Red Deer Investments

As the prior higher inflation prints are lapped, expected future inflation chart looks more visually settling:

While much ink is spilled about every change in inflation expectations, 10 year expectations are comfortably below 3%. We’ll see if that is the reality we experience in light of a very hot economy in 2024.

Investment income for the quarter was down 8% vs the prior year, a trend we will see throughout this year due to one time catch up dividends issued in 2023 along with sales of investments that currently sit in cash. For the full year I’m projecting investment income to be down 10%.

However, on a two year basis (2023-2024), 1Q24 income is projected to be up 22% or 10.5% annualized. I’m projecting investment income to be 12.5% from the start of 2023 to the end of 2024 or ~6% annualized over two years.

Inflation was ~2.8% in 2023 (PCE), and the Federal Reserve expects it to average 2.4% in 2024 – so roughly 2.6% annualized. Our ~6% expected annualized income increase thus theoretically provides a respectable 3.4% real return over these two years.

On a more granular basis, NAV was up materially, reducing the yield of the portfolio. While paper mark-ups feel nice, anchoring to income provides a more sober view of performance. Moreover, we had one loss that was crystallized in 1Q24 that was particularly painful.

We owned a complicated financial company of which the simple thesis was that there would be a cyclical recovery in M&A volumes. That has indeed started happening but unfortunately this is was not the vessel with which I should have expressed this view. The company took on accounting related issues and became a magnet for short selling. While unforeseen downside events are a part of investing, not moving on immediately when the situation shifted well outside my narrow lane of competence was a mistake. While this was not a large core position, any loss hurts and I aim to not repeat the same mistake in the future.

Separately and unrelated, we have had multiple publicly traded BDC positions return to NAV from a discount position. We also own two positions in privately traded debt funds that mark holdings at their (theoretically 3rd party verified) NAV each quarter. One thing I’ve been pondering is whether during times like these when publicly traded BDCs are trading at or above NAV, is to hold mostly private versions and then to swap for public versions during drawdowns in public markets. In theory, these assets are similar and in some cases the same underlying loans, but private funds are slow to mark down their holdings or outright disagree with public marks and refuse to mark down. A small tactical thought but one I’m chewing on.

Looking forward, we have a modest cash position due to a lack of ideas and the sales of a few investments. Thankfully, a high relative return on cash keeps me away from reaching and I’m near certain that time will offer up interesting opportunities to get fully invested again. Happy hunting.

Spending time around trading markets, measured in decades, results in very occasionally making “blink” speed investment decisions (a term I came across on another blog).

In a prior post, House of Brindle, I mentioned how I had followed the career of Richard Brindle over the past decade. I owned stock in his prior vehicle, Lancashire, before he moved on and started Fidelis with private ownership. Every now and again I would collect all of the updated news on him in hopes of finding out when he would bring a vehicle to the public market again.

That happened in 2022 with the vehicle going public in 2023. I read the prospectus and presumed the vehicle would trade at a rich price given his track record. When the IPO busted I looked closer and was turned off by the heavy fee structure Brindle extracts from the public vehicle. But after the share price took a further dive post 3Q23 earnings, I dug further and concluded that the discount was too much. I outlined the following highly complex, nuanced, and detailed investment thesis (I kid):

The reasons one invests in FIG are simple. You believe that Brindle cares about FIG’s success, will write good paper, and pass on bad paper. You believe that there may be an extended hard market. You believe that he will return capital when things get soft. And last, you believe you’re getting compensated for the fee arrangement through purchase at 65% of book value. That’s it.

65% of book value was ~$12 / share, where the shares were trading in December. The simple math was book value was $18.50 and a 13% ROE (low point of their guidance) was $2.40 / share in earnings. A 20% earnings yield on a $12 stock if one believes that the business isn’t a melting ice cube. Pair that with structural reasons why others may not be able to own the stock today including recent IPO / low time in market, high fee structure, new corporate structure (MGU / Balance Sheet separation), and odd Q3 premium drop. While I didn’t make a knee jerk / “blink” investment decision, it wasn’t an overly complex investment decision and I sized us up within one month.

Fast forward only a few short months to today, FIHL / FIG released Q4-23 numbers which included a 13% increase in book value over the three month Q4 period, $1.15 / share in adj. earnings for Q4 alone, a 23% ROE for Q4, and guidance for similar premium growth in core segments for 2024 when compared to 2023. Book value sailed higher to roughly $20.50 / share. All good things.

Accordingly, the shares popped to ~$18 / share, which equates to roughly 87% of the latest book value. Profit guidance was upped to a 14-16% ROE, so to do the math again, a 14% ROE equates to roughly $2.87 / share in earnings on an $18 stock, a ~16% earnings yield (vs a 20% earnings yield in December).

While this was a quick hit, Brindle has a long history of prudent capital allocation during both soft and hard markets within the P&C space, making it a nice one to sit on and not have to think too much about going forward. One can hope that they hit their 12-15% ROE target net of fees over the long run and we have the buffer of buying at a fraction of the book value of equity.

Last, I tried to think about what lessons are learned from this scenario and I can think of two. First, aligning one’s interests with one’s investments. I’m odd in that I find insurance fascinating despite having no industry experience in the field. I probably should have worked in insurance if I had to redo my career. This interest enabled me to want to follow this guy for over a decade. Second, focusing on situations where there are barriers to ownership today that may resolve to allow greater supply of buyers in the future is probably a good thing.

One thing is certain though, lasting lessons often come from bad investments, and I have a note to pen on one of those that were crystallized recently and left a very foul taste in my mouth. More on that later.

In a prior note I penned in August, I suggested Jackson’s efforts to push regulatory change was perhaps more real and near term than one would normally assume when corporations think of government timelines.

In December the company announced that it had come to a preliminary agreement with the Michigan regulator for a new regulatory framework that would achieve the goals Jackson outlined, namely less RBC ratio volatility and less uneconomic hedge spend to defend against uneconomic RBC movements.

As the stock has not moved since the 8-K release, I thought I would put on paper what I expect the company will say with respect to the tangible outcomes for shareholders when it releases earnings this week.

Note: The below is a brain dump versus an article to capture eyeballs, so keep that in the back of your mind.

Capital Surplus

In the past, the company maintained an RBC ratio target of between 425-500%. However, it was comfortable with and often carried an RBC ratio above 500%, including when it last reported in November. Does that change with the new regulatory framework in place? I think that the company indicated as such on the prior call:

“So first on the Michigan solution, assuming you get it in early ’24, would that change how you think about your RBC target of 425 to 500%”

“I think that’s a likely outcome, Suneet, that we would want to revisit that, not indicating that how it would change. But I do think that when we set that 425% to 500% target range, we set a wider range purposefully, given the volatility in our business. And I think to the extent that some of that volatility was contributed to by the cash surrender value floor, a solution that mitigates that cash to undervalued floor solution could very well likely mean that we don’t need such a wide range to think about. And therefore, that’s something that we would be considering as we look forward and provide our outlook and targets for 2024.”

JXN 3Q22 Earnings Call

Given that the company was sitting above 500% in the prior quarter, it is not unreasonable to presume a return of something like 75 basis points (bps) of capital to shareholders (or a partial return) could be in the cards. Seventy-five basis points on total adjusted capital (TAC) of roughly $5 billion and 525% risk-based capital (RBC) would be something like $750 million, on a market cap of $4 billion.

However, I hesitate to presume anything like that will happen. If anything is clear about this management team, they have a track record of being conservative and disciplined. The odds they “stair-step” their way to an eventual resting place are very high, in my own opinion. So, say they want to likely settle on a range of 350-425% given the new framework, my guess is that they lower it to 400-475%, and then 375-450% the following year, etc.

In a different vein, the company has said it aims to maintain a minimum cash buffer of $250 million at the holding company. As of last quarter, the company had $900 million in cash equivalents and up to $1.5 billion in total assets at the holding level. Furthermore, the company generates something like $200 million per quarter, roughly speaking, in cash in the old regulatory regime, so that amount is likely higher now. So, will the company return a substantial amount of cash independent of a potential release of capital from the insurance entity?

Again, my gut feeling is likely no. The company had a target of $500 million returned to shareholders in 2023, and they were roughly at $350 million at the end of Q3. So, to get to $500 million, they roughly returned the cash they generated in Q4. But more importantly, the company is trying its hand at growing a new product category, RILA, given its distribution capabilities and differentiation of the product versus its core variable annuity (VA) product. It has grown the line of business (LOB) quickly, and if I were in the CEO’s shoes, I would consider this a “moment” in which, if the returns in RILA continue to clear a reasonable hurdle, it is a moment in time to put the foot on the gas and not be capital-limited in expanding RILA.

Call Buying

The company was buying roughly $500 million in calls in 2018 when the book was smaller and less “floored out” to the extreme. Given the book is far larger now, but more importantly, more floored out than prior, I would presume the call buying is somewhat higher than the $500 million figure. Since the uneconomic call buying may be “mitigated,” I presume this figure is now gone, a material cash saving on an annual basis. However, in the release, it also explicitly called out interest rate hedging in the new regime.

In the prior world, Jackson was clear that their hedging program was a more holistic economic approach versus a 1:1 “immunization” of macro factor risk inputs. Other insurers explicitly called out their immunization strategies to help investors focus and value the company based on the risks it is taking. With this wording, it seems, Jackson is moving closer to an immunization strategy with respect to interest rate risk. To that end, I would expect some portion of the prior call buying outlay to be utilized for rate immunization. How much? I have no informed view, and my hope that it is material is speculation. But if it does result in a net savings of around $250 million or 50% of the 2018 call buying budget, it is material against capital generation of $700-900 million per year.

Moreover, sustained annual savings are what I presume the board will overlay potential increases in returns of capital to shareholders. If cash generation increases 25% as a result of the new regime, I would presume that a material portion of this increase would apply to the dividend/buyback.

Crystal Ball

Altogether, while a more aggressive management team may initiate a one-time massive share repurchase paired with a substantial increase in returns to shareholders, I don’t think that will be the case at Jackson. I personally believe the management team prioritizes “consistency and discipline,” words that have been used ad nauseam in communications with shareholders. My best guess is the management team increases its budget for annual return of capital to shareholders from the current range of $450-$550 million to something like $550-$650 million, with guidance that any future increases in shareholder returns will continue to follow the prior framework of 40-60% of annual capital generation.

Lots of things to be thankful for in 2023 including a few special trips, good health, and a new home. 2024 is shaping up to be a fun year with winter delivering a few great days on the snow already:

On a more professional note, the inflation narrative appears to be calming down as future expectations for inflation pushing lower, down to below 2.25% over the next 10 years.

Investment income was down 1% from the prior year quarter as we lapped a major portfolio rotation in 2022 and catch up payments that were issued in 2022 disappear. While income was up 25% for the year, again mostly on the back of portfolio rotation along with some special distributions, 2024 is projected to be down 8% as these one time events are not repeated.

Furthermore, certain investments have struggled. As an example – a retail shopping center that financed itself with bridge debt with the goal of refinancing in the CMBS market never made it to the second step. Interest rate caps expired. What was previously producing $18K in annual income in 2022 reduced to $4.5K in 2023, and is projected to be $0 for 2024. Ouch. This has been balanced by others having more productive recent years.

Over the past 9 months I’ve tried to bias toward buying “duration” of income. Rather than own something like a 5yr bond that will come due soon-ish and need to be re-invested, owning equity that may have a much longer runway of earnings has been the target of my search. Moreover, while much ink has been spilled over the high absolute yield of floating rate debt, very few talk about the post-tax returns of such investments. Even fewer discuss what may happen in a recession: low fed funds rate and high defaults, both bad for these assets. Whether this bias towards equity is productive over the longer term is obviously yet to be seen.

Last, NAV changes. As expectations for inflation stabilized, equity markets rocketed higher. With that, the NAV of our public investments followed suit. But with a firm grounding in investment income, not a whole lot has changed. What I hope for in 2024 is simple: that our investments grow earnings well in excess of inflation. I believe that many of our largest investments have good potential to substantially grow their earnings, but beliefs have to turn into reality for them to mean something. In the meanwhile, we’ll just keep buying things that for some reason have fallen to an interesting price and own t-bills when I have no interesting ideas. Onward and upward.

As a younger lad, Lancashire Group was in my orbit, I believe by virtue of the Corner of Berkshire and Fairfax forum that I used to frequent back then. Lancashire was the small kingdom of a one Richard Brindle, somewhat a legend in the industry. The group followed the simple, and common strategy, of writing paper when pricing was good and the less common strategy of returning money to shareholders when pricing was bad. Brindle exited Lancashire in 2014 to “retire” and sell all his shares only to reboot publicly only six months after his non-compete expired on January 1, 2015. His reboot was named Fidelis and it stayed private for the better part of eight years, receiving equity and sidecar co-invest funding from large institutional investors.

Brindle watched and keenly understood how General Partner (GP) and MGA / MGU businesses traded versus balance sheet investors and balance sheet insurers. To get his PE investors some liquidity without selling the MGU at a discount to his perceived idea of true value, he took the balance sheet part of Fidelis public in 2023. The structure is similar to other publicly traded PE balance sheets that are externally managed by PE GPs. Think BBU, CODI, etc. The fees the balance sheet pays the MGU include ceding commissions, management fees, and carry. The publicly traded Fidelis balance sheet (called Fidelis Insurance Group or FIG) basically eats a steady diet of Brindle underwritten paper from Fidelis MGU. The MGU is also taking on other “star” underwriters by giving them a seat, capital, and admin support allowing them to focus on trading. Does this sound familiar to the pod shops that are all the rage these days? In my opinion, it rhymes.

In any case, FIG was slated to go public at book value, roughly speaking. The range was adjusted downwards as IPO conditions were rocky, appetite to pay up up for an externally managed vehicle was (and is) low, and incentives were (and are) unclear. Pricing cleared around 80c on the book value dollar with existing investors pulling out of the offering and the company was left as the only seller of about $100m in primary equity. After its second earnings report as a public company, the stock dropped to ~$12 as premium growth softened.

Its mission is 12-15% (shocker) net returns to equity (post-fee) through the cycle. Currently it is printing high teens [adjusted] ROE in the face of a very hard P&C market. The reasons one invests in FIG are simple. You believe that Brindle cares about FIG’s success, will write good paper, and pass on bad paper. You believe that there may be an extended hard market. You believe that he will return capital when things get soft. And last, you believe you’re getting compensated for the fee arrangement through purchase at 65% of book value. That’s it.

It remains to be seen if this entity can trade at a healthier multiple to book value, especially given the fee arrangement. Furthermore, there is substantial equity overhang from existing investors that likely need to get out as limited life funds near end of life. Last, while Brindle’s very direct guidance that he and the entity exist to make money above all, that includes issuing shares at FIG at a discount to book if the math on the paper pencils positive. Said differently, FIG will likely issue at 65% of book if it can price slugs of paper at sufficiently high prices.

Nothing is guaranteed. Investing is best when one’s interests cross with some form of value, and in this case, I was probably destined to own Fidelis at some point. That time came sooner than expected, time to buckle up for the ride.

Delayed post as we were fortunate to spend extended time in the sun over the past month in Costa Rica. If thinking about a trip there, Puerto Viejo was our favorite spot. Much less touristy and much more soul than locations on the west side of the country, in our opinion.

Inflation expectations have changed from the prior quarter’s summary, which shouldn’t be surprising to most:

That said, while people debate the likelihood of reaching the 2% target and the potential for changing the target to 3%, for the purposes of keeping up with or exceeding the rate of inflation – expectations of 2.5% over the long term seems manageable for now.

Investment income was up 32% over the prior year’s quarter again due to timing mismatches and reallocating to new investments. The problem child list continues to be three investments. The shopping center is essentially a poster child for getting hung on higher rates as they didn’t refinance out of their bridge in time and rate caps eventually expired. While the actual asset performs well, the balance sheet does not and only lower rates cures the equity here. The hotel is consistently struggling with retaining labor, which is not surprising, and while it continues to make distributions, it’s a shaky asset at best. Last, a financial we own has taken a major hit as it has become a lightning rod for short sellers. I won’t get into the details – but there’s a lesson here for me personally. And that is that I ignored concerns I had about the balance sheet.

Looking forward, I expect Q4 income to be down 1% from the prior year as the timing mismatches start burning off, with total annual income for 2023 up 25% from 2022. I did a quick projection of 2024, and with no increases to distributions I expect 2024 to be down 3% from 2023 as the catch up distributions we received in 2023 won’t happen again. Perhaps we end up flat to 2023 with some good fortune on distribution increases. That said, going back to the beginning of this note, the hope is that 2025 investment income materially exceeds the 2.5% inflation expectation to stave off long term degradation in purchasing power.

In Q3 I added Legal and General to the portfolio, if it wasn’t obvious from prior posts. It’s cheap and has a good core engine. Expectations are so low vis-a-vis its share price and nothing heroic has to happen for the business to be bigger in five years. While share price based expectations can always get worse, it doesn’t get much worse than UK financials across developed markets.

Last, I mentioned in my past note that paying down our 6.75% mortgage was potentially attractive from a combination of financial and personal money psychology perspectives. I believe that still holds true but for some reason it also doesn’t feel like a slam dunk. I continue to chew on this and expect at some point it will become clear one way or another, like it always does.

Have a great holiday season.

It’s a beautiful morning: clear sky, a full moon glowing, stars everywhere, and much to be thankful for. Not all can say there’s beauty, let alone peace, above their heads.

Markets have been… boring, for me. Not that markets have been boring for all, but for me, they have been. There’s not much to do. A lot of trees have been harvested in the portfolio over 2021 and 2022, and new seedlings planted. It takes time to see how they grow, don’t grow, or die off.

In light of this boredom, perhaps the only thing I have found somewhat interesting is the force with which those who make investments based primarily on historical results have been affected of late. Primarily, in this vein, I think of Compounder-ism. The idea that mega-star management teams that primarily utilize repeat M&A, leverage, and buybacks as the drivers of future value creation. When investing in these sorts of businesses, the typical pitch I see is summarized as: what happened in the past will happen in the future, and if it happens less well, it’s still fine because I’m buying a short-term dip in the stock price.

John Malone is a legend in the business world, immortalized to investors in the book “Cable Cowboy.” It’s a really fun read but tugs at the flaws of human tendency. That is, it creates tribalism around that story of the past. There are scores of Liberty (Malone) investors that have picked at the various securities Malone offered to investors in an effort to recreate the wealth creation of Malone’s past. The focus on the past persisting into the future has unfortunately produced unsatisfactory results from the perspective of returns.

Thinking forward to the future is really, really hard. Furthermore, if buying into a future sentiment shared and reinforced by a tribe, the odds one is already paying for certainty of that future outcome are elevated. But thinking hard about the future is table stakes work. At its core, good investing is very simple: you want to own businesses that will earn materially more money and be owned by substantially more constituents in the future.

VCs are in a difficult position. Coming off the massive run-up post Covid, general sentiment is there is too much money chasing too few deals, with too little talent deploying the said money. But at its core, I think VC investing does encapsulate the simplicity of good investing across the spectrum, well. Invest in a collection of companies with the hope that a few become far larger businesses that many more people are interested in owning. Other forms of investing can easily become complicated and muddied by shorter time horizons, financial engineering-based returns, or a lack of respect for the terminal value of a business.

So what of it? Nothing more than a reminder to myself to think hard about the future but don’t bet on any single outcome. Think hard about the future but form unique opinions that aren’t shared by a tribe. Think hard about the future and consider how many more people may “agree with me, but later.”

Companies that dominate the corporate news cycle often make the simple act of a customer parting ways with their money in exchange for goods or services seem so straightforward. The cream of the crop during a phase of an era proverbially “sells itself.”

However, we all know that the reality is it’s a dogfight for most other companies to simply keep the whole clown car together. Financials-first investors often have no idea what a functioning mess companies are internally. I think they would be horrified to experience that reality firsthand. Securing that near-term revenue dollar, let alone ensuring some measure of long-term value, is a difficult proposition at best.

The quality and security of future revenue vary greatly. Mainstream clothing retailers’ revenue varies dramatically by season and fad, as purchasing is ad-hoc, selection/competition is wide, and preferences change quickly. In contrast, the local utility provider is the only game in town, and you have to purchase to keep the lights on. As such, on average, people tend to pay a higher premium for utilities versus clothing brands, for example.

Lately, I’ve been looking into a certain line of business mostly known to a small niche of folks. Each “sale” generally guarantees revenues for decades, with an average duration of those revenues in the range of 10-15 years. The transactions are lumpy and happen a handful of times annually, though the market is growing quickly and likely peaks around 10 years from now. Only a handful of players can participate in this market, as participation requires substantial internal capabilities, arduous regulatory blessings, deeply investment-grade credit ratings, and a track record that is convincing to the customer.

The companies serving this niche have, to date, generally recouped the money they invest to secure the revenue back in approximately 4-5 years and aim to generate 15-20% returns on that investment for the life of the revenue stream if things go according to plan. All in all, I would consider this a highly attractive revenue stream on face value.

However, the profit stream doesn’t come without risks. One may not receive the above returns if a certain macro factor veers materially off-course. They also won’t make their returns if they didn’t appropriately configure the revenue stream against their costs, a very difficult mistake to correct in this line of business. Lastly, this sort of revenue stream is more episodic, as mentioned, driving more uncertainty about incremental revenue and thus can be viewed as lower quality than one that has better-defined future growth.

All told, the goal of the above is an example of how I attempt to think about business models without bias. How is one to think about things differently than the market if one takes the market narrative as gospel first? The above business line sells for a single digit multiple on supposed profits which may, or may not be the right price. But in a search for value, it certainly is an interesting place to expand one’s portfolio of knowledge.

The Financial Times published a nice piece on the UK the other day. Its cheeky headline was memorable:

It’s no secret that the UK has suffered of late as measured by multiple traditional measures. In part, it lacks the growth names that dominate the US headlines and aid in elevating US indices ever higher.

One of the interesting things I’ve found the be at least partially true about investing is: puzzles that have no answer often result in little investor interest. We as humans like to know the road came from, are on now, and the ultimate destination.

As an example, a UK listed and UK based company has the following past with respect to earnings per share:

Over the past 10 years, it has roughly increased earnings by 12% annually with little fanfare with exception of Covid. A fine performance.

In 2021 it guided to a continuation, or rather an acceleration, of its performance by the end of 2024 and has largely met its promise to date.

But today it trades a roughly 6x annual earnings and pays roughly an 8% dividend, nominally cheap metrics. An astute investor (not I) could probably guess the industry and perhaps the company, but that’s not the point. If a company has a strong past and reasonable odds of a good near term future, shouldn’t it have reasonable appetite for its shares?

Alas, the long term future is unknown, as the company undergoes a CEO transition, has no strong comparables, resides within the flows or lack thereof of UK stocks, and is in an industry that is generally unloved at present. Said simply, there is good reason for statistical cheapness. Or more tangibly, there’s no clear catalyst today, for a turn in the narrative to reverse its cheapness. And thus the lack of investor interest.

Perhaps therein lies opportunity. Certain investors have success investing behind defined catalysts. Event driven investors make their hay doing exactly that. But what of companies that get priced in a manner that you do “alright” for an individual investor (not a performance fee gathering investor) if nothing happens? I tend to like such situations and believe certain businesses, including one or more that reside in the UK, offer modest returns with unknown odds that for some reason, the buyer pool changes.

Alas, key to such an approach is diversification: an acknowledgement that accumulating such upside options do not offer certainty in upside. Just odds that the narrative may change at some undefined point.

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.