General Electric's Biggest Bear Digs Into Its Insurance Business. What You Need to Know.
Barron's
Sep 05, 2019
How bad is General Electric's long-term-care insurance business? It's the most important question for investors in the troubled company, whose shares fell 21% in August, worse than the 1.7% decline of the Dow Jones Industrial Average over the same period, after a report slammed the company's insurance accounting.
On Wednesday, Gordon Haskett analyst John Inch -- the biggest GE (ticker: GE) bear on Wall Street -- hosted a client conference call with insurance expert Jukka Lipponen to conduct a deep dive into GE's long-term-care insurance book of business. It was a chance for investors to learn more about the intricacies of insurance accounting, though big questions remain.
Inch, who rates GE shares the equivalent of Sell with a $5 price target, the lowest one on Wall Street -- is worried about the company's future liabilities, but acknowledges insurance is a "complicated topic."
Many Wall Street analysts -- all with more-bullish outlooks for the stock than Inch -- have offered opinions on the report published by forensic accountant Harry Markopolos claiming General Electric's accounting for long-term-care insurance is fraudulent.
GE referred Barron's to its prior comments. The company has dismissed claims as " meritless."
The back story. Overall, Wall Street appears to be comfortable with GE's accounting, but that hasn't put the issue to bed. "Long-term-care insurance is a failed product," said Lipponen, founder of Independent Insurance Analysts, a consultancy, on the conference call. But that shouldn't be a surprise to investors. Many industry participants have taken charges to shore up insurance reserves, and GE took a $6.2 billion after-tax charge announced in early 2018 reflecting the deterioration in the long-term-care insurance business.
The debate about whether long-term-care insurance is a problem or not is settled. It is. Investors now need to decide whether Markopolos is right and GE's accounting is incorrect -- something which seems unlikely, according to the Street -- whether weakening industry trends will still mean more cash required by GE to fund future liabilities, or, in the best outcome, whether GE has put its insurance issue behind it after committing $15 billion in cash to its insurance reserves in 2018.
"Without access to detailed assumptions, it's difficult to know," said Lipponen, referring to the potential for more charges against earnings and more cash required by GE. That, ultimately, is the problem. The accounting is complex, and the number of assumptions is myriad.
The uncertainty looks to be hurting GE's share price.
What's new. The insurance issue is hardly a new one for GE investors. To allay fears, GE hosted an insurance "teach-in" in March. At that time, company explained how earnings would be impacted when accounting assumptions change. These assumptions are now being scrutinized by the Street.
Inch's call with Lipponen focused on many of these assumptions. Lipponen appears most concerned with the company's "morbidity assumption" -- its estimate for what proportion of the insured population will qualify for a claim. GE assumes morbidity will improve, meaning that a small proportion of the people receiving benefits will get better.
If the company would assume no improvement in morbidity, it would have to take a $3.7 billion noncash charge to its financial statements. That amount was disclosed in March.
GE also increased its expected return on its insurance portfolio assets, moving to change its asset mix. That assumption has been challenged because interest rates are falling -- and falling interest rates makes it harder to earn more money on insurance premiums received. Lipponen noted that GE's insurance portfolio was less risky than its peers and that its move to change the mix of assets is defensible.
GE said it had previously disclosed the impact of the accounting changes and that they didn't impact cash flow.
Looking ahead. The large 2017 insurance charge, announced in early 2018, was unavoidable given industry trends, according to Lipponen. But the question remains: What's likely to happen in the future?
One thing that's certain is an accounting change coming in 2021, which will impact GE financial statements. The change mandates the discount rate used to calculate liabilities. A lower discount rate inflates liabilities. Investors can think of it this way: If a company needs to set aside money to repay a $100 note in the future, more cash is required up front if interest rates are low and the money set aside won't earn much return.
"I don't think the market cares at all about accounting changes of this nature or, for that matter, any other variety of accounting changes," accounting expert Robert Willens told Barron's. Investors care about actual cash drains on the company, and accounting changes don't alter the cash required to fund the troubled long-term-care insurance business.
Willens' opinion could be construed as good news for investors, but it still doesn't answer the question of whether or not more cash will be required as the business worsens. At least GE has the wherewithal to pay. "I don't see a huge liquidity event," Lipponen said on the call. He argued that GE has enough cash sources to meet liabilities. That, again, is a bit of good news.
But insurance, a business acquired by GE a generation ago, looks to be something investors will have to deal with for the foreseeable future. Inch deferred to Lipponen's expertise, but all the uncertainty is one reason he remains bearish on GE stock.
GE stock was up 2.4%, at $9.01, in recent trading, while the Dow Jones Industrial Average was up 1.7%.
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