Genworth Financial (GNW) Long Term Care Looks Good

As you recall we invested in Genworth when their two primary business units; U.S. mortgage insurance and long term care (LTC) insurance were performing poorly. The housing crisis and escalating long term care costs raised questions about the viability of the company’s main business lines. Our investment thesis [Source] centered on a turnaround that was already underway in the U.S. mortgage insurance and the steps being taken to address long term care (LTC) insurance issues. To our advantage these early improvements were being ignored by Mr. Market who was overly pessimistic on the company. This gave us a buying opportunity.

The Mortgage Insurance business continued to improve over the past number of quarters to change investor’s perspective of this unit from an impending disaster to a growth business with good prospects. GNW helped this along with a new CEO and a creative capital plan that further removed fears of capital inadequacy in the mortgage insurance unit.

Pessimism remains on the Long Term Care insurance business unit. As competitors exit the business line, many question the economic viability and capital adequacy of GNW’s LTC insurance business. Why is GNW management not exiting the business as well? GNW is the LTC market leader with 35% market share and this unit will have a significant impact for better or worse.

The new CEO Tom McInerney explained on arrival that time was needed to complete a thorough strategic review to determine the long term viability of LTC insurance business. He also promised more openness and disclosure to help investors better understand whatever the findings would be but investors remained skeptical. The results are now in and the good news is the LTC business is viable and can be viewed as one with good prospects for a number of reasons.

GNW Light House

Long Term Care

On December 4, 2013 management presented the results of the extensive strategic review and backed their conclusion with the disclosures and openness promised to investors.  The major conclusions are:

  • Genworth will remain in the Long Term Care business.
  • The reserves for future LTC losses are adequate under different tests.
  • The LTC business represents a significant future opportunity for GNW.
    • Proactive premium increases are already improving returns.
    • Many competitors exited the business leaving a more profitable opportunity for GNW.
  • LTC will be managed more like health insurance and less like life insurance.
    • More frequent and smaller rate hikes will be requested.
    • Initial policy assumptions continually reviewed and acted upon as needed.
  • Changes in new policy sales already underway include:
    • More stringent underwriting standards on prospective buyers
    • Raising premiums
    • Limiting new policies to five years or less
  • Regulators understand a viable LTC industry is needed to meet future needs.
    • Aggressively request rate hikes for older policies to just break-even.
    • New products are structured to earn a 20 percent return.

Passing the Warren Buffett Discipline Test:

The top leadership at GNW including CEO Tom McInerney and CFO Marty Klein are insisting on the needed discipline as described by Warren Buffett who has made a huge and successful mark investing in insurance. He explains on page 11 of the Berkshire Hathaway 2010 Letter to Shareholders [Source]:

“At bottom, a sound insurance operation requires four disciplines:

  1. An understanding of all exposures that might cause a policy to incur losses;
  2. A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does;
  3. The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and
  4. The willingness to walk away if the appropriate premium can’t be obtained.”

The LTC business was evaluated with three margin approaches:

Three Margin Analysis

Genworth’s Long Term Care Insurance View [Source]

The Analysis:

  • Using projections of cash flows discounted at projected portfolio rates:
    • The after tax statutory balance sheet margin is approximately $4.6 billion.
    • The after tax GAAP balance sheet margin is approximately $4 billion.
  • Margins are tested under various sensitivity assumptions including:
    • Lower reinvestment rates
    • Lower lapse rates (fewer policy holders canceling before payouts begin)
    • Less morbidity improvement (lower health of policy holders leading to higher/longer payouts)
    • Lower additional premiums resulting from the 2012 rate actions.
  • Balance sheet margins were adjusted to arrive at the Statutory and GAAP margins:
    • Statutory after tax cash flow margin (as filed with regulators) is approximately $2.6 billion with various provisions for adverse deviations.
    • GAAP loss recognition testing required annually shows the pretax GAAP margin is approximately $3 billion.
  • Long-term-care goodwill is fully recoverable with an excess margin of approximately $400 million, over 100% more than recorded goodwill of $354 million.

The Analysis

Improvement Actions Initiated or Underway:

In the presentation management highlighted previously discussed improvements already taken or underway to improve margins. New business written is projected to add $250-300 million in after tax margin.

The details of these actions shown in the slide below include:

  • Significant premium rate increases on older policies bringing them closer to breakeven.
    • The estimated increases add approximately $2.5 billion after tax to the balance sheet margins in reserve testing.
  • After-tax hedge gains in accumulated other comprehensive income on the GAAP balance sheet.
    • After tax benefit to balance sheet margins of $1.6 billion to amortize into income over time.
    • Similar after tax benefit of $865 million hedge gains on the statutory balance sheet in the interest maintenance reserve to also amortize into income.
    • Hedged interest rates starting in 2000; gains contribute significant margin to long-term-care reserves.
  • Genworth has written significant new business over the last several years with tighter underwriting, higher prices, and higher returns than the older blocks.
    • Profits from the newer blocks of business more than offset losses or low returns on the older books.
    • New business margins strengthen overall statutory and GAAP margins.
  • The newest Privilege Choice Flex 3.0 product starting in late November has projected returns of over 20%, and will margins in the future.

Improvements

Key Sensitivities Tested:

Long term care as the name implies is a long duration product so changes in assumptions will impact performance over time. GNW’s management provided a sensitivity analysis around the key assumptions that are roughly a one standard deviation from the estimates. They include:

  • Lapse sensitivity (Sensitivity A below); further accelerates the decline in actual lapse experience by reducing lapse rates by 25 basis points from the assumption of 0.7% to less than 0.5%, on average.
  • Morbidity and mortality improvement sensitivity (Sensitivity B below); assumes medical progress over the last 20 years slows down with 10 years of morbidity and mortality improvement averaging 1.6% and 1% the annual improvement horizon reduced to five years.
  • The in-force rate action sensitivity (Sensitivity C below) assumes premium rate increases will only reach $250 million vs. the $250-300 million assumption.
  • Interest rate sensitivity (Sensitivity D below) delays the US economic recovery keeping treasury rates low with the 10-year ultimate treasury rate 110 basis points lower than the assumptions.
  • Flat interest rate sensitivity (Sensitivity E below) holds treasury rates flat with the 10-year rate at approximately 2.5% through the analysis period.

Under these reasonably conservative sensitivities the statutory and GAAP margins remain solid in each case as shown below. Further a case that assumes all A through D sensitivities occuring at the same, although highly unlikely, statutory margin remained positive at approximately $1.8 billion, and GAAP margin at approximately $1.2 billion.

Sensitivites

LTC Review Summary:

Key Points

Insightful Strategy Shift:

 

Albert Einstein is reported to have said; “We can’t solve problems by using the same kind of thinking we used when we created them” (which probably morphed into the more popular statement also attributed to him; “Insanity is doing the same thing over and over again and expecting different results”). Whether Einstein said it or not the logic of the statements is sound.

The problem with the logic in business is the difficulty to publicly admit something is wrong when your pay, or your job, depends on getting it right. Harder still is to figure out how to get it right and then get everyone on board with a departure from an ingrained strategy. Tom McInerney, President and CEO working with Marty Klein CFO deserve credit for a fresh look at the business and in my view the most important findings; it was being managed wrong; what to do to fix it and how to get stakeholders on board with the change.

As Tom McInerney said at the end of the conference call, “…the most important point I want you to take away from today’s presentation is that long-term-care insurance must be managed proactively with annual reviews of experience and the pursuit of smaller, more manageable rate actions, as warranted, somewhat similar to how health insurance products are managed. In hindsight, I think the entire long-term-care industry would have been better off if it had filed for smaller, more frequent rate increases on long-term-care insurance policies, as experience differed from initial assumptions.”

In life insurance actuarial data is pretty reliable based on age and health; insurers only gain if you live longer. In long term care insurance where you must consider the rapid changes in health care, cognitive impairment, and medical costs over the long haul; insurers lose the longer you live and collect on LTC policies.

Implementing the Strategy:

To implement such a change in strategy, regulators need to understand the need. Tom McInerney goes on to explain the key points discussed with regulators:

  • …we should be aligned in our objectives to have a robust private insurance market for long-term care.
  • Many individuals remain unaware that Medicare does not generally cover long-term-care needs.
  • Several companies have already left the LTC market.
  • …if the private market goes away…Americans will ultimately need care through state Medicaid plans.
  • These Medicaid plans are already paying 25% to 50% of their budgets for long-term-care claims.
  • In 15 to 20 years… 76 million…reach the ages where they’re likely to need long-term-care insurance.
  • …the stress on Medicaid budgets will be enormous, and even more strained than they are today.
  • I can say with certainty that state public policy makers are very concerned about this issue.

Summary:

Investors are now recognizing Genworth’s progress in the mortgage insurance business as evidenced by the 175% one year gain since our purchase in November 2011. The  LTC insurance progress in this review too will be recognized over the next number of quarters eventually providing additional gains. Further gains can be expected with the prospects of an Australian mortgage business IPO, reinstating the dividend, and our long hoped for share buybacks as future catalysts.  Stay tuned!

Genworth Financial (GNW) continues to sell at a significant discount to our estimate of its true (intrinsic) value even. This lingering pessimism provides continued opportunity to buy shares at about $15.00/share or $7.00 below our $22.00 estimate of intrinsic value for a 30% margin of safety.

Disclosure: Long GNW

Resources:

  • Genworth Financial Website [Source]
  • Long Term Care Insurance Review & Transcript [Source]

 

 

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