Description

This quote, in a nutshell, summarizes the predicament facing participants in the long-term care insurance market.  They got “it” wrong, badly wrong, “it” being the key assumptions underpinning the insurers’ historical underwriting risks.  The result has been a sea of losses and industry turmoil that has hit especially hard at Genworth (GNW), one of the industry pioneers focused on long-term care insurance.

Investors have left GNW for dead and for good reason as it has been a serial disappointer, a veritable value trap for years (witness its last appearance on VIC:  posted in November 2009 at $11.47 when mortgage insurance was the principal overhang).  Consider that GNW is down 50% over the past year and five years while it is off some 60% from its 2004 IPO and a whopping 75% off its all-time high in 2007.  Although risk clearly remains, I believe that GNW shares already reflect the known bad news and ongoing risks while under-appreciating the remedial actions underway and several potential upside catalysts.  As such, GNW shares provide a pretty interesting risk/reward profile at roughly 5x normalized EPS and 0.3x book value.

Genworth was previously a subsidiary of GE that was IPO’d in May 2004 and spun off as an independent company.  Today, the Company operates through three segments:  U.S. Life Insurance, which offers long-term care insurance (LTC), life insurance, and fixed annuities; Global Mortgage Insurance, which offers mortgage insurance primarily in Canada, Australia, the U.S. and to a lesser extent in other European countries; and the imaginatively named Corporate and Other segment which includes a variety of lines in runoff as well as the non-core International Protection business that is currently being marketed for sale.

U.S. Life Insurance.  GNW offers various forms of long-term care insurance, life insurance and fixed annuities. 

GNW was a pioneer in long-term care insurance (“LTC”) some 40 years ago and currently is the leading underwriter of LTC with a 17% market share and 2.1 million policyholders.  LTC products provide defined levels of financial protection against the costs of long-term care services provided in the insured’s home or in assisted living or nursing home facilities.  Simply put, LTC has been a millstone around GNW as older policies were dramatically underpriced and have generated massive losses over the years.  The combination of increased longevity and sharply higher medical costs relative to the assumptions originally underwritten have proved a toxic combination.  To make matters worse, GNW has had a few false starts in attempting to quantify and address its LTC issues, which has cost management credibility with investors.  Importantly, from a regulatory perspective, LTC is a guaranteed renewable policy so regulators are required to approve actuarially justified rate increases.  We will return in more depth to LTC below.

GNW’s life insurance products include term life insurance and universal life insurance in the form of index universal life and linked-benefit products, combining a universal life insurance contract with a long-term care rider.  GNW distributes its life insurance products primarily through independent brokerage general agencies (“BGAs”).

The fixed annuities business also provides its products through BGAs where GNW competes with a host of other life insurance companies, many of which are bigger and enjoy better credit ratings, an important consideration in the annuity and life insurance markets for obvious reasons.  GNW currently is the 16^th largest provider of such products in the U.S.  According to recent published reports not denied by GNW, the Company has retained Goldman Sachs to evaluate alternatives for the life and annuity business, which could include an outright sale in whole or in part or reinsurance transactions for certain blocks of coverage that would provide liquidity.

Global Mortgage Insurance.  GNW is a leading provider of mortgage insurance in Canada and Australia through two publicly listed subsidiaries, Genworth MI Canada (MIC on the TSX; 57% owned) and Genworth Mortgage Insurance Australia (GMA on the ASX; 66% owned), respectively.  Private mortgage insurance enables borrowers to purchase homes with lower down payments, typically less than 20%.  In Canada, mortgage insurance is mandated for such loans while in both countries regulatory capital requirements and access to securitization incentivizes lenders to require mortgage insurance for high loan-to-value mortgages.  Both markets are effectively oligopolies with limited but stiff competition.  In addition, both markets are characterized by a very concentrated mortgage banking sector so there is substantial customer concentration in each market.

In 2014, the Canadian and Australian subs dividended $109 million to GNW, a figure that is expected to increase to at least $150 million in 2015.  Both entities enjoy capital positions above their targets and appear to be stable, profitable businesses, though their quarterly financial results can be erratic.  As public entities, there is plenty of information available for each.  The combined value of GNW’s stakes in these businesses is approximately $2.5 billion, representing fully two-thirds of GNW’s current market cap.

GNW holds an approximate 15% share of the U.S. mortgage insurance market, which is similarly driven by regulatory and bank capital considerations.  Fannie Mae and Freddie Mac (together, the “GSEs”) generally will not purchase mortgages with loan-to-value ratios above 80%, effectively requiring that such loans obtain some form of mortgage insurance.  The U.S. mortgage origination market, though it has consolidated in recent years, is not as concentrated as the Canadian and Australian markets.  At year-end 2014, 56% of GNW’s U.S. MI risk in force was from policies from 2009 forward, a figure which should increase to some two-thirds this year. 

As expected, the GSEs recently issued new capital requirements for private mortgage insurers, which will require an additional $500-700 million of capital for GNW’s U.S. MI subsidiary, which is not new news but nevertheless is one of the drivers of the current strategic review process.  Although GNW’s U.S. MI business will not be in a position to issue dividends to the public holding company for a few years, it is clear that the dark days of the financial crisis are past, and the business is on the upswing.

Set forth below are summary revenues and operating income for each of the mortgage insurance operations.  Please note that the Canadian and Australian figures are shown fully consolidated.

Corporate and Other.  This “segment” houses a collection of products that are no longer offered for sale and are in runoff such as variable annuities and variable life insurance.  Though in runoff, these products represent nearly $13 billion of assets that in 2014 generated $275 million of revenues and $48 million of operating income.  Included in this segment is also the Lifestyle Protection business that is currently being offered for sale.  GNW’s lifestyle protection insurance, which is sold primarily in Europe, provides payment on certain consumer loans in the event of the insured’s illness, accident, involuntary unemployment and disability.  The business generated $837 million in revenues and $8 million of operating income in 2014, though in each of the two previous years it generated $24 million of operating income.

LTC.  For readers unfamiliar with long-term care insurance, I recommend a read of the Barron’s article quoted above entitled Protect Your Future in the April 13, 2015 issue.  The article provides an overview of the product and marketplace from a consumer’s and advisor’s perspective.  Although the industry correctly anticipated the growing market need for the product, the industry grossly underpriced it, which has led to massive industry-wide losses and a consolidation of the business as numerous players have exited the market.  Today, GNW is the market leader with 17% share while the top 5 players control 71% of the market. These remaining players, like Genworth, have been overhauling pricing and benefits while playing catch-up on receiving substantial premium increases for older, unprofitable policies.

GNW recently completed a comprehensive review of its LTC book of business and associated statutory and balance sheet reserves with outside experts including its auditors and third-party actuarial firms.  The net effect of this review was a substantial increase to reserves leading to the minus $815 million in LTC operating income in 2014 (a roughly $500 million charge after tax).  I encourage anyone with serious interest to review the company’s presentation (available on the GNW website) and associated commentary from the February 11 earnings call when management reviewed the presentation and results.

Perhaps the most important ongoing GNW initiative is obtaining price increases on existing LTC policies.  Recall that from a regulatory perspective, LTC is a guaranteed renewable policy so companies may not decline to renew unprofitable contracts; however, regulators are required to approve actuarially justified rate increases.  GNW has been working diligently to obtain such increases, which is critical to a stabilization of the LTC book. 

In 2007, GNW applied for rate increases and ultimately received approval in 90% of its jurisdictions for rate increases that averaged approximately 10%, representing $50-60 million of incremental annual premium.  In 2010, GNW rolled out another set of rate increases for a portion of its in-force policies, obtaining an average increase of 17% in 94% of its jurisdictions, producing an incremental $40-50 million of annual premiums.  In 2012, GNW began to initiate much more substantial rate increases of 30-50% and to-date has received approvals from approximately two-thirds of jurisdictions.  When fully implemented, GNW expects to realize annual premium increases of $250-300 million from the 2012 initiative, the low end of which should be in place by mid-2015 and fully realized by 2017.  In aggregate, these and other pricing initiatives taken since 2007 are expected to have added nearly $500 million of annual premiums when fully implemented in the next few years.  The recent review of GNW’s LTC book that resulted in a the large charge assumes further rate increases in the future to partially offset continued adverse cost and utilization trends.  This assumption seems reasonable given the track record of rate increases that are actuarially justified, but it is important to recognize how critical an assumption it is.

One last point about these rate actions.  GNW is increasingly seeking to offer policyholders the option of taking reduced coverage in lieu of a price increase to maintain their existing coverage.  As the CFO explained:  “We believe providing alternatives to policyholders, so they can choose between accepting higher premiums or electing benefit reductions in these guaranteed renewal policies is important, and we expect to see even more focus and receptivity of reduced benefits as an alternative to higher premiums.  We believe regulators and policyholders generally are more receptive to this approach and certainly prefer having choices.  Such reduced benefits generally are expected to be actuarially equivalent to higher premiums, and so the margin impact should not be significantly different.  However, with reduced benefits, our exposure to changes in future claims costs is lower.  In other words, our tail risk is reduced.”  Though that conclusion may sound inconsequential, it is exactly the negative tail risk of a long-duration product that was grossly underpriced at inception that the industry has struggled with for many years.  Any mitigation of it going forward is a positive for GNW and its stakeholders.

The key question for investors is whether GNW’s LTC reserves are now adequate.  Regrettably, only time will tell, but it is clear that investors do not seem to think so as GNW trades at merely 0.3x its stated book value.  I believe GNW’s current valuation provides an adequate margin of safety to assume this risk.

From a balance sheet and regulatory capital perspective, Genworth appears to be adequately capitalized in the aggregate and to have ample near-term liquidity, including some $1.1 billion of cash and equivalents at the parent holding company.  GNW targets parent company liquidity equal to 1.5x interest coverage plus a $350 million buffer.  Based on these requirements, GNW had $685 million of excess liquidity at the holding company.  However, as indicated above and previously acknowledged by management, GNW will need to boost capital in its U.S. MI business by $500-700 million.

I won’t spend much time on the investment portfolio, which is $73 billion and 85% high quality fixed income.  Like all insurers, GNW has suffered from the Fed’s financial repression both in the investment portfolio and from a balance sheet liability perspective.  In this respect, insurers are interesting diversifiers for a portfolio since on balance they should benefit from a gradual increase in interest rates (IMHO not something that is likely anytime soon).

With the the recent writedowns in LTC precipitating ratings downgrades, together with the need for additional U.S. MI capital, GNW has commenced a comprehensive restructuring designed to reduce costs, further enhance liquidity and strengthen capital levels, including through potential divestitures.  As indicated above, the Lifestyle Protection business is on the block, though it is too small by itself to move the needle.  More importantly, GNW is reported to be shopping its life and annuity unit.  GNW management has indicated that it would like to reduce debt at the holding company by $1-2 billion, which would enhance financial flexibility.  It seems the ultimate endgame is to separate the LTC and mortgage insurance businesses, which makes strategic sense but isn’t deemed to be feasible with GNW’s current balance sheet.

There is so much bad news embedded in the GNW share price that it should not take much good news, or perhaps even simply the absence of incremental bad news, for the shares to be re-rated to be more in-line with the peer group, which trades at a modest premium to book value and at 8-11x earnings.  I believe GNW has at least $1.60 of annual earnings power in the next few years, which would result in a nearly $13 stock at the low end of industry valuations.  Recall that GNW’s stakes in its publicly traded mortgage insurance subs in Canada and Australia are worth a total of $2.5 billion at current market prices and exchange rates meaning investors are ascribing merely $1.3 billion of equity value to the rest of GNW that has book equity of over $10 billion.

A sale of the life and annuity businesses at a decent price could also be a catalyst as it would allow GNW to shore up the balance sheet, focus on its stronger core businesses and eventually effectuate a split of mortgage insurance and LTC.  Management could also elect to separate the older LTC book into a closed block that would isolate these policies from the ongoing business and provide further transparency to claims trends and the profitability of the ongoing LTC business.  One analyst has even suggested that  investors in Genworth are receiving a free option on Biogen’s experimental Alzheimer’s drug since about 50 percent of Genworth’s long-term care insurance claims payments are for Alzheimers or other forms of dementia.  That strikes me as a little far-fetched, but the point is that GNW has many potential levers to pull to unlock value.

Catalyst

No more bad news; sale of the life and/or annuity business; ultimate separation of the LTC and MI businesses.