Changing the Rules

One of the nearly certain truths about investing is that the proverbial sandbox is shifting all the time. A value investment may turn into a growth profile investment, or vice versa. A long-term play may turn into a short-term special situation, etc.

Yesterday, Jackson Financial reported earnings. It’s an odd duck for many reasons, not limited to focusing on the VA sector, terribly confusing accounting, and a lack of comparables. A variable annuity (VA) is kind of like a mutual fund with an insurance policy. You’ll capture equity upside, but if things go south, don’t worry, we’ve got you covered.

Jackson is the market leader in this space, a niche that has been plagued by bad consumer sentiment due to high fees and product opacity. It likely wouldn’t exist but for the tax efficiency, as gains within a VA policy are generally sheltered, much like a 401(k). Alas, Jackson tends to perform well when equity markets go up more than usual, thereby reducing the likelihood that they will have to pay out on the downside insurance they provide. In contrast, they perform less well when equity markets underperform, and the burden they shoulder in guaranteeing certain minimum levels of returns/income increases. The trick is underwriting the right level of conservatism so that the company can pay out on these guarantees in bad times, but not so much conservatism that the pricing is uneconomical or unappetizing for the policy buyer.

Jackson is in a unique position at present as its current book of policies is deeply in the money. In other words, equity performance has exceeded what the company hoped for when it underwrote the policies. And not by a small amount.

As of the end of June, almost all of the 10,000 scenarios used in VM-21 were floored at the cash surrender value, which is further into the tail than we have ever experienced. 

In simpler terms, this generally means that even in the worst equity outcomes, Jackson generally isn’t paying out on its downside guarantees. However, the accounting regime it operates under from a regulatory perspective does not seem, at face value, to be designed for the situation Jackson currently finds itself in. Under the regime, Jackson is not receiving regulatory credit for rising equity markets and the decreasing likelihood of paying out on guarantees. In fact, the regime requires Jackson to put up more capital. The net result is the company having to uneconomically hedge against the scenario that the market continues to rise, something that logically should actually be what the company wants to happen (because it will have fewer guarantees to pay out).

Jackson revealed that it is in discussion with its home regulator about changing the accounting regime to better align with the economics of the business as it stands today. Conversations with regulators can notoriously drag on for years without producing any results. But one set of words has me thinking that perhaps there is an expectation that there will be some measure of capital relief as a base case:

So what we’ve been looking at is while we definitely want to provide as much insight and help others get the greatest amount of insight into the business, we do think that the best time to update those will be just after we get our solution in place with respect to the cash value floor so we have a clearer picture of how we think capital will emerge as we move forward under that solution. I think that will be a lot more meaningful, and it will be a good opportunity to refresh that information.

Essentially, they are delaying investor disclosure due to the expectation that there will be an updated accounting regime. While far from guaranteed, I personally view this probabilistically as a real scenario. In that vein, what can come of it?

Jackson has spent $500 million per year on hedging in the past when the book was in a similar state. They mentioned on the call that hedge spending is currently below guaranteed fees of roughly $750 million per quarter. Therefore, I would presume that since the level of moneyness in the book is at an all-time high, hedge spending is higher than $500 million and less than $3 billion. Any measure of regulatory relief that reduces the need to spend this uneconomical capital on upside protection to generate reserves is meaningful. With a market cap of $2.7 billion, saving half of the low end of $500 million in hedge spending is nearly 10% of its market cap annually. If hedge spending is $1 billion, one can ponder the potential amount of capital redirected to an excess bucket versus hedge spending.

As such, to return to the beginning, I view this situation as a value investment that has morphed into a hybrid special situation. Will something come of it? I don’t know for certain, but a new upside scenario has emerged with unknown but meaningful odds. As the company has guided for approximately $700-900 million in annual capital generation paired with roughly $500 million per year in capital returned to shareholders, one doesn’t have to make that bet, but rather just tuck it into a set of upside options.

In conclusion, most of this message has focused on the details of a medium-term event. It should go without saying that the trajectory of the core business is more important than any of this in the long term. Will Jackson’s anemic VA sales gain traction again? Will Jackson make a significant impact in the RILA market compared to its initial 5% share? These are the most important questions, but they are for another day.