Tuesday, November 11, 2014

Getting Gemütlichkeit with Genworth's LTCI

Genworth has shat the bed! This calls for something special: a complete, unedited, typo-ridden, stream of unconsciousness, celebration of the fallibility of human judgement (...hopefully not my own.)

The company reported over $500M each in reserve charges and goodwill writeoffs in Q3. What's more, the circumstances of the charges indicate a large GAAP active life charge in Q4.

The pending charges are the probable reason that Genworth was at one point down over 50% in two days. My current guess is that this pretax GAAP charge will be greater than "Fitch's current rating expectations assume an additional $500 million to $1 billion of pre-tax GAAP charges." 

Rating agencies took disparate views on the news. Fitch put the company on negative watch while expecting more charges. S&P took the opposite position, downgrading the company and noting "Any additional material reserve strengthening could result in a downgrade." Moody's was least committal, placing the company on rating watch negative while it "will use the review period to evaluate the results of Genworth's review of the margins on its LTC active life reserves."

Moody's also quoted it's SVP, Scott Robinson, who said "Genworth has taken prudent actions to protect its capital position and has the capacity to absorb the announced reserve charge, which was higher than we expected. While we will gain insight into the company's long-term care reserve margins during the review process, we believe the company remains exposed to further, significant deterioration in its legacy block of business."

Indeed. The policies in the active life reserve display much better characteristics than those in the claim reserve (other than not being in claim e.g. tighter underwriting, benefit length, daily max, attained age, etc.). However the active life reserve is split into two buckets for GAAP reserve loss recognition testing (LRT) margin, the older of which is markedly worse than the newer. The GAAP LRT margin on this pre-10/3/1995, "PGAAP" group of policies was only $100M on a $2.5B reserve (both are after tax). The newer "HGAAP" block of policies has a $2.9B GAAP LRT margin on a $13.4B reserve.

The Q3 claim reserve strengthening was roughly 15%. Claim reserves are best estimates, which are used to the active life testing margin process to establish the economic balance sheet margin. That margin is then stress tested to come up with the LRT margin. The bad news is that the actual best estimate of the present value of future claims on the active life book was $37.8B at the end of last year. The good news is that the increase to this number should be substantially less than 15% due to the shorter tail and better risk profile of this book. It is harder for claim severity to increase when duration and daily benefits have tighter caps.

The assumption changes appears to expose PGAAP book to considerable negative margins, while the HGAAP book appears to maintain a decent margin. The increase in PGAAP expected future claims will be higher than for HGAAP. The ratio of expected future claims to active life reserve is certainly higher for PGAAP. We can only guess, but perhaps it is as high as 3.5 versus the aggregate ratio of 2.3. Using a 15% increase on this assumption infers a GAAP charge of roughly $1.3B before any remedial action.

As noted, active life reserves are not just best estimates of future losses, they also also include expected future premiums. Increased loss expectations may increase the companies expected future premium rate increases. This led Genworth to note in its earnings report that "the company is developing related management actions, that it expects will offset much, or possibly most, of the reduction on margins from the claim reserve review." So maybe this pretax GAAP charge number we are playing with gets down to $1B.

But Q4 GAAP troubles could be compounded by additional goodwill writeoff of as much as the remaining $300M. The company noted in a November 6th press release responding to credit rating changes that "These changes in ratings or outlook are expected to reduce sales in some of its products." Lower expected sales was one reason for the Q3 writeoff and there is no indication that the company anticipated the rating and outlook changes.

All this GAAP analysis raises one of the central questions surrounding investment management: "who really gives a shit?" Now that we know the actuarial assessment has changed the economics outlook for the book of business, who cares how the bean counters catch up with reality? For one, we will gain more, albeit incremental insight into the book with every quarter and every review. For another, if we switch to statutory accounting, the bean counting determines dividend capacity and could even require regulators to intervene in the subsidiary's operations. 

There are big differences in GAAP and statutory margin tests. A big one for Genworth is how the book is divided. Rather than PGAAP and HGAAP books, Genworth's statutory tests divide the company between subsidiaries: GLIC, GLICNY, and BLAIC (a Bermuda reinsurance entity for GLIC and GLICNY). GLIC is the largest unit with the coziest margins. GLICNY is smallest and has already established an asset adequacy reserve. This reserve was actually reduced by $40M at the end 2013, but the take away for investors is that this margin is nil. This is where the likely statutory charge will come from in Q4.

Any distinct (non-geographic) characteristics between the books of GLICNY versus GLIC are not immediately clear to your blogger, but it is safe to say that GLICNY book is generally better than the claim reserve book and PGAAP book. GLICNY accounts for less than 10% of total active life reserves and probably accounts for less than $3.8B of the $37.8B aggregate PV of claims and expenses.

Being a New York subsidiary GLICNY follows that state's mandates for margin testing. This includes the unique disallowance of any expected but not yet approved rate increases. This nullifies managements main lever in offsetting increased loss reserves. Still the size of the likely statutory charge in Q4 will be a few hundred million or less. While this could drive unassigned surplus and therefore dividend capacity to or below zero for 2014, management has precluded dividends anyways. 

To put this in perspective, the company would have to post a about a $3B pretax reserve charge to take its RBC ratio down to 200% where the company would be required to submit a plan on how it intends to increase the ratio. $3.6B might get the company to a level at which regulators can take action (principally restricting new business). $4.2B is the level at which regulators have the option to take control of the company and either liquidate or - as is more commonly the case - rehabilitate it. At about a $5B the regulators would be required to take control of the life subsidiaries. 

Needless to say, none of those charges are coming out of the NY sub alone anytime soon. The aggregate book meanwhile would need expected losses to increase at twice the rate of the claim reserve book, with no management action to get to a level where Genworth needs to file an company action plan. Its more likely that the claim book loss expectation increase will be more than twice the rate of active life book loss expectation increase and that the latter will be reduced by management action.

Such reserve charges look increasing unlikely given that two of the large drivers of LTC  mispricing are approaching their limits. When underwritten, the oldest books of business were assumed to lapse at a rate of 6.5% and earn a yield of 6.75%. The lapse rate in the 2013 statutory CFT margin is 0.45%. Genworth uses the actual forward rate curve to predict future investment returns. A final 10 year yield that is 220 bps lower would decrease margins at the company about $2B. A final 10 year yield below 1.5% would be needed to to completely erode the 2013 CFT margin. A ten year of approximately 0.3% is needed to completely erode the 2013 economic balance sheet margin on its own. Given where the forward rate is now, this level of adjustment in interest rates will not be coming this year.

What about reserve increases in future years? This is a more valid concern, but Genworth's life insurance subsidiaries book over $500M of pretax profits annually across all busisness lines. Additionally the present value of future profits on new LTC business accretes to margin analysis as it is booked. Combined these add over $700M to margins annually. Meanwhile the oldest, worst business runs off.

Of course, many believe that it's impossible to make money in longterm care insurance. The most common reasons sited are the information advantage of policyholders, the contradictory incentives of insurer and insured, and the difficulty of necessary forecasting. There may be no other form of insurance that suffers so broadly from all three conditions. 

There may be no business today that suffers from such sparse competition and a negative sentiment. This bodes well for future returns. Genworth has shortened its tail risk, tightened underwriting, and increased prices for expected returns above 20% on new business. So prices for new business have risen not just to reflect more conservative assumptions, but also to make more money per unit of new risk. Meanwhile, Genworth has proven the regulatory appetite to allow for significant price increases on existing business to offset extreme deviations from industry forecasts.

While this is a LTC focused post, there just has to be some comment on valuation. The yield on the jr. subordinated 6.15s of 36 spiked above a 10% ytw from around 7% before the earnings blunder. Genworth has $4.4B of carrying value of outstanding debt (excluding debt at in international MI) with $1.1B of cash at the holding company and $3.3B value of its interest in publicly traded international mortgage insurance affiliates. This shows an impressive faith in management's ability to lose money.

Genworth's US MI unit, GMICO is worth $2.9B if valued at 2/3 (an approximation of relative rate of NIW) the enterprise value of larger MGIC. There are several ways to get to the current enterprise value (with debt at carrying value) from here. One way would value all of Genworth's other businesses at 2x 2013 earnings except for LTC which will need a 0x multiple to get us to the 8.8B EV. 

Taking a different view, management has estimated they can achieve a long term RoE of 9%. If they achieve that target, buying at 1/3 of book value will earn a return on market equity of 27%. Of course, what type of consensus makes for 27% return on your investment?

This may look like child's play to veterans of the mortgage insurance meltdown, but it still is uncertain how the market will react to the Q4 charges. Even though many called for $500M in reserve charges in Q3, the end results still drove many to despair. In the meantime we'll be keeping our pockets open and hoping for GNW to be a penny stock again soon.


  1. Hi Mark. Thank you so much for that awesome piece. Can you explain why you applied the 15% charge to the ~$37.8 billion PV of future benefits and expenses instead of applying the charge to the $15.1 billion ALR?

    1. of course! So for the claim reserve, the reserve itself is the actual best estimate PV of future claims. But for the ALR, the PV of future claims is only a component of the margin analysis. So the 37.8B is that PV of future claims... though in this case it is actually an aggregate number for two subsidiary margin analyses. However the 15% won't apply because of differences in the books... blah dee blah blah blah.

      BTW The 15.1B is a number that is locked in at the time the business was written.