In his recent one-volume history of American capitalism, “Americana,” author Bhu Srivnivasan recounts the rise of many of the country’s large corporations in the late 19th century, including the long-standing U.S. industry stalwart, General Electric. GE was formed when Wall Street bankers engineered the merger of two fledgling electrical services providers, including the company formed by Thomas Edison, Edison Electric. The company has since grown to become a massive conglomerate and something of a mainstay of the U.S. commercial economy, in many ways a bellwether for the country’s economic health and a representative example of the country’s industrial might. More recently the company has gone through some high-profile struggles, drawing questions for the company’s management – and as discussed below, attracting securities class action litigation as well.
What’s Past is Prologue
While the company has been scuffling recently, only a short time ago it was a financial market favorite. Under Jack Welch, who was the company’s Chairman and CEO from 1981 to 2000, the company’s share price rose 4,000%. In the following 17 years under Welch’s successor, Jeffrey Immelt, the company’s share price essentially remained unchanged. During that time a host of unflattering questions have arisen about how exactly Welch was able to deliver steady and consistent earnings increases every quarter.
More recently, Wall Street has had to become accustomed to the company more regularly missing quarterly projections. The company has also been dogged by a series of self-inflicted wounds, including the controversy late last year involving Immelt’s strange use of the company’s corporate jets, in which the company’s CEO would regularly travel with a second empty jet flying along behind him apparently as some kind of a back-up.
More Recent Events at GE under New Leadership
Investor hopes for a turnaround under new CEO John Flannery were dashed last October, when, in the first quarterly report under Flannery, the company’s results fell below analysts’ expectations. As reflected in media reports at the time, the company’s results disappointed due to restructuring costs and a weak performance in its power and oil and gas businesses. The company also lowered earnings projections for the remained of the year. In a conference call the same day, Flannery said that it is “clear” from the company’s current results that “we need to make some major changes with urgency and depth of purpose. Our results are unacceptable to say the least.”
The October 2017 earnings release drew a securities class action lawsuit. As reflected here, on November 1, 2017, a GE shareholder filed a securities suit in the Southern District of New York against the company, Immelt, Flannery, and GE CFO Jeffrey Bornstein. The complaint, which can be found here, alleges that the defendants failed to disclose “(1) that the Company’s various operating segments, including its Power segment, were underperforming Company projections, with order drops, excess inventories, and increased costs; (2) as a result the Company overstated GE’s fully year 2017 guidance; and (3) that, as a result of the foregoing, Defendants’ statements about General Electric’s business, operations, and prospects, were false and misleading and/or lacked a reasonable basis.” The complaint seeks to recover damages on behalf of a class of investors who purchased the company’s stock between July 21, 2017 and October 20, 2017.
GE’s Recent Massive Quarterly Charge
Even with the lowered expectations that followed after the company’s reduced 2017 projections, investors were unprepared for the company’s recent announcement that it was taking a huge fourth quarter charge in order to massively increase its reserves on its run-off long term health care insurance business.
As reflected in its January 16, 2018 press release (here), the company recorded in its fourth quarter 2017 results a $6.2 billion after-tax charge reflecting reserve increases in its run-off insurance portfolio, relating primarily to long-term health care policies written by primary insurance companies and reinsured in the company’s North American Life & Health Portfolio. The company said the charge was the result of a comprehensive review undertaken earlier in the year of the adequacy of the company’s run-off insurance reserves.
As distracting as the headline is about the $6.2 billion charge, the news is actually quite a bit worse than the headline alone would suggest. The $6.2 billion charge is the after-tax result of a pre-tax charge of $9.5 billion. The company said the indicated statutory reserve contributions “will be a higher number than the GAAP charge” due to modifications of certain assumptions to reflect various potential adverse conditions.” How much higher? Well, among other thing, the press release states that the company’s GE Capital division expects to make statutory reserve contributions of approximately $15 billion over the next seven years, with the contributions phased in between 2018 and 2024.
The Latest Securities Class Action Lawsuit
Given the unexpected magnitude of GE’s charge, it will not surprise any of this blog’s readers to learn that plaintiff class action attorneys have filed yet another securities class action lawsuit against the company and its senior officials.
On January 18, 2018, a GE shareholder filed a securities class action lawsuit in the District of Connecticut against Flannery, Immelt, Bornstein, and Keith Sherin, who had been GE’s CFO from December 1998 until July 2013 and who served as GE Capital’s CEO from July 2013 until September 2016. The plaintiff purports to represent a class of investors who purchased the company’s shares between February 26, 2013 and January 12, 2018.
The complaint, a copy of which can be found here, alleges that the defendants made false and misleading statements or failed to disclose that:
(i) GE was failing to allocate sufficient reserves with respect to premium deficiencies and other risks associated with GE Capital’s legacy reinsurance business; (ii) these risks were then accruing billions of dollars of unreported impairment charges for GE; (iii) consequently, the value of GE was overstated during the Class Period, and additional undisclosed impairments were necessary; and (iv) as a result of the foregoing, GE’s public statements were materially false and misleading at all relevant times.
Behind the Bad News: Long Term Health Care Insurance
Underneath GE’s massive quarterly charge are fundamental underlying problems with the way long term health care (LTHC) insurance policies were first marketed and sold in volume in the 80s and 90s. As discussed in an interesting January 17, 2018 Wall Street Journal article entitled “Millions Bought Insurance to Cover Retirement Health Costs. Now They Face an Awful Choice” (here) the LTHC product, once a mainstay of the life and health insurance sector, has caused massive problems for insurers and policyholders alike.
As is now all too apparent to the insurers that wrote the business, the insurers “badly underestimated how many claims would be filed and how long people would draw payments before dying. People are living and keeping their policies much longer than expected.” The impact of these factors has been even further exacerbated by nearly a decade of ultralow interest rates that have left insurers with far lower investment returns than projected. In hindsight, insurers went into this business with flawed assumptions about nearly every aspect of how the product would perform.
These unexpected developments have cause problems for policyholders, who expected annual premiums to stay relatively steady, but who instead have faced years of successive increases. As the Journal article notes, “Steep increases that many policyholders never saw coming are confronting them with an awful choice: Come up with the money to pay more – or walk away from their coverage.”
Buried amongst the interesting faulty assumptions that created this mess are several very interesting aspects of human nature that underscores how features of human behavior can undermine efforts to use calculation alone to project future events. Built into the insurers’ assumptions about the LTHC insurance product was a projection that a certain number of the buyers would drop out each year, as they decided not to pay their annual premiums. But rather than a 5% annual drop-out rate as assumed, the drop-out rate has proven to be less than 1%. As it turns out, the kind of people who buy these kinds of policies are “meticulous planners who intended to always pay their premiums.” These people, the kinds who look ahead and who prepare, “might also have carefully looked after their health and diet, enhancing the chances they would live long.”
A particularly unfortunate side effect as LTHC insurance has gone sour is that the poor results seem to have affected the behavior of insurers as they handle the claims. Most of the insurers that were once active in this area have long since withdrawn. As the Journal article puts it, as the industry “reels from its mistakes,” some policyholders “complain that it has nothing to lose by denying legitimate long-term-care claims.” Some of the LTHC insurers have gone into bankruptcy, leaving policyholders with payments from guarantee funds far below what they expected when they bought the insurance, and in some cases even below what the policyholders paid in premiums.
The LTHC debacle may be an industry-wide problem, but at least at the present moment, it is GE that is taking the arrows from Wall Street and from investors over the massive increase in its insurance reserves. The sheer size of GE’s current charge and anticipated future reserve increases, as well as the timing, coming as it does at this late date more than a decade after the company exited the business, does raise questions about the adequacy of reserves amongst the many other insurers and reinsurers that were exposed to this business. If I were an investor or analyst looking at any insurance business these days, I would certainly want to know everything I can about how exposed the business is or was to LTHC insurance.
The lessons from the troubled tale of LTHC insurance should be required study for everyone in the insurance industry. I have to say I am more than a little bit surprised by the timing of the most recent turbulence involving LTHC insurance. The fact that there are deep problems with the way this product was priced and sold is not sudden or unexpected news. Over 15 years ago, back when I was on the insurer side of the business, I was sitting through presentations detailing the flawed actuarial assumptions that had gone into pricing the product and the long term problems that would mean for insurers who sold the product, given its long-tail nature. That was even before the long run of ultralow interest rates even further undermined the product’s returns.
I will say this, some of the problems associated with LTHC insurance are present any time the insurance industry tries to promote an entirely new product. In the absence of long-term claims history, the new product’s projected loss results are always going to be conjectural. The difficulty of projecting future losses for a new insurance product is exacerbated when the product’s performance is highly subject to social or demographic changes. Indeed, there are those in the industry who might say some current relatively new products – such as, for example, cyber liability insurance – are subject to these kinds of risks.
All of the dangers for the industry from these kinds of risks are magnified when competition drives pricing down, reducing any margin for error. The willingness for new players to enter a space with competitive pricing frequently is spurred precisely in those situations when the likely loss costs are relatively unknown and difficult to project.
As I noted above, the history of LTHC insurance is a cautionary tale. And as GE’s reject charge underscores, there may yet be more of this tale to be told before its final and worst outcomes are fully known.
How to Boost Productivity: A recent study published by the World Economic Forum may have some helpful advice for how to increase your team’s productivity. The title of the study – I am not making this up — is “New Research Finds that Kids Aged 4-6 Perform Better During Boring Tasks When Dressed as Batman.” The study, published on December 4, 2017 on the World Economic Forum website, can be found here.