Today, Fitch Ratings published its annual report on long-term care (or LTC) insurers, ranking GE (GE) second on its list of the 16 riskiest LTC insurers, just behind first-place Genworth Financial (GNW). At 2:44 PM EDT, GE stock was down 3.18% on the news.
Genworth stock was trading flat at the same time while the broad-based S&P 500 Index (SPY) was down 0.57%. Since Harry Markopolos, the Bernie Madoff whistleblower, accused GE of committing accounting fraud last week, GE stock has been active. The stock fell 11.3% on August 15, when the GE Whistleblower Report was published. The stock recovered the next day as Wall Street came to the rescue.
The GE fraud saga: LTC insurance exposure in the spotlight
The Markopolos report put GE’s LTC insurance exposure back in the spotlight. The Fitch report seemed to affirm some of the concerns that Markopolos’ report highlighted. Fitch analyst Anthony Beato, who worked on the annual report, stated that he hasn’t seen Markopolos’ report yet.
First, LTC insurance has turned out to be a disaster for insurers, including GE, Prudential (PRU), and others. In late 2017, GE took a $6.2 billion charge related to the LTC insurance segment that it discontinued in 2006.
In August 2018, Prudential reported a $1.6 billion loss in divested businesses as the assumptions behind the original long-term care insurance failed. Prudential stopped selling LTC policies seven years ago. Prudential stock was trading 1% lower at 2:46 PM EDT.
What’s the problem?
This problem is twofold. Firstly, General Electric reinsured these policies when the LTC insurance industry was still evolving. The premium calculations underestimated the claims that would come due years later. Because there was competition between companies to scale up this relatively new business line, most priced their reinsurance aggressively. However, mayhem ensued when claims started coming in.
Secondly, insurers didn’t anticipate the low-yield environment after the 2008 recession. To see how low interest rates hamper insurers, let’s look at the business model. Insurers typically collect premiums from policyholders in advance and invest them mostly in high-grade bonds. These investments help them meet claims in the future.
If they are earning higher returns than assumed in premium calculations—assuming the claim assumptions are fine—they don’t need to make contributions to the reserves. If their returns fall short, they have to use the reserves. When they don’t have enough reserves, they must take a charge and make a contribution to the reserve.
As a reinsurer, GE assumes claim responsibility and premiums for many insurance policies written by primary insurers. With bonds in the investment portfolio yielding low, GE started falling short on meeting the claims.
Why could it get worse?
According to the American Association of Long-Term Care Insurance, 70% of the claims happen after the 80th birthday of the average policyholder. GE’s average policyholder was 75 years old. In short, the company may have a lot more LTC claims coming its way in the next few years.
To make the situation worse, yields are expected to drop further with the dovish Fed and other global central banks. As a result, GE is looking to move some of its portfolio to equities and high-yield loans in search of returns. However, these asset classes are inherently riskier.
The Markopolos report alleges that GE is hiding $29 billion in LTC losses. The report stated that an accounting change would force GE to take an additional charge in 2021.
Regulators to the rescue?
Meanwhile, the Kansas Insurance Department, the regulator that oversees GE’s LTC reinsurance business, called the Markopolos report “fairly simplistic.” In our view, the GE fraud saga is getting more interesting by the day.