Brighthouse Financial, Inc. Q1 FY2020 Earnings Call

Good morning, ladies and gentlemen, and welcome to Brighthouse Financial's First Quarter 2020 Earnings Conference Call. My name is Daniel and I'll be your coordinator today. At this time, all participants are in a listen-only mode. We will facilitate a question-and-answer session towards the end of the conference call. In fairness to all participants, please limit yourselves to one question and one follow-up. As a reminder, the conference call is being recorded for replay purposes. Also we ask that you refrain from using cellphones, speaker phones, or headsets during the question-and-answer portion of today’s call. I would now like to turn the presentation over to David Rosenbaum, Head of Investor Relations. Mr. Rosenbaum, you may proceed.

Thank you, operator. Good morning and thank you for joining Brighthouse Financial's first quarter 2020 earnings call. Our earnings release, slide presentation and financial supplement were released last night and can be accessed on the Investor Relations section of our website at brighthousefinancial.com. We encourage you to review all of these materials, and we will refer to the slide presentation in our prepared remarks. Today you will hear from Eric Steigerwalt, our President and Chief Executive Officer; John Rosenthal, Chief Investment Officer; and Ed Spehar, our Chief Financial Officer. Following our prepared comments, we will open the call up for a question-and-answer period. Also here with us today to participate in the discussions are Myles Lambert, Chief Distribution and Marketing Officer; and Conor Murphy, Chief Operating Officer. Our discussion during this call will include forward-looking statements within the meaning of the federal securities laws. Brighthouse Financial's actual results may differ materially from the results anticipated in the forward-looking statements as a result of risks and uncertainties, including those related to the COVID-19 pandemic and others described from time-to-time in Brighthouse Financial's filings with the U.S. Securities and Exchange Commission. Information discussed on today's call speaks only as of today, May 12, 2020. The company undertakes no obligation to update any information discussed on today's call. During this call, we will be discussing certain financial measures used by management that are not based on Generally Accepted Accounting Principles, also known as non-GAAP measures. Reconciliations of these non-GAAP measures on a historical basis to the most directly comparable GAAP measures and related definitions may be found on the Investor Relations portion of our website, in our earnings release, slide presentation or financial supplement. And finally, references to statutory results including certain statutory base measures used by management are preliminary due to the timing of the filing of the statutory statements. And now, I'll turn the call over to our CEO, Eric Steigerwalt.

Thank you, David, and good morning, everyone. I want to cover a few topics today. First, I will provide some perspectives on the current environment. Next, I will give an update on our share repurchase program. And finally, I will cover Brighthouse Financial's results in the first quarter. Let's start with the current environment. I hope that you and your loved ones are safe and well as the COVID-19 pandemic upends our communities and the world. Brighthouse Financial's top priority at this time remains the well-being and safety of our employees and their families, our partners and our customers. Through the Brighthouse Foundation and Brighthouse Financial corporate contributions, to-date we have donated more than $500,000 to local food banks and other organizations in our communities to support those in need throughout this pandemic and beyond. As cities and states across the country began to enact measures to help protect the health and safety of their communities, in March, we promptly implemented our business continuity plans, and quickly and successfully shifted all our employees to a work-from-home environment where they remain today. We have taken a number of steps to support our employees through this time, including flexible work arrangements and additional vacation days that are intended to allow them to spend time with family or to take care of personal needs, while the work-from-home period remains in effect. And in the midst of these trying times, we continue to bring on outstanding talent to add to our team. It is in uncertain times like these when our mission to help people achieve financial security becomes even more important. Please note that despite the challenges created by the pandemic, thanks to the incredible adaptability and resilience of our employees, we remain steadfastly focused on our mission and strategy and on delivering for our partners, customers, and our shareholders. While the pandemic continues to impact the global economy, driving equity markets down, increasing volatility, and leading to historically low interest rates, we believe we are well positioned to weather the current downturn. On Slide 4 of our earnings presentation, we have provided a summary of certain potential ongoing impacts of the current environment on our business, which we currently believe are manageable. We entered this situation from a position of strength and we remain confident in our focused strategy. Finally, our balance sheet and liquidity positions are strong, and our investment portfolio is well diversified. The second topic I would like to cover is share repurchases. In 2020, through May 8th, we repurchased approximately $316 million of our common stock, representing over 12% of our shares outstanding relative to year-end 2019. This was a significant value-creating action for our shareholders. And since the announcement of our first stock repurchase authorization in August of 2018, we have repurchased a total of approximately $864 million of our common stock through May 8th of this year, a reduction of more than 22% of our shares outstanding from the time we became an independent public company and well ahead of our initial expectations. Now you have heard us use the word prudence many times. And given the unprecedented market environments in which we are operating, we are temporarily suspending repurchases of our common stock. We will continually evaluate our repurchase program and we'll resume repurchases of our common stock as circumstances warrant. Importantly, our target of returning $1.5 billion of capital to our shareholders by year-end 2021 remains in place. Now, let me turn to first quarter results. Our key highlights for the quarter are summarized on Slide 5 of our earnings presentations. First, we continue to prudently manage our statutory capitalization. Our hedging program performed extremely well in the first quarter of 2020. Importantly, we estimate that our combined risk-based capital or RBC ratio was 515% to 535%, even though we paid a $300 million ordinary subsidiary dividend to the holding company in the quarter. Ed will provide more details on statutory results shortly. Second, we had very strong sales in this quarter. Annuity sales were approximately $2 billion, up 15% compared with the first quarter of 2019. Additionally, we generated approximately $16 million of life insurance sales in the first quarter of 2020, ahead of our expectations and up 33% compared with the fourth quarter of 2019, driven primarily by SmartCare. I am very pleased with our sales results in the first quarter and the transition our teams made, moving from a face-to-face model to a virtual model in order to connect with and remain in front of financial professionals. And we remain focused on supporting our financial professionals and their clients during these times. Looking forward, it probably does not surprise you that the current market environment is a headwind to near-term sales of annuity and life insurance products for the industry and for Brighthouse. As a result, it may be challenging to generate sales growth in annuities for this year, coming off of a very strong 2019. With respect to life insurance, we launched SmartCare last year, and have been focused on building relationships with firms and advisors. Obviously, that becomes more challenging in a virtual world and may have an impact on the timing of when we achieve our life insurance sales targets. However, it is clear that our plan for 2020 was achievable and that gives me great confidence with respect to our strategic goal for life insurance going forward. Even though we will be facing headwinds, we are laser-focused on growing our life insurance business. As I said previously, rising healthcare costs, unforeseen healthcare needs, and insufficient income in retirement are pervasive retirement concerns for Americans. And we believe Brighthouse Financial is well positioned to help people achieve financial security and help address retirement concerns over the long-term. Third, let me turn to total annuity net outflows, which were approximately $900 million in the quarter, down from both the first quarter of 2019 and down sequentially. As we’ve said previously, we expect to see a continued shift in our business mix profile over time, as we add more cash flow generating and less capital intensive new business, coupled with the runoff of less profitable business. Fourth, corporate expenses, which do not include establishment costs, were $214 million in the first quarter, consistent with our expectations. We remain committed to reducing corporate expenses by $150 million on a run rate basis by the end of this year, and by an additional $25 million in 2021. Finally, we continue to make necessary investments in our technology infrastructure, and in our business. We refer to these investments as establishment costs. In the first quarter establishment costs were approximately $18 million before tax. We continue to believe establishment costs will be around $150 million to $160 million in 2020 and $25 million to $35 million in 2021, both on a pre-tax basis. As I’ve said before, we are being prudent in how we are managing our way through our expected final couple of years of TSAs. These TSA exits and associated systems transitions put us one step closer to our future state operating platform. To wrap up, I want to thank our employees for the dedication and resilience they have shown in the face of this unprecedented situation. As a result of their adaptability and commitment, we are able to continue to support our customers and financial professionals, both now and into the future. Our balance sheet and liquidity positions are strong and we expect them to remain strong even in the midst of a stressed market. We continue to believe we have the right strategy in place to deliver long-term shareholder value. And we believe that we are well positioned to continue the execution of our strategy. I'll now turn the call over to John Rosenthal, our Chief Investment Officer, who will provide an overview of our investment portfolio, as well as details on several asset sectors of interest.

Thank you, Eric. Let me start by saying that we believe our investment portfolio is well positioned for a downturn as we have a very well diversified high-quality portfolio. We've been preparing for a turn in the cycle since early last year and adopted a more conservative investment strategy as a result. This included limiting new investments into cyclical and weaker investment-grade credit, no longer allocating new money to below investment-grade credit, and reducing the portfolio's exposure to the below investment-grade credit sector, as well as higher-risk investment-grade positions. Let's start on Slide 6 of the presentation, which provides an overview of our investment portfolio. As you will see, this is a very good story. At March 31st, we had approximately $105 billion of total investments excluding cash and cash equivalents on a GAAP carrying value basis. The pie chart on the left illustrates the level of diversification and demonstrates that we are not overly concentrated in any one asset class. The chart on the right illustrates the ratings distribution of our fixed maturity securities portfolio. Approximately three-quarters of the investment portfolio is fixed maturity, of which roughly 96% is investment grade. With that as a backdrop and given the current environment, I want to provide some perspectives on specific asset sectors, both corporate credit and commercial mortgage loans that may be more exposed to COVID-19 risk. Overall, this is a good story for us, what we believe to be manageable exposure. Turning to Slide 7 in corporate credit. On a book value basis, we had approximately $108 billion of total investments, including cash and cash equivalents. We have a high-quality credit portfolio with about 93% rated investment grade at the end of the quarter. Importantly, our corporate credit allocation of approximately 40% of total investments is low relative to the industry, which we believe is an important distinction during an economic downturn. Over the last several years, we've been putting more of our new money to work in private corporate, which we believe these assets will generally perform better in a downturn, due primarily to the structural protections. These assets accounted for more than 25% of our corporate credit portfolio at the end of the quarter. Our exposure to sectors we believe likely to be more impacted by COVID-19, including energy, retail, leisure, metals, autos, and airlines was approximately $6.3 billion at March 31st or less than 6% of our total investments. As I’ll discuss shortly, most of this exposure is to higher-quality energy and retail credits. From the $6.3 billion, only $3.1 billion or approximately 3% of our total investment had NAIC 2 rating for publics or below investment-grade ratings for publics and privates. So again, a very good story with what we believe are manageable exposures. I'd like to now provide a little more detail about our holdings in the energy and retail credit sectors, as well as our retail and hotel exposure that we have in our commercial mortgage portfolio. Moving to Slide 8, we’ve provided an overview of our $2.8 billion energy exposure at March 31st. Overall, our exposure is higher quality with 67% rated BAA2 or higher and 88% rated investment grade. Approximately 50% of our energy holdings are midstream energy companies, which is generally less volatile as a result of having less commodity price risk and contractual cash flows. Our integrated energy company holdings, which accounted for another 16% of our energy sector exposure had an average rating of high A at March 31st. Finally, we believe that our independent exploration and production company exposure is manageable at slightly less than $600 million or about 20% of our energy holdings at March 31st. Of this $600 million, only about 30% is rated below investment grade. Our $1.7 billion retail exposure related to corporate credit at March 31st is detailed on Slide 9. Almost two-thirds of these holdings were retailers. This exposure is high quality with 96% rated investment grade. In fact, our top five corporate retailer exposures are Walmart, Home Depot, Lowe's, Walgreens, and Target which together accounted for about 50% of this exposure and had a weighted average rating of single A at March 31st. Importantly, we had no direct department store exposure. The remaining one-third of our holdings is retail real estate investment trusts. These holdings are geographically diversified and highly rated. Before turning the call over to Ed, let me touch on our commercial loan portfolio. In total, our commercial loan portfolio was approximately $9.5 billion as of March 31st. Overall, we believe that our commercial mortgage portfolio is well diversified across vintage, geography, and property type. It is also high quality with an average loan-to-value of 53% at March 31st. The two subsectors that we believe will be most impacted by COVID-19 are retail and hotels, and are summarized on Slide 10. Like our overall portfolio, these mortgages have strong credit metrics. Our retail commercial mortgage loan exposure was approximately $2.1 billion, covering 70 loans. These are high-quality assets with strong sponsors and located in affluent markets. Our hotel commercial mortgage loan exposure was approximately $923 million covering 22 loans. These assets are also well diversified geographically and are generally located in prime areas with major brands. To summarize, our overall investment portfolio is high quality and well diversified and we believe our exposure to asset sectors likely to be more impacted by COVID-19 is manageable. With that, I'll turn it over to Ed to discuss our financial results.

Thank you, John, and good morning, everyone. I hope you're all staying safe and healthy. I would like to start by repeating something I said on our March business update call. Prudence and flexibility are two words you will hear frequently from us and recent market movements were a reminder of the value of both for a financial services company. Because of our focus on prudence and flexibility, we entered this challenging environment with a strong statutory balance sheet and a material reduction in our equity market risk profile. And as I believe our first quarter results illustrate, we have maintained a strong capital and liquidity position despite the steep decline in equities and interest rates in the first three months of the year. I will begin my prepared remarks with comments on our statutory results. I will then discuss holding company liquidity and share repurchases and finish with comments on adjusted earnings. At the end of the quarter, combined statutory total adjusted capital or TAC was $7.2 billion, down from $9.7 billion at year-end 2019. There were three primary drivers of the change from year-end. First, an increase in variable annuity or VA reserves as a result of the decline in equity markets and interest rates, which was only partially offset by the benefit from hedge gains and lower reserves for our Shield annuity products. Second, a $300 million ordinary dividend paid from Brighthouse Life Insurance Company or BLIC to the holding company. And third, unfavorable results for our non-variable annuity business. It is important to point out that we expected VA reserves to increase substantially in an environment like we experienced in the first quarter, and that this increase will have a negative impact on total adjusted capital. As I said on our March 5th business update call, and as also discussed in our 2019 10-K, the impact on total adjusted capital could be greater than our maximum loss target for our hedging program. But if it was, we would expect a substantial offset in required capital, which would diminish the impact on the RBC ratio. This is how VA reform works and exactly what we saw in the first quarter. We estimate that our combined RBC ratio was in the range of 515% to 535% at March 31st. This compares to 552% at year-end 2019, and includes an approximately 20 point negative impact from the $300 million ordinary dividend paid by Brighthouse Life Insurance Company in the quarter. We had a normalized statutory loss of approximately $800 million in the first quarter. However, we did not use any of our up to $500 million first loss position, which is the revised hedge target we discussed with you on our fourth quarter earnings call and the March 5th business update call. Gains on our previously out of the money interest rate hedges fully offset the negative impact of other market-related items. Approximately two-thirds of the normalized statutory loss was attributable to increased volatility in tax liabilities associated with our adoption of VA reform. We view this impact as non-recurring, as we have incorporated this into our hedging program going forward. The remaining one-third of the loss was driven by non-variable annuity results below the level seen over the last two years, which was a function of unfavorable mortality, and an impact from low interest rates on our market value adjusted annuity book. To summarize, our hedging program performed extremely well during a challenging market environment. Our total asset requirement for variable annuities at CTE98 increased by $8.1 billion in this quarter or almost 90%, but this was more than offset by an $8.3 billion increase in our variable annuity assets. The real test of hedge effectiveness is during a stressed market environment. And we believe that an $8.3 billion increase in assets relative to an $8.1 billion increase in asset requirement suggests a very effective hedging program. Success on variable annuity risk management is the key reason that we are reporting an RBC ratio in a stressed market environment that is well above our long-term target of 400% to 450% in a normal market environment. I'd now like to discuss our holding company liquidity. We ended the first quarter with holding company cash of approximately $1 billion or almost 5 times annual fixed charges. Since the end of the first quarter, the holding company received an additional $500 million dividend from Brighthouse Life Insurance Company. So, even after considering the shares of common stock repurchased in the second quarter to-date, we would anticipate a significant increase in holding company cash at the end of the second quarter. Looking forward, we will continue to emphasize prudence and flexibility when evaluating dividend plans from our operating subsidiaries, including the $450 million remaining of our 2020 planned Brighthouse Life Insurance Company dividend of $1.25 billion. Also, as a reminder, we expect more than $200 million of annual inflows to the holding company before consideration of any operating company dividends, which covers most of our holding company fixed charges. Additionally, we have a robust liquidity stress testing framework that helps ensure we maintain the liquidity necessary to support our business. We comfortably exceed our liquidity coverage targets under a scenario-based analysis, which includes a capital stress scenario similar to the 2008 financial crisis, as well as a spike scenario for interest rates in equity markets. I'd now like to take a moment to talk about our common stock purchases. We have taken significant action to create value for our shareholders. As Eric mentioned, in the year-to-date through May 8th, we repurchased $316 million of common stock at an average price of $24.26 per share, representing over 12% of our shares outstanding relative to year-end 2019. Approximately 84% of the 2020 repurchase amount as of May 8th was completed after our March 5th business update call at an average price of $22.51 per share. As you heard from Eric, we have temporarily suspended our repurchase program and we will exercise prudence as we continually assess when to resume share buybacks. Moving to adjusted earnings, last night we reported first quarter adjusted earnings, excluding the impact from notable items of $273 million, which compares with adjusted earnings on the same basis of $265 million in the fourth quarter of 2019 and $259 million in the first quarter of 2019. There were two notable items in the quarter, which decreased adjusted earnings by $62 million. The notable items on an after-tax basis were; a $48 million unfavorable impact to runoff related to a reinsurance recapture and a one-time adjustment from the transition to a new vendor and establishment costs of $14 million in corporate and other. Sequentially adjusted earnings less notable items were driven by lower corporate expenses in the first quarter, along with favorable net investment income, partially offset by unfavorable market impacts, and an unfavorable underwriting margin. Starting with corporate expenses: Corporate expenses were $214 million, down approximately $69 million compared with the fourth quarter. As Eric mentioned, we remain committed to reducing corporate expenses by $150 million on a run rate basis by year-end 2020 and an additional $25 million of corporate expense reduction in 2021. Moving to investment performance, net investment income increased sequentially. Alternative investment returns were 3.7% in the first quarter, which compared with 2% in the fourth quarter. Keep in mind that alternative returns this quarter reflected the favorable market returns in the fourth quarter of last year, as alternatives are reported on a one-quarter lag. Given equity market performance in the first quarter, we expect second-quarter alternative returns to be negative, but it's too early to provide a meaningful estimate. Also, we continue to see asset growth, which contributed to the positive sequential change in net investment income in the quarter. Turning to market performance, separate account returns were negative 14.3% in the quarter, driven by the significant decline in the stock market. Separate account return performance drove an increase in DAC amortization for variable annuities and life insurance, along with an increase in VA reserves. However, the increase in VA DAC amortization was offset by lower Shield DAC amortization. Moving on to our life insurance businesses, sequential results were impacted by unfavorable underwriting, which was driven by higher severity of claims in the first quarter. Claims frequency was relatively flat compared with the fourth quarter of 2019, but above historical levels. While the data we've seen does not suggest a significant impact from COVID-19 to-date, cause of death reporting isn't perfect. In addition, there is still uncertainty around timing of the first U.S. infection and death related to this pandemic. Turning to adjusted earnings at the segment level, starting with annuities, adjusted earnings excluding notable items were $316 million in the quarter. DAC amortization and expenses were lower sequentially, which had a favorable impact on earnings. This was partially offset by higher reserves and lower fees. Life segment adjusted earnings excluding notable items were $11 million in the quarter. Sequentially, results were impacted by higher claims and higher DAC amortization, partially offset by lower expenses and higher net investment income. The Run-off segment reported adjusted loss excluding notable items of $22 million in the quarter. Sequentially, results were driven by higher claims partially offset by alternative investment income. Sequentially, Other had an adjusted loss, excluding notable results were driven by lower expenses. Overall, I am very pleased with our results this quarter. We have a strong capital and liquidity position and we continue to emphasize prudence and flexibility as we manage the balance sheet to protect the franchise through stressed markets. With that, we'd like to turn the call over to the operator for your questions.

Our first question for Erik Bass, Autonomous Research. Your line is now open.

How should we think about the future dividend capacity from BLIC as well as the captive and then how this is affected by the recent equity market and interest rate movements? And related to that, can you just provide an update on assigned surplus as of March 31st?

Yes. Good morning, Eric, it's Ed. I would like to refer you back to the March update call when we discussed our potential dividend capacity, or distributable earnings, in a bear scenario. We mentioned $1.3 billion. To date, we've taken $800 million out of BLIC. Over the coming months, we will evaluate what to do with the remaining $450 million. We have not taken the usual dividend from NELICO, which is not a very market-sensitive business and is more of a runoff block with more predictable dividend capacity. Regarding BRCD, we were pleased to receive the $600 million dividend at the end of last year. As we mentioned, that did not affect our near-term dividend plans, which we will review over time. In terms of BRCD's capitalization, we are well hedged for low rates, and our cash flow testing margins at significantly lower rates than today remain similar to those in our base scenario for BRCD. Therefore, we feel positive about BRCD's cash flow testing margins, which inform our view of its capitalization. Lastly, for unassigned funds, our estimate is slightly more than negative $100 million at the end of the first quarter. As you know, this does not affect this year's dividend capacity, which is based on year-end 2019 capital unassigned funds and prior year operating gains.

Got it. Thank you. And then moving to just the operating earnings, can you just provide a little bit more details on the movements in annuities and the interplay between Shield and the legacy VA block? And how should we think about the equity market sensitivity of your earnings going forward relative to I think the $0.07 to $0.11 per kind of 1% move in separate account returns that you’ve given previously?

Sure. We're currently reevaluating the sensitivity, but I don't have a new guideline to share. It's different from our previous assumptions and is largely influenced by the growing significance of Shield in our total in-force book. If you recall from our business update call, we mentioned that Shield's share of our annuity block increased from around 2% in 2016 to 11% by the end of 2019. In the last quarter, while we faced a negative DAC impact from our VA block, we experienced an even larger positive DAC effect from our Shield block. To help clarify how to approach DAC amortization moving forward, I'd like to point out a couple of things. First, the average DAC amortization for the annuity segment over the last five quarters is approximately $103 million per quarter when adjusting for the third quarter assumption update. In the first quarter of this year, the amount was $38 million. So, you can see the difference between that five-quarter average and $38 million reflects the net positive impact of Shield compared to the net negative effect of the VA DAC. Additionally, while we are still investigating, it seems that the negative impacts we observed for Shield throughout 2019 are not significantly different from the positive impact we noted in the first quarter. This makes sense considering that our separate account returns for the full year 2019 exceeded our baseline by roughly the same margin by which they fell short of the baseline in the first quarter.

Our next question comes from Tom Gallagher with Evercore. Your line is now open.

Eric, first question is, just want to get a little more behind the thinking of the decision to be aggressive with buyback kind of in the earlier part of the second quarter getting to almost $200 million and then deciding to pause. Was that just the opportunity where you saw the value and maybe just a little more color behind the pause versus deciding over the last month and a half to be more aggressive?

Hi, Tom. You’ve kind of got it. Let me flesh it out a little bit. Look in a nutshell maybe, we came into this situation with the flexibility to buy, which we did and now we have the prudence to pause. So we knew we were well positioned coming in with respect to capital and liquidity. As a result of all of our stress testing, we also felt good about buying back roughly the amount of stock that we bought through early May. Now, obviously, this was a value-creating exercise for our shareholders. But having repurchased what we sort of said we wanted to, we feel it's appropriate to pause at this point just to survey the economic, market landscape, et cetera, over the coming months, and see where we're at. We're going to be constantly monitoring this. So it's pretty straightforward what we’re able to do.

Sure, Eric, there was nothing new that you sound out within the last week or so that has changed your view. Really, it's just a matter of let’s say the opportunity and now having done a lot taking a pause. Is that a fair way of describing it?

Yes, there's nothing new or unusual here, and you're likely hearing similar sentiments from various companies. We're pleased to have conducted our share buybacks at favorable prices. Right now, we're taking a break, much like many other companies, to assess the current economic situation. Ed, do you have anything to add?

Yes, I would like to emphasize that the amount of stock we repurchased was over 12% of our outstanding shares at the end of 2019. It's important to mention this figure, as it represents a significant portion compared to what we would typically consider a normal pace. The fact that we were able to invest as much money as we did to buy back more stock than we initially anticipated for the entire year is noteworthy.

Can you provide some perspective on your updated view regarding consolidated excess capital? On one hand, your RBC remains solid and steady when you adjust for the dividend. However, on the other hand, excess capital is related to a percentage of TAC, which has decreased by 25%. There are some nuances to consider here. What is your view on the updated excess capital at the company level?

Thank you, Tom. Let me take a moment to discuss the changes in total adjusted capital that you mentioned. As I noted earlier, we have been examining the disconnect between the total adjusted capital movement and our first loss position in relation to our hedge target. I've addressed this in my previous remarks and on our recent business update call, as well as in our 2019 10-K filing. This has been an indication of what could happen in a situation like the one we experienced in the first quarter, which indeed occurred. It's important to remember that we manage according to a total element of variable annuity reform, which we adopted at the end of 2019, and the reserves play a crucial part in this reform. When markets decline, there tends to be a shift from capital to reserves. An adverse event that was previously reflected in capital becomes an actual adverse event now shown in reserves. Consequently, you do not need to allocate capital against it, resulting in a decrease in required capital. Therefore, it's essential to consider the RBC ratio because the changes in total adjusted capital and required capital together relate directly to our first loss position. You referenced the ending RBC ratio of 515 to 535, which is essentially unchanged from the end of the previous year after accounting for the dividend adjustment of about 20 points. As we see the rebound in the market during the second quarter, this may lead to an increase in total capital, which typically would increase required capital due to the dynamics we've discussed. However, total adjusted capital will fluctuate based on market conditions. It’s not surprising that a bear market would negatively impact total adjusted capital, but if there is a market reversal over time, total adjusted capital should respond accordingly.

Our next question comes from Elyse Greenspan with Wells Fargo. Your line is now open.

My first question, can you just give us a sense of the macro environment or sort of sensitivity that you’d need to see for that remaining $450 million?

Good morning, Elyse, it's Ed. We won't dive into specific factors affecting our decision regarding the remaining $450 million. Given the uncertain environment, we're prioritizing caution, prudence, and flexibility. We plan to monitor how the rest of the year unfolds before deciding on the remaining funds. After securing $800 million, even accounting for the buybacks we conducted in the second quarter, I mentioned that we expect a significant rise in holding company cash. Our best estimate puts it around $1.3 billion by the end of the second quarter. We're optimistic about our current position at the holding company and will evaluate the second half of the year before making a final decision.

As we think about life insurance sales, you called out some kind of headwinds there. Can you just help us think about levels of sales that you could see for the balance of the year given just got COVID related headwind?

Yes, hi. Good morning, it’s Myles speaking. So, as Eric mentioned earlier on the conversation, we do expect to see an impact on life sales. And if you really think about our life franchise, it was very much in startup mode. We began to bring on distributors selling the product last May and that really continued on through October. So the distributor that we're working with, they’re really new to selling the product, the life insurance teams have been highly focused on establishing relationships with advisors. And they were doing that very successfully. And I think you can look to our results over the last several months to see that. But because the base of advisors is still relatively new, because we’ve just started selling the product not even quite a year ago, it's going to be difficult for our life insurance wholesalers to prospect in this environment as they work remotely. But our strategy was absolutely working and we remain committed to our distribution strategy which has proven to be successful. And we look forward to getting back to more of a normal environment where we could start to grow sales again.

I'll just jump in for one second too. So I just got to say, a shout out to all of our wholesalers and the advisors that they work with, they have been tremendous, taking care of their clients, and we're taking care of them. This is an important business for us. It was very exciting to see the results develop in January, February, March in the life business. And look we're just going to keep pushing. It's not like we're not in a virtual environment, where we're not talking to financial advisors. We're talking to them all the time. And they're trying to take care of their clients. But I do think it's fair to say that, that we'll have a little slowdown here. But the overall targets and the strategy of getting back into the life insurance business from a new sales perspective is unchanged.

Our next question comes from Ryan Krueger with KBW. Your line is now open.

From the lower expected sales activity this year, do you expect I guess any material amount of additional capital generation due to that?

Hi, Ryan, it's Ed. So, I don't think we want to put a number on anything like that right now. I think, you recall that at our business update we talked about the sort of the strain from new business on our distributable earnings and we had said it might be in the neighborhood of $400 million, and that over time, that obviously flips. But we're not going to get into any specifics around how that might change going forward.

It's Eric. I'll just add one thing. Look, it might end up that we do free up a little capital because it's not used to back new sales. But we want to sell. We want to be there for advisors and their clients. So, I think as we move farther down the road in the year here, we can give you a number if that materializes. But frankly, I'd like to get back to selling as quick as possible.

Ed, you mentioned an RBC sensitivity to equity markets down 25%, with interest rates at 1% in credit, which totals about 100 points of RBC. Can you clarify how much of that is attributed to credit versus markets and interest rates so we can analyze them individually?

Yes, sure, Ryan. So I'll start and then I'll pass it over to John for some more color. But in our business update call, we provided the stress and it included, as you said, equity market shock, interest rates down and credit losses of migration. So, we obviously saw two of the three occur in the first quarter. As I'm sure you're not surprised there was a very minimal impact in the quarter from impairments and credit migration. But I guess what I would say is that with two of these three items playing out in the first quarter, and standing up at 515 to 535 RBC ratio and holding company cash at $1 billion, I think it's fair to say that we have the cushion to absorb the losses that we had anticipated when we gave our business update, as well as something beyond that if you want to overlay some more stress type of scenario. So, I'll pass it over to John now to maybe provide some specifics on what we had talked about in terms of the impact back in March.

Ryan, I want to remind you of the assumptions we applied to the March data. We estimated corporate credit losses based on actual experiences from the financial crisis, particularly using Moody's data from 2008 to 2010 concerning migrations and defaults. For structured finance, we relied on projections from our external managers, who provided their best estimates of expected losses and migrations in such scenarios. Regarding our mortgage loan portfolio, we utilized data from 1990 to 1993 to assess potential shocks to our loan-to-value ratios, which help inform expected credit migration losses. In response to your question, this stress scenario for credit losses and migration would likely result in about a 50 percentage point effect on the Risk-Based Capital over a two-year period.

Thank you. Our next question comes from Humphrey Lee with Dowling & Partners. Your line is now open.

Good morning. Thank you for taking my questions. I was wondering if you can provide some updates on kind of interest rate sensitivity, especially in the sub 1% 10-year environment. I think in the Business Update call, you kind of stopped at 1%. How should we think about in the sub 1% environment?

Yes, hi Humphrey, it's Ed. Let me discuss what we experienced in the quarter and provide some qualitative insights. The reason we didn't utilize any of our first loss position concerning our hedge target in the first quarter is due to significant gains from our previously out of the money interest rate protection, which offset the negative impacts from the markets. We have previously mentioned our substantial out-of-the-money protection for interest rates, and it has proven to be very valuable in the current environment. Furthermore, we demonstrated in our business update that we benefit from higher interest rates and improved separate account returns, as shown when comparing our base scenario to the scenario with lower separate account returns and interest rates. I won't provide an update on distributable earnings numbers related to the 10-year treasury at around 70 basis points. However, I can say that we feel optimistic about our current capital position and the interest rate protection we possess, as well as the gains it has yielded. We'll need to see how the markets evolve moving forward, especially in this uncertain environment.

That's helpful. And then just to follow on you early comment about you feel very comfortable with the cash flow testing margins in a low rate environment, should I kind of take that as, you don't expect any meaningful kind of statutory impact on capital from the current interest rate environment or is it just simply it's pretty manageable. Like how should we think about that?

Yes, let me clarify my comments regarding BRCD, our life insurance captive. The cash flow testing margin, which is crucial for assessing the capitalization of that entity, remains very strong, even with rates significantly lower than what we currently have. This is an important aspect of our life block. As for overall cash flow testing margins, I won’t ahead of our fourth quarter cash flow testing process. Last year at year-end, we were fine. Regarding the third-quarter assumption update or fourth-quarter cash flow testing, it’s not prudent to speculate at this time. There is a significant amount of work involved in calculating those impacts, and we will have to wait until the second half of the year to share more details.

Thank you. Our next question comes from Alex Scott with Goldman Sachs. Your line is now open.

I would like to follow up on the total adjusted capital and the excess capital. When I was evaluating the quarter, I focused on the amount of total adjusted capital you have beyond what is necessary to meet your targeted minimum levels for risk-based capital. My calculations show a decline quarter-over-quarter, which I don't find surprising. However, I'm trying to reconcile that with your statement about the first loss position remaining intact. Is there a difference in how you approach managing capital and your excess capital that I should consider?

Hey Alex, it's Ed. The first thing I want to mention is that we adopted VA reform at the end of 2019. The framework for VA reform includes a total asset requirement. As I pointed out earlier, there's a shift between capital and reserves based on the market environment. Since you're technical, let me delve deeper. When adverse market events occur, which we experienced this quarter, there’s a convergence between CTE70 reserves, which form the basis for VA reform reserves, and CTE98, the basis for capital under VA reform. This convergence happens because CTE70 does not account for potential adverse events as thoroughly as CTE98. To emphasize this, if we consider the average outcomes of the 30% worst scenarios, the average is actually not too bad overall. For example, if we hadn't hedged, our CTE70 reserves would be lower than they currently are. This is due to hedging acting as a cause rather than a benefit when examining the average of the 30% worst scenarios. Looking at this quarter, when potential adverse events materialize, your CTE70 reserves increase because the average of that 30% isn't particularly concerning. Thus, when a real event occurs, the rise in CTE70 is greater than that of CTE98. This situation is consistent with what others will face when managing their businesses under a CTE framework. As a reminder, for a pure VA company under VA reform, CTE98 equates to a 400% RBC ratio. I understand your concerns regarding the shift in TAC between capital and reserves. However, when considering total asset requirements and managing the risk of this business, I believe looking at changes in the RBC ratio is more indicative of a first loss concept than focusing on any individual component.

I have a follow-up regarding the credit stress. I believe that the total adjusted capital suggests credit losses may consume a larger portion of your go-forward TAC as of March 31. Were the credit stresses noted as of year-end or as of March 31, and do they significantly affect the sensitivity to credit losses, impairments, or downgrades?

Hi, it's John. The stresses were based on our December 31 portfolio. Things haven't changed much since then, and I would say that a greater proportion of the use of capital is actually coming from downgrades rather than losses, probably something in the range of 55-45.

And our next question comes from Andrew Kligerman Credit Suisse. Your line is now open.

I find it intriguing that the first dollar loss of $500 million hasn’t been utilized. With the equity markets recovering, it appears that you may not reach that threshold. What scenario do you think might lead to its activation? Additionally, could you clarify your hedging effectiveness in the first quarter with regard to variable annuities?

Hey Andrew, it's Ed. You cut out a little bit on the second part of your question, I wonder if you could just repeat that.

Yes. Given that you never utilized the first loss of $500 million, could you outline a situation where that might happen? Also, regarding hedging effectiveness, could you quantify that? I recall you mentioning that about two-thirds of $800 million and possibly a bit over $500 million represented the statutory loss. Was that the hedging effectiveness?

Yes. Okay, Andrew. So let me start with this hedge effectiveness question, because I know a number of people talk about this, and I find it fascinating because I think the real measure of hedge effectiveness occurs, I think, relatively infrequently. And it occurs in a quarter like we saw that we just lived through. So just to restate what I had commented on in my script, our total asset requirement at CTE98 was $9.4 billion at the end of 2019. That number went up to $17.5 billion at the end of the first quarter. So we had an $8.1 billion increase in CTE98. This is the quarter when you assess hedge effectiveness and the fact that the combination of our derivative gains, which were $5.3 billion, our benefit from the Shield product which was $2.5 billion, and our VA product cash flows, which was a $0.5 billion, you had an $8.3 billion increase in variable annuity assets before the dividend. So, I mean I don't know how people calculate percentages, but I would say if your total asset requirement goes up by 90% and its $8.1 billion increase and your VA assets go up by $8.3 billion that's a pretty effective hedge program.

Sounds good.

Part two; the first loss. I noted that we experienced significant gains from our interest rate protection. If interest rates were to rise again, some of those gains could diminish. However, I don't believe anyone would be opposed to seeing interest rates increase, so it's not necessarily a negative development. Additionally, I want to clarify that this target of up to $500 million first loss is just that—it’s up to $500 million. We have not specified an exact target, but I think we are quite satisfied with how things unfolded in the first quarter.

Yes, it sounds like you're in a very strong position there. And maybe lastly on that reinsurance recapture $48 million, you know a lot of companies saw that spike up a few years ago. I think we saw Lincoln recently do a recapture. What's your sense going forward? Is there any major risk that you may have to recapture on any other individual life treaties or do you think that's it? Yes, hi Andrew. We have encountered some of these situations. It's difficult to predict what others may arise in the future. When they do, we need to make decisions based on the best economic outcome. In this case, the right choice was to recapture. Unfortunately, I can't provide specific guidance on how to interpret that. Regarding the $48 million you mentioned, it's important to note that not all of it was from the reinsurance recapture. There were two components included in that figure; one was linked to a TSA exit and a vendor change, meaning the reinsurance recapture was approximately two-thirds of the $48 million total. This gives you a bit more context on the matter.

Hey Andrew, it's Conor. Let me just add a little context. The recapture, it's a little over 1% of the ULSG in force and it's about 0.25% of the overall in force block of over a million policy. So it's not a significant amount in the context of the overall in force.

Thank you. Ladies and gentlemen, I will now turn the call back over to Mr. Steigerwalt for any closing remarks.

Thanks everybody. So, hopefully, you got a sense here. You know, we entered the current climate from a position of strength. Our balance sheet and liquidity position are strong and we expect them to remain strong, even in the midst of the stressed markets. Our overall investment portfolio is high quality and well diversified. As you heard today, our hedging program performed extremely well during a challenging market environment. And we continue to believe we have the right strategy in place and we're going to execute on that strategy. So I hope you and your loved ones stay safe and healthy, and we look forward to talking with you again.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.