Unfavorable change in divested businesses of $861 million ($618 million, net of income tax)
Post-Separation, we are well-positioned in less volatile and fee-based businesses; as a result, we expect our results to be less sensitive to interest rates. Assuming interest rates follow the observable forward yield curves as of the year ended December 31, 2018, we expect the average ratio of free cash flow to adjusted earnings over the two-year period of 2019 and 2020 to be 65% to 75%, assuming a 10-year U.S. Treasury rate between 2.0% and 4.5%. We believe that free cash flow is a key determinant of common stock dividends and common stock repurchases.
Significant items contributing to the changes to DAC and VOBA amortization in 2016 consisted of the following:
A decrease in amortization of approximately $180 million from net derivative losses from freestanding derivatives hedging the variable annuity guarantees.
An increase in amortization of approximately $110 million from the annual actuarial assumption update of the closed block.
Economic assumption updates resulted in net favorable changes in reserves and DAC of $38 million ($29 million, net of income tax).
U.S. Tax Reform. The changes from U.S. Tax Reform resulted in a decrease in adjusted earnings of $40 million for 2018 compared to 2017.
Business Overview. In connection with the Separation and the U.S. Retail Advisor Force Divestiture, we have discontinued the marketing of life and annuity products in this segment, which has led to lower revenues. This will result in a declining DAC asset over time and we anticipate an average decline in premiums, fees and other revenues of approximately 5% per year from expected business run-off. A significant portion of our adjusted earnings is driven by separate account balances. Most directly, these balances determine asset-based fee income but they also impact DAC amortization and asset-based commissions. Separate account balances are driven by sales, movements in the market, surrenders, withdrawals, benefit payments, transfers and policy charges. Separate account balances decreased primarily due to the impact of negative net flows, as benefits, surrenders and withdrawals exceeded sales, as well as equity market performance. Although we have discontinued selling our long-term care product, we continue to collect premiums and administer the existing block of business, which contributed to asset growth in the segment, and we expect the related reserves to grow as this block matures.
Underwriting, Actuarial Assumption Review, and Other Insurance Adjustments. Unfavorable mortality in our life businesses, partially offset by favorable underwriting, primarily due to the impact of favorable rate actions in our long-term care business, and mortality gains on life-contingent annuities, resulted in a $32 million decrease in adjusted earnings. Our annual actuarial assumption review resulted in a decrease of $56 million in adjusted earnings when compared to 2017. Changes in operational assumptions, including updates to closed block projections, maintenance and other expenses, were less favorable in the current period. Refinements to DAC and certain insurance-related liabilities that were recorded in both 2018 and 2017 resulted in a $23 million increase in adjusted earnings. This includes the following 2018 refinements: (i) a charge relating to an increase in our IBNR life reserves, reflecting enhancements to our processes related to potential claims; (ii) a favorable reserve adjustment relating to certain variable annuity guarantees assumed from a former joint venture in Japan; and (iii) two separate favorable reserve adjustments resulting from modeling improvements in our life business. This also includes the following 2017 refinements: (i) a favorable DAC adjustment related to certain assumed participating whole life business; (ii) two separate favorable reserve adjustments resulting from modeling improvements in our life business; (iii) an unfavorable adjustment related to the recapture and novation of, as well as adjustments to, assumed and ceded agreements covering certain variable annuity business; (iv) an unfavorable net impact from a life reinsurance recapture; and (v) an unfavorable reserve adjustment resulting from modeling improvements in our long-term care business.
Market Factors. Market factors, including interest rate levels, variability in equity market returns, and foreign currency exchange rate fluctuations, continued to impact our results; however, certain impacts were mitigated by derivatives used to hedge these risks. Investment yields decreased primarily due to declines in prepayment fees and derivative income, as well as lower returns on real estate joint ventures. These reductions in yields were partially offset by higher returns on other limited partnership interests, driven by improvements in equity market performance. In our deferred annuity business, higher equity returns drove an increase in average separate account balances which resulted in higher asset-based fee income. Adjusted earnings increased due to declines in DAC amortization. The changes in market factors discussed above resulted in an $8 million increase in adjusted earnings.
real estate risk, relating to commercial, agricultural and residential real estate, and stemming from factors, which include, but are not limited to, market conditions, including the supply and demand of leasable commercial space, creditworthiness of borrowers and their tenants and joint venture partners, capital markets volatility, changes in market interest rates, commodity prices, farm incomes and U.S. housing market conditions.
The majority of our RMBS holdings were rated Aaa/AAA by Moody’s, S&P or Fitch; and were designated NAIC 1 by the NAIC at December 31, 2018 and 2017. Agency RMBS were guaranteed or otherwise supported by Federal National Mortgage Association, Federal Home Loan Mortgage Corporation or Government National Mortgage Association. Non-agency RMBS include prime, alternative residential mortgage loans (“Alt-A”) and sub-prime RMBS. Prime residential mortgage lending includes the origination of residential mortgage loans to the most creditworthy borrowers with high quality credit profiles. Alt-A is a classification of mortgage loans where the risk profile of the borrower is between prime and sub-prime. Sub-prime mortgage lending is the origination of residential mortgage loans to borrowers with weak credit profiles.
Policyholder account balances in this segment are held largely for fixed income retirement and savings plans, fixed deferred annuities, interest sensitive whole life products, universal life and, to a lesser degree, liability amounts for Unit-linked investments that do not meet the GAAP definition of separate accounts. Also included are certain liabilities for retirement and savings products sold in certain countries in Asia that generally are sold with minimum credited rate guarantees. Liabilities for guarantees on certain variable annuities in Asia are accounted for as embedded derivatives and recorded at estimated fair value and are also included within policyholder account balances. A sustained low interest rate environment could adversely impact liabilities and earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We mitigate our risks by applying various ALM strategies and with reinsurance. Liabilities for Unit-linked investments are impacted by changes in the fair value of the associated underlying investments, as the return on assets is generally passed directly to the policyholder.
We offer a range of GMDBs to our contractholders. The table below presents GMDBs, by benefit type, at December 31, 2018:
Includes $422 million and $523 million of debt that is non-recourse to MetLife, Inc. and MLIC, subject to customary exceptions, at December 31, 2018 and 2017, respectively. Certain investment subsidiaries have pledged assets to secure this debt.
MetLife, Inc. maintains a commercial paper program, the proceeds of which can be used to finance the general liquidity needs of MetLife, Inc. and its subsidiaries. MetLife, Inc. had no short-term debt outstanding at either December 31, 2018 or 2017.
Other policy-related balances include policy and contract claims, premiums received in advance, unearned revenue liabilities, obligations assumed under structured settlement assignments, policyholder dividends due and unpaid, policyholder dividends left on deposit and negative value of business acquired (“VOBA”).
Effective January 3, 2017, the Chicago Mercantile Exchange (“CME”) amended its rulebook, resulting in the characterization of variation margin transfers as settlement payments, as opposed to adjustments to collateral. These amendments impacted the accounting treatment of the Company’s centrally cleared derivatives for which the CME serves as the central clearing party. As of the effective date, the application of the amended rulebook reduced gross derivative assets by $1.8 billion, gross derivative liabilities by $2.0 billion, accrued investment income by $101 million, accrued investment expense recorded within other liabilities by $14 million, collateral receivables recorded within premiums, reinsurance and other receivables by $991 million, and collateral payables recorded within payables for collateral under securities loaned and other transactions by $816 million.
Other invested assets is comprised primarily of freestanding derivatives with positive estimated fair values (see Note 9), tax credit and renewable energy partnerships, annuities funding structured settlement claims, leveraged and direct financing leases and operating joint ventures.
Changes in estimated fair value subsequent to purchase for investments still held as of the end of the respective periods included in net investment income were principally from Unit-linked investments, and were ($771) million, $662 million and $427 million for the years ended December 31, 2018, 2017, and 2016, respectively.
The Company purchases interest rate caps primarily to protect its floating rate liabilities against rises in interest rates above a specified level and against interest rate exposure arising from mismatches between assets and liabilities and interest rate floors primarily to protect its minimum rate guarantee liabilities against declines in interest rates below a specified level. In certain instances, the Company locks in the economic impact of existing purchased caps and floors by entering into offsetting written caps and floors. The Company utilizes interest rate caps and floors in nonqualifying hedging relationships.
Estimated fair value equals carrying value, based on the value of the underlying assets, including: mutual fund interests, fixed maturity securities, equity securities, derivatives, hedge funds, other limited partnership interests, short-term investments and cash and cash equivalents. Fixed maturity securities, equity securities, derivatives, short-term investments and cash and cash equivalents are similar in nature to the instruments described under “- Securities, Short-term Investments and Other Investments,” and “- Derivatives - Freestanding Derivatives.”
At both December 31, 2018 and 2017, independent non-binding broker quotations were used in the determination of less than 1% of the total net derivative estimated fair value.
Interest and dividend accruals, as well as cash interest coupons and dividends received, are excluded from the rollforward.
The Company’s Credit Facility is used for general corporate purposes, to support the borrowers’ commercial paper programs and for the issuance of letters of credit. Total fees associated with the Credit Facility were $10 million, $13 million and $15 million for the years ended December 31, 2018, 2017 and 2016, respectively, and were included in other expenses. Information on the Credit Facility at December 31, 2018 was as follows:
The only awards MetLife, Inc. granted under the 2015 Director Stock Plan and its predecessor plan, the MetLife, Inc. 2005 Non-Management Director Stock Compensation Plan (the “2005 Director Stock Plan”), through December 31, 2018 were Stock-Based Awards that vested immediately. As a result, no awards under the 2005 Director Stock Plan or 2015 Director Stock Plan remained outstanding at December 31, 2018.
The aggregate number of Shares authorized for issuance under the 2015 Director Stock Plan at December 31, 2018 was 1,660,961.
The Company’s binomial lattice model incorporates different risk-free rates based on the imputed forward rates for U.S. Treasury Strips for each year over the contractual term of the option. The table below presents the full range of rates that were used for options granted during the respective periods.
Reflects dividend amounts that may be paid by the end of 2019 without prior regulatory approval.
The weighted average expected rate of return on plan assets for use in that plan’s valuation in 2019 is currently anticipated to be 5.75% for U.S. pension benefits and 5.11% for U.S. other postretirement benefits.
U.S. other postretirement benefits do not reflect postretirement life’s plan assets invested in fixed maturity securities AFS.
The decrease in 2018 is primarily related to the non-cash benefit from the tax audit settlement discussed above.
Plaintiffs filed this putative class and collective action on behalf of themselves and all current and former long-term disability (“LTD”) claims specialists between February 2011 and the present for alleged wage and hour violations under the Fair Labor Standards Act, the New York Labor Law, and the Connecticut Minimum Wage Act. The suit alleges that MetLife improperly reclassified the plaintiffs and similarly situated LTD claims specialists from non-exempt to exempt from overtime pay in November 2013. As a result, they and members of the putative class were no longer eligible for overtime pay even though they allege they continued to work more than 40 hours per week. Plaintiffs seek unspecified compensatory and punitive damages, as well as other relief. On March 22, 2018, the Court conditionally certified the case as a collective action, requiring that notice be mailed to LTD claims specialists who worked for the Company from February 8, 2014 to the present. The Company intends to defend this action vigorously.