual trouble in the sector.

MetLife’s failure comes mostly from its falling short of the projected minimum Tier 1 leverage ratio (a measure of leverage that divides the firm’s core capital ratio, including equity capital and reserves, by its average total consolidated assets) that the Fed set out. Under the stress test scenario, the Fed found MetLife would have a minimum Tier 1 leverage ratio of 3.6% through the end of 2013, or 3.4% if the company were to go through with its plans to buy back $2 billion of shares and increase its dividend by 49% (both plans have been on-hold pending the results of the stress test.)

While most of the bank holding companies were held to a Tier 1 leverage ratio minimum of 3%, Met and three other non-traditional lenders (Ally Financial Inc., American Express Co. and Capital One Financial Corp.) were required to meet the higher standard of 4%. Not only is there no good reason to hold an insurer to a higher leverage ratio than a bank, the entire enterprise of applying Tier 1 capital tests to life insurers is wholely misguided.

The Tier 1 process treats assets held in customers’ separate accounts (such as clients’ investments in mutual funds, variable annuities and variable life contracts) as if they were deposit obligations. They are not. The risks on such assets are borne by the fund participant or policyholder, with the insurer’s only obligation being to make good on any guarantees embedded in the products. Though such guarantees still exist, the ones available in the market today are much less generous than what companies were offering before the financial crisis in 2008. In any case, the Fed should certainly have excluded MetLife’s more than $200 billion in separate accounts assets from its total consolidated assets, as the company does not control the separate accounts. Had they done so, MetLife almost certainly would have passed.

Equity analyst Randy Binner of FBR Capital Markets noted that Tier 1 capital measures also assign higher risk weightings to corporate bonds than insurance regulators do, as the insurance regulatory process requires determining that such investments are consistent with the insurer’s credit risk. The Tier 1 process also risk-weights deferred acquisition costs and does “not reflect the fact that life insurers stochastically stress their reserves each quarter while banks do not.”

Binner added that he thought the credit losses the Fed estimated for MetLife seemed to be very high.

“The CCAR test estimates stress scenario credit losses of $11.5 billion, or 2.3% of MetLife’s general account portfolio,” Binner said. “In our capital analysis, which is more of a moderate stress case, we estimate credit losses of $3.3 billion. We understand that the parameters of the Fed test are bearish, but we find that level of loss to be difficult to reconcile. MetLife had a credit loss to total invested assets of 2.8% in the 2009 stress test. Given $3.6 billion in credit losses taken since 1Q08, de-risking strategies, and generally tight bond spreads, we thought the credit result would have been more improved from 2009.”

Of course, MetLife was already aware of the problems of Fed regulators trying to fit its insurance business into a bank-shaped hole, which is why they’ve been busy trying to shed the bank holding company designation. In addition to running off their mortgage origination business, MetLife in late December agreed to sell its depository and warehouse finance business to GE Capital.

Nonetheless, Chairman and CEO Steve Kandarian understandably took issue with the stress test results, noting in a statement that the company’s insurance subsidiaries posted a consolidated year-end 2011 risk-based capital ratio of 450%, well above minimums set by state insurance regulators:

“At year-end 2011, MetLife had excess capital of $3.5 billion. We project our excess capital will grow to $6 billion to $7 billion at year-end 2012, before any capital distribution actions. It continues to be our strong belief that excess capital should be returned to shareholders and we remain fully committed to doing so,” continued Kandarian.

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