The story of financial institutions teetering at the edge of an abyss in 2009 and 2010 remains alive today, with rules under the resulting Dodd-Frank Act still being cranked out (with many more to come).
Since the carnage of autumn 2008, when Lehman Brothers, Merrill Lynch and Bear Stearns all vanished as stand-alone going concerns, most large financial firms have managed to survive. But for many of them, it hasn’t been easy.
A case in point: The Hartford Financial Services Group, the big insurer. On March 6, 2009, its stock price bottomed out at $3.62. Less than two years earlier, on May 21, 2007, the shares had reached $105.54. The main culprits were the same ones that dealt grievous blows to many other financial firms: an investment portfolio heavily weighted in structured mortgage-backed and asset-backed securities, which became virtually worthless during the financial crisis, and risk-management systems that failed to detect the looming disaster. The Hartford ended up writing off $7 billion worth of value on the toxic securities.
The stock had fought its way back up to $30.58 as of late Wednesday morning, with much of the growth coming during the past year. But the turnaround began in the fall of 2009, when a new CEO, Liam McGee, came on board. A few months later he hired a new CFO, Chris Swift, who had headed finance at AIG. The two aggressively attacked the balance sheet, retired debt, revamped risk management and eventually established a more solid footing for the company.
Something of a watershed moment came in 2012, when the firm decided to divest its life insurance, retirement planning and 401(k) management businesses and focus on other business lines that showed potential for greater returns. All three deals closed in January 2013. Finance chief Chris Swift recently sat down with CFO to discuss those moves, how he and McGee went about rescuing the firm and his views on some new and proposed regulations. An edited transcript of the discussion follows.
They brought you in in 2010 to fix stuff. How bad was it?
At the time, the whole financial-services industry was restructuring and fixing balance-sheet issues. And The Hartford was one of probably three insurance companies that took TARP money, so we were at the epicenter of a lot of activity.
What was the mindset at the company when the stock price crashed to three bucks?
I wasn’t there at the time. I was at AIG. But everyone was experiencing the same thing. It was disbelief and numbness. It was surreal.
What was the thinking behind the firm’s recent divestitures?
When Liam and I joined the company, it had a wonderful brand and culture. But it obviously had fallen short in a couple of areas, primarily risk management and investment. He and I were soldiers in arms, side by side exploring returns, exploring growth opportunities, exploring market conditions and exploring our cost of capital as it related to supporting six or seven major lines of business.
Through that work and through consultation with the board, we ultimately determined to narrow the organization’s focus. The capital base wasn’t sufficient to feed all our children. You know, you love them all but some of them needed to be part of other organizations to flourish and grow. We had consumed too much capital during the financial downturn. There wasn’t enough to support both our risk profile and our capital needs going forward.
How did you determine which businesses to keep and which to unload?
A financial services organization is terribly sensitive to broad macroeconomic factors – unemployment, interest rates, equity levels of different stock markets around the world. So we had to take a view of what was really going to happen over a longer period of time. We ultimately determined to make a best bet on the businesses where we had substantial strength from a market-share perspective and that offered substantial opportunity to improve returns and margins in a relatively short period of time.
Did you also consider what competitors were doing? For example, New York Life also did some divestitures, and that seemed like the path for insurance companies after the financial crisis. So was it, “Well, if they’re in that market then we’ll take this market?”
Yes, we did look at the competitive landscape, our stature in the marketplace and our capabilities. If you look at property and casualty insurance, which we decided to retain, we’re a top-five player. We have both commercial and personal P&C product lines. We don’t compete with Allstate, Geico or Progressive, but in our niche, serving older drivers through AARP, there’s no one better. In group benefits, specifically the disability-insurance and group-life-insurance products we sell to employers, we are a top-three player. In the mutual-fund space, given our relationship with [mutual-fund manager Wellington Management], we have a unique position. So we kept businesses where we had either a top-five market position or real uniqueness.
In addition to the life-insurance and retirement-planning businesses, we also sold a broker-dealer, the bank we used to access TARP funds and a Canadian mutual-fund firm. We’ve really reshaped the firm over the last two years.
What was the revenue impact of the sales?
We were approximately a $26 billion revenue shop and now we’re $20 billion, so we still have substantial heft. Our asset base, at its peak, was about $350 billion and these days it’s about $280 billion. Equity has gone down from about $25 billion to $20 billion. So it’s not dramatically different, because the things we shed weren’t core competencies.
The company has also eliminated a lot of debt. Can you tell us about that?
Even before the new long-term strategy was established, a key priority was to repay TARP. From start to completion The Hartford had TARP money 10 months. We always viewed it as a temporary expense of capital. I didn’t really consider that money to be debt, but we had to repay it.
As I studied the balance sheet in close consultation with our treasurer, we had really leveraged the organization during the crisis. We had a big capital investment from Allianz, the German insurer, that was structured as debt along with a smaller equity piece and convertible warrants for a larger stake in the organization. Essentially, we granted Allianz the right to own up to 20 percent of the organization through a debt instrument. Luckily we were able to negotiate a fair outcome for both parties in March of 2012 when we raised about $2.2 billion from the sales of the businesses.
But we had more work to do on the balance sheet, so we announced a $1 billion debt-repayment program. We actually tendered for about $800 million par value of debt. We had a couple of maturities coming due late 2013 and early 2014 that would total about $1 billion we would use to pay down principal. We also then rewarded our shareholders with a $500 million equity-repurchase program.
You mentioned that you de-risked your investment portfolio. What did that look like?
During the crisis there was a lot of stress and strain on structured products – asset-backed and mortgage-backed products, commercial loans, commercial real-estate loans. The Hartford was overweight with those products in its investment portfolio, and the $7 billion write-off consumed a lot of capital, ergo the need for TARP.
But though we had written down bad debt according to what we thought was fair value at the time, those assets were still on the books and consuming some level of capital. So we looked at every asset class and re-underwrote every security with a fresh perspective, a new view of fair value. If it was trading below fair value, it was a hold. If it was above fair value, it was a sell – right away.
By how much has the risk in the portfolio been reduced?
I would say 90 percent, by any measure. We might have had $13 billion of distressed assets at the end of 2008, and our current portfolio has $1 billion of what we would consider distressed assets.
What approach are you taking now with those securities?
With structured products you couldn’t do good underwriting. You relied on credit-rating agencies to guide a view of how the security tranche would be rated, which turned out to be optimistic. But for the things that we can fully understand and can collect the appropriate risk premiums, we’re comfortable applying capital back into that asset class. You have to take some risk to make money. I think the real lesson is that The Hartford got out of balance, with deep concentrations of risk and less-than-ideal risk management systems to fully identify and understand all those risks.
What is the biggest risk you’re managing now?
It’s security threats and terrorism, whether cyber, biological, chemical or nuclear. To insurers it’s a big unknown. How do you model it? How do you understand it? Where does it happen? What’s the frequency? That’s our macro factor and we discuss it heavily. We try to model it the best way we can to understand potential impact.
There’s a big Congressional debate going on right now with the Terrorism Risk Insurance Act, which needs to be extended by the end of 2014 to provide that ultimate government backstop for terrorism events. Without that the insurance industry would have to ultimately re-underwrite its risk – i.e., reprice it and shed a great deal of it.
And who would have predicted that Superstorm Sandy would have hit where it did, when it did, at high tide during a full moon. We incurred about $350 million of losses, which is a big number, but relative to our size and balance sheet was fully digestible and within the risk parameters we manage to. But the weather patterns in North America and around the world have changed. We’re seeing more frequent, dispersed and severe storms in every region of the world.
But is there really any way to protect against an ultimate risk, like a nuclear bomb in Times Square?
There is a way. It’s to limit your exposure to the damages of that expected event. That’s easily modeled.
If that actually happened, The Hartford’s financial results might not be that important, even to you.
I believe in the power of society to rebuild and carry on from whatever natural disaster or man-made disaster occurs. So we do have to worry about what might happen.
What regulatory issues are keeping you up at night?
One is the SIFI [Systemically Important Financial Institutions] designation, [by which some large non-bank financial institutions are being subjected to rules that previously applied only to banks]. I understand what FSOC [Financial Stability Oversight Council] is trying to do, but I think there’s a fundamental disconnect between bank and insurance structures and liabilities, and how we finance ourselves. I hope the regulators would spend a little more time with the industry to fully understand why our balance sheets are different. We don’t use leverage like banks have historically. Our liabilities are policyholder-driven, not necessarily funding-driven. Trying to apply bank rules to insurance companies is misguided.
Another regulatory concern is that FASB is way off track on international accounting standards. There are two things that just make me cringe. One is the new exposure draft on accounting for investments and insurance contracts. We’ve always had to use mark-to-market accounting on the balance sheet for changes in those securities that don’t have credit impairments going through AOCI [accumulated other comprehensive income]. It works. Why change it?
[Under the proposed rule,] if you look at longer-duration liabilities – and you generally have to have longer-duration assets to back those liabilities – you’re going to mark-to-market changes in interest rates and market movements of the assets, then run them through the P&L. But that will create a lot of income volatility. It’s unnecessary, and I’m fearful that it’s going to drive up our cost of capital.
Then there’s the craziest thing I ever heard from the credit-impairment side. The proposal wants you in essence to put up credit losses on Day 1 on a security that you either purchased or originated, like a commercial loan. If you expect ultimate losses on a pool or an individual security, say 75 basis points, FASB wants you to accrue that on Day 1. They’re trying to build capital buffers, creating lower retained earnings, where you carry more capital and have less debt because you’re putting up more up-front losses.
Well, you don’t futz with accounting just to have a desired capital solvency regime. If that were allowed to happen, I just think it would be a travesty.