F&G Annuities & Life Inc

NYSE:FG

Earnings Call Transcript 2018-Q1

[Operator]

Good morning, and welcome to the FGL Holdings First Quarter 2018 Earnings Conference Call and Webcast. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Diana Hickert-Hill, Senior Vice President of Marketing, Investor Relations and Communications. Please go ahead.

[Diana Hickert-Hill]

Thank you, operator, and good morning, everyone. We appreciate you joining our earnings call. Today, we will discuss our financial results for the first quarter of 2018, which ended on March 31. You can find the financial information for FGL Holdings on the Investors section of our website, fglife.bm.

Today’s presenters include Chris Littlefield, President and Chief Executive Officer; and Dennis Vigneau, Chief Financial Officer. Some of the comments we make during this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. We do not intend to update any comments on this call to reflect new information, subsequent events or changes in strategy. A number of risks and uncertainties exist that could cause our actual results to differ materially from those expressed or implied. We discussed these factors in detail in the Form 10-K that we filed with the SEC on March 15 of this year.

During this conference call, we may refer to non-GAAP financial measures that we believe may be meaningful to investors. Please refer to our first quarter earnings release, financial supplement and investor presentation that we posted to our website. These documents contain a reconciliation of non-GAAP financial measures to GAAP. And finally, all comparison comments today will be to the first quarter 2017 unless we state otherwise. Now, I will turn the call over to Chris.

[Chris Littlefield, President and Chief Executive Officer]

Thank you, Diana, and good morning, everyone. We are very pleased with our first full quarter as FGL Holdings, and we are continuing to make progress on building the new transformed F&G on a number of fronts. At the Investor Day in March, we outlined our priorities, and I want to start by highlighting our progress against those priorities to date.

First, we are focused on securing ratings upgrade to help grow our business and increase our strategic flexibility. We received a double-notch upgrade from S&P at closing. Fitch followed with an upgrade in December. And in February, A.M. Best raised our ratings outlook to positive.

In April, we further strengthened our balance sheet by successfully completing a $550 million debt offering that refinanced our existing debt at reduced rates, while also providing additional capital to support our business. We remain actively engaged with all our rating agencies and believe we are well positioned for further ratings enhancements.

Second, we’ve made good progress working closely with Blackstone to reposition our investment portfolio. We told you on our last earnings call about the $2.7 billion block trade that we executed in February. We are now focused on the next 2 phases of the portfolio repositioning, an increase in structured investments and an increase in alternatives. And Dennis will provide more details on that progress in a minute.

Blackstone has unique, best-in-class investment capabilities that will continue to fuel increased profits going forward. Third, we stated that we wanted to significantly increase profits in ROE. For the first quarter of 2018, AOI is up 61% to $61 million, and AOI ROE has increased to 16.1%.

Last, we stated that we were targeting total annuity sales growth of 10% to 12% for the full year. Total annuity sales, including International, in the first quarter, were $811 million, up 11% over last year and up 28% over the sequential quarter.

Of that, FIA sales were $436 million, on par with last year, but down a bit against the sequential quarter. On our last call, we reported that FIA sales in January are a bit slower than planned. However, we did see improved sales through the rest of the quarter despite a fairly competitive environment and reduced appetite for safe money products. And our momentum is continuing into the second quarter with April FIA sales at $189 million. At this pace, we see second quarter sales increasing about 15% over last year’s second quarter.

Our MYGA and institutional spread-based sales totaled $342 million, up 16% over last year. This quarter – this year’s quarter includes a $200 million FHLB funding agreement compared to a $136 million funding agreement executed last year. We continue to believe that MYGA and institutional spread-based products offer strong opportunities to grow our business, particularly with Blackstone’s best-in-class asset management capabilities that help us source shorter-duration, higher-spread assets to back these liabilities. Most importantly, we continued to be disciplined in our pricing and have consistently exceeded our profitability targets with our aggregate new business unlevered IRR exceeding 14%.

Turning to indexed universal life, or IUL. Our sales in the quarter were $6 million compared to $14 million last year. Consistent with our comments last call, we expected the decline as we focus on the quality of new business. And finally, in March the Fifth Circuit court of appeals issued a ruling vacating the Department of Labor fiduciary rule. We are monitoring whether the administration will seek review of this ruling by the Supreme Court and the deadline for that is June 13.

We believe the Fifth Circuit ruling is a positive for our business, and we will continue to work actively to support independent agents so they can serve middle American consumers, whose needs for principal-protected products and retirement income remain underserved.

In addition, we are actively engaged with the NAIC as it considers potential changes to its suitability standards and are monitoring the SEC’s proposed best interest standard. As a reminder, the sale of our products is not regulated by the SEC, but the SEC proposal could influence other regulatory efforts. Now I’ll turn the call over to Dennis to provide more details on the quarter.

[Dennis Vigneau, Chief Financial Officer]

Thanks, Chris, and good morning. Today, I’ll focus my comments on the following: Adjusted operating earnings, including any areas where results were impacted by the nuances of purchase accounting; an update on where we are with the tax reform; the overall performance of the investment portfolio; and then I’ll wrap up with a few thoughts on capital and liquidity. Beginning with the discussion of the adjusted operating earnings on Page 7 of the presentation posted to the website, I will note that we have – we’re helpful to put the periods on a comparable basis to best demonstrate the trends in each of those periods.

First, adjusted operating income available to common shareholders in the first quarter of 2018 was $61 million or $0.28 per share compared to $38 million or $0.18 per share in the first quarter of last year. Although there can be quarterly fluctuations in earnings, a simple annualizing of the Q1 EPS of $0.28 would put the full year AOI right in the middle of the range we discussed at Investor Day of $1.10 to $1.15 earnings per share.

The worst and notable items in both periods impacting AOI, which are shown on the chart, net of intangible amortization and taxes. First, in the first quarter of 2018, there was $8 million favorable earnings, largely from better actual to expected mortality in the single premium immediate annuity product line. The $38 million of AOI available to common in the first quarter of 2017, which has now been adjusted to our current definition of AOI which excludes M&A cost, was impacted by a net unfavorable $1 million relating to three specific items:

First, a $3 million unfavorable adjustment related to higher DAC amortization, related to equity market performance; $1 million unfavorable expense from legacy incentive compensation plans; and lastly $3 million of favorable income, largely from actual to expected mortality performance. Considering these notable items, we’d view the underlying performance as $53 million in the current quarter and $39 million in the prior year period or about 36% growth year-over-year.

The trended details of these notable items can be found in our quarterly financial supplement. Let me provide a few comments on where we are with tax reform. As I mentioned on the call last quarter and in our recent Investor Day, we expect our effective tax rate, or ETR, to be about 21% for 2018. We are tracking to that estimate on an AOI basis. There are some timing differences on a GAAP reported basis related to the Modco reinsurance transaction and the embedded derivatives within coming through this quarter and as a result of the tax planning that we’ve put in place to avoid BEAT tax.

More specifically, while we see clarification from tax authorities on the issue of gross versus net calculations for affiliated reinsurance, the company has made a tax planning – has put a tax planning strategy in place under IRS code Section 953(d) to have its Bermuda base F&G Re Ltd. subsidiary treated as a U.S. taxpayer. The election will maintain flexibility for our International platform to ensure we have no exposure to the BEAT tax during this interim period.

If the BEAT tax question results in a gross calculation, we would recapture this business from Bermuda and have no exposure to BEAT relative to the 21% we’ve currently booked. If we end up in a net calculation, we would then release the previously recognized expense at the 21% rate, resume new business reinsurance and end up closer to a 10% to 12% tax rate overall. We expect to finalize our actions and plans by the end of the year. In parallel to the 953(d) election, we continue to work on third-party strategies and opportunities, which would not be subject to BEAT, to leverage the International platform and over time reduce our effective tax rate to about 15%.

Let me turn to the investment portfolio and talk a bit about how that’s performing. Average assets under management were $25 billion at March 31, reflecting an increase of $4.8 billion over the first quarter of last year. As mentioned, AUM was boosted by $1.2 billion increase from the purchase accounting mark-to-market at the close of the merger, plus the inclusion of a combined $1.9 billion in assets for Front Street Re and FGL Holdings now reflected in our consolidated results, as well as $1.7 billion net sales in other items.

The purchase accounting, or PGAAP, mark-to-market is a noncash adjustment, which will amortize as a reduction to net investment income over the remaining asset life. GAAP earning yield on the portfolio was 4.2% for the first quarter and on par with the sequential quarter. This level was approximately 70 basis points lower than the 4.9% premerger yield in the first quarter of 2017. Because it reflects the yield reset for both the higher-average assets under management, I just discussed, and also reflects a full quarter of the PGAAP premium amortization.

For the current quarter that amount was $25 million. It’s important to note that on a statutory basis, which is not impacted by PGAAP, the yield was approximately 5.1% and in line with the prior period. It’s also important to note that this yield will begin to rise as we further reposition the portfolio with Blackstone to enhance investment income and earnings. I’ll get to an update on the portfolio reposition in just a moment. Next, in terms of asset purchases during the quarter, that was $3.7 billion, at an average yield of about 5%.

This volume included the block trade of $2.7 billion we discussed back in February, which will deliver $40 million of net investment income on an annualized basis. The remaining $1 billion of asset purchases during the current quarter included our typical mix of investment grade corporate bonds and structured securities.

Net investment income was $263 million in the current quarter, about flat sequentially and up 6% over the first quarter of 2017. As I mentioned, net investment income in the current quarter reflected a $25 million impact from the mark-to-market premium amortization.

The after-tax unfavorable impact of this amortization was $14 million or $0.07 per diluted share for the quarter. Underlying quarterly net investment spread has been stable for all products with recent periods at 240 to 250 basis points before the reset to 188 basis points from a full quarter’s affect of purchase accounting on the portfolio yield and from average AUM increases.

For our core product FIAs, we have seen a steady trend in the net spreads underlying of about 300 basis points, which have now been reset to 234 in the current quarter, again reflecting the premium amortization from purchase accounting. Again, these impacts are noncash in nature and spreads will begin to rise back towards historical levels as we reposition the investment portfolio, driving further earnings and ROE enhancements.

To that end, I’m pleased to share some details on the progress we’ve already made on – with Blackstone to lift the yield on the investment portfolio. Looking beyond the block trade, the next few legs of the portfolio reposition involve allocations to structured products and alternative assets. First, with respect to structured products, we intend to rotate out of approximately $4 billion over the next few quarters.

This $4 billion shift will come from relatively low yielding public corporates and migrate into structured asset, sourced by our Blackstone partners. We like the enhanced yield, floating rate upside and the enhanced credit protections of this asset class. And overall, this phase is expected to deliver an additional annualized lift of about $75 million of net investment income once completed.

Second, and with respect to alternative assets, this program is well underway as we target close to $1 billion in commitments by the end of this year, with more being deployed in 2019, as we grade towards an overall rating of 5% for the portfolio. We intend to deploy this allocation across a wide range of assets that will include credit, real estate infrastructure and private equity.

Blackstone has a proven track record of providing the required deal flow and returns in line with our repositioning strategy. Overall, once completed, at the end of 2019, we believe the shift to alternative assets will add $100 million to $125 million of annualized net investment income lift to the portfolio.

Our partnership with Blackstone is progressing well and the opportunities thus far have exceeded our expectations. I would note that beyond the portfolio reposition opportunities, we are also seeing meaningful benefits on the new money flows at higher risk-adjusted yields than we have historically achieved.

For example, we estimate that since the closing of the deal at the end of November and through April, Blackstone business units have executed almost $700 million of investment grade quality trades at a purchase yield of over 5.6%. The underlying investments were on the gamut from opportunistic credit to real estate debt-related securities, with almost 3/4 of these buys in the NAIC 1 rated category. Let me end with a few thoughts on capital.

At March 31, we have a strong capital position with an estimated consolidated statutory RBC ratio of about 480%. This includes expected adjustments due to tax reform. Looking ahead, we will be managing capital to fund growth in sales, maintain RBC at greater than 450% and to secure ratings upgrades. The effective tax reform, which only applies to RBC, has the rating agency capital models are generally pretax and not materially impacted.

In April, we issued $550 million of 5.5% senior notes due in 2025. A portion of the proceeds were used to repay in full, the $435 million of outstanding combined debt between our senior notes and credit facility, and the remaining proceeds will be available for general corporate purposes. Including the effect of this debt offering, our debt-to-capital ratio, excluding AOCI on a GAAP basis would be 22%. From a rating agency perspective, we’re sumptuary to preferred stock as 50% debt and 50% equity.

Our rating agency debt to capitalization, excluding AOCI, would be 30%. Readily deployable capital is approximately $400 million, comprised of both surplus and available debt capacity. In summary, since closing, we have good momentum in executing on the strategy, and we’ve delivered a good first quarter. With that, I’ll turn it back to the operator to begin the Q&A.

[Operator]

[Operator Instructions] The first question comes from Jimmy Bhullar with JPMorgan. Please go ahead.

[Jimmy Bhullar, JPMorgan]

So I had a couple of questions. First on the merger-related costs that are not in operating income. Could you give us an idea on how long they’ll continue and what the magnitude will be in the next 4 quarters?

[Dennis Vigneau, Chief Financial Officer]

Sure. For the full year, we’ve forecasted a total of around $10 million. We’ve had roughly $7 million of that come through this couple of lingering cost that will feather in over the rest of the year, and then that will be completed. Last year, the adjustment we made – the last year adjustment we made was $2 million when we took that back to the first quarter of last year.

[Jimmy Bhullar, JPMorgan]

Okay. And then on – if you can just give us an idea on what’s going on in terms of competition in the annuity market. And it seems like your outlook for sales is fairly upbeat, I think you mentioned 15% increase in second quarter. What gives you the confidence that you can – because that’s implying a decent improvement from here. So other than seasonality, what should drive the improvement in 2Q?

[Chris Littlefield, President and Chief Executive Officer]

Jimmy, yes, I think, I would say that it’s fairly competitive in the environment right now. I think, there is a lot of products, actions being taken and – as well as some new products entering the category. I think from our perspective, there has been just growing momentum behind the sponsorship that we have, the increase in the potential ratings profile and that story is really taking hold with the distribution and they see a real opportunity to be able to grow with us.

So again, we started slowly in January, but we’ve seen increasing sales in each one of those months going forward. Obviously, sales can be lumpy, but we feel pretty good about where we stand for the second quarter compared to last year at that sort of 15% range. And we feel really comfortable with our guidance at 10% to 12% for the full year on total sales.

[Jimmy Bhullar, JPMorgan]

And then is that assuming any benefit from ratings upgrade or you feel that, that’s – that would be incremental on top of that?

[Chris Littlefield, President and Chief Executive Officer]

Yes. That’s no benefit from ratings upgrade. Again, we don’t know when those upgrades will come through, but we do think that there’s additional upside once we actually are able – if we are able to actually secure our rating that would get us to an A-with A.M. Best.

[Jimmy Bhullar, JPMorgan]

Thank you.

[Operator]

The next question comes from John Barnidge with Sandler O’Neill. Please go ahead.

[John Barnidge, Sandler O’Neill]

My question is around sales guidance for the second quarter. Can you talk about the composition that you think that will be made up of? And how much will MYGA through the reinsurance come into play on that?

[Chris Littlefield, President and Chief Executive Officer]

Yes. So I think, you’re going to see – for the second quarter, without breaking it down by individual products or individual segments, I think you’re going to see a pretty good growth on the FIA primarily. I think you’ll probably see International fairly consistent for where it was in the first quarter. And then we currently don’t have any plans to do a funding agreement. So I think you would probably see a nice uptick in the MYGA business as well in the second quarter.

[John Barnidge, Sandler O’Neill]

And then, could you also talk about what you are seeing in M&A opportunity perspective, either whole companies or block transactions?

[Chris Littlefield, President and Chief Executive Officer]

I think that there’s a number of different opportunities available. I think you’re seeing a variety of opportunities, including blocks, entire companies, and we’re actively looking at a number of opportunities. So it’s – I would say, the pipeline’s pretty full, and there’s a lot of things to evaluate over the next several months.

[John Barnidge, Sandler O’Neill]

And then my last question. Now that you’re further into the new organization, do you feel like you’ve identified more opportunities around may be cost cuts than you may be initially expected? And that will be it for me.

[Dennis Vigneau, Chief Financial Officer]

John, this is Dennis. We are looking – as we’ve talked at – back at Investor Day and previously, our greatest opportunity from an expense efficiency perspective is to drive growth in AUM. Having said that, we are working with our various sponsored groups to identify synergies. We don’t have anything to report on that just yet. But we think we’ll find some as we move throughout the rest of the year.

[John Barnidge, Sandler O’Neill]

Thank you, and congrats on the quarter.

[Operator]

[Operator Instructions] The next question comes from John Nadel with UBS. Please go ahead.

[John Nadel, UBS]

Good morning, thanks for taking my question. I’m going to sort of start with John just left off. If I look at the expense levels in the first quarter, would you characterize that as a reasonable way to think about a run rate? Or is there some seasonality we should be considering?

[Dennis Vigneau, Chief Financial Officer]

No, I think our general expenses net of deferrals, I think, is a reasonable run rate for what you should expect to see. We don’t have any significant IT or other investments that we’re making at this current time. So I think it’s pretty steady-state.

[John Nadel, UBS]

And the intangible amortization at $19 million, that should be reasonable too?

[Dennis Vigneau, Chief Financial Officer]

Yes. I think from an intangible amortization, I think, the first quarter is a good indicator. As you know, there can be quarterly fluctuations. But I think – and we’re early into post PGAAP. But I think that’s a good indicator. We’ll have a better feel as we move throughout the year and have a few more quarters come into under our belt. I will say, as we get into the third quarter and go through our typical and annual unlocking, depending upon where the reposition and the yield on the portfolio is, we may have some updates later on in the year to reflect improved yields on the portfolio. But we’ll have more to report on that in the third quarter.

[John Nadel, UBS]

Got it. Understood. And then if I think about the lift that you’re expecting to achieve from alternatives getting to about 5% of the portfolio, where do alternatives stand today as a percentage of the portfolio? Is that other investments? I’m trying to understand what the starting point is.

[Dennis Vigneau, Chief Financial Officer]

Yes. I would say, in terms of commitments, we’re probably at 75 basis points, maybe 1% commitment level, sort of setting aside the recent approvals and commitments that we put in place for – with Blackstone this quarter and into April. In terms of actual funded, that our earning, I would say couple $300 million maybe at most. So we are – you should consider it nascent and this upside to come as we get – hopefully, get to that $1 billion by the end of the year, and then the remainder of it in 2019.

But we’re making great progress, I will say, because – and this is just sort of some sausage making here. But because we have an affiliated relationship with Blackstone, there are approval processes that we have to go through. We’ve sort of put that process now in place. It’s running smoothly. And we are seeing great traction in the commitments and ultimately, the fundings will accelerate significantly throughout the rest of the year.

[John Nadel, UBS]

That’s helpful. And then I have one last one to sneak in, just also related to the portfolio. I think you have a little over $1 billion of cash and equivalent. And maybe there is some timing there, I don’t remember if the $550 million debt offering happened within the quarter or just after. But what level of cash and equivalent should we think you guys run with on a normalized basis?

[Dennis Vigneau, Chief Financial Officer]

For various things, whether it’s collateral that we hold from counterparties, liquidity needs, it generally runs when we think about when we’re efficient and fully invested. It’s probably in the $500-ish million range. The excess that you’re seeing at the end of the quarter is just some maturities that we had in the portfolio and it’s short-term timing differences is all. I would say at this point, in April and May, we’re fully invested.

[John Nadel, UBS]

Thank you very much.

[Operator]

Seeing no further questions in the queue, this concludes our question-and-answer session. I will now turn the conference back over to CEO, Chris Littlefield, for closing remarks.

[Chris Littlefield, President and Chief Executive Officer]

Well, thank you. As we’ve laid out this morning, we’ve made substantial progress in transforming and improving our company. We’ve secured the rating enhancements and believe we’re well positioned for more. We’re moving forward with our portfolio repositioning and it’s resulting in significantly increased net investment income.

Our profits and ROE have increased significantly, and we’re on track to deliver and potentially exceed our sales plan, all while achieving our new business profitability targets. So really appreciate your interest and investment in our company, and we look forward to being back and updating you on our progress in the second quarter. Thank you.

[Operator]

This concludes our conference call. Thank you for attending today’s presentation. You may now disconnect.