UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2013
OR
For the transition period from to
Commission file number 001-32195
GENWORTH FINANCIAL, INC.
(Exact Name of Registrant as Specified in its Charter)
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification Number)
6620 West Broad Street
Richmond, Virginia
(804) 281-6000
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of October 23, 2013, 494,259,563 shares of Class A Common Stock, par value $0.001 per share, were outstanding.
NOTE REGARDING THIS QUARTERLY REPORT
As previously announced, on April 1, 2013, we completed a holding company reorganization in connection with a comprehensive capital plan for our U.S. mortgage insurance business, which is discussed in further detail in note 1 of the financial statements in “Item 1—Financial Statements” of this Quarterly Report on Form 10-Q. Pursuant to the reorganization, the public holding company historically known as “Genworth Financial, Inc.” (now renamed Genworth Holdings, Inc. (“Genworth Holdings”)) became a direct, 100% owned subsidiary of a new public holding company that it had formed and that now has been renamed Genworth Financial, Inc. (“New Genworth”). In connection with the reorganization, all the stockholders of Genworth Holdings immediately prior to the completion of the reorganization automatically became stockholders of New Genworth, owning the same number of shares of stock in New Genworth that they owned in Genworth Holdings immediately prior to the reorganization. New Genworth, as the successor issuer to Genworth Holdings (pursuant to Rule 12g-3(a) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), began making filings under the Securities Act of 1933, as amended, and the Exchange Act, from April 1, 2013.
On April 1, 2013, in connection with the reorganization, Genworth Holdings distributed to New Genworth (as its sole stockholder), through a dividend (the “Distribution”), the 84.6% membership interest in one of its subsidiaries (Genworth Mortgage Holdings, LLC (“GMHL”)) that it held directly, and 100% of the shares of another of its subsidiaries (Genworth Mortgage Holdings, Inc. (“GMHI”)), that held the remaining 15.4% of outstanding membership interests of GMHL. At the time of the Distribution, GMHL and GMHI together owned (directly or indirectly) 100% of the shares or other equity interests of all of the subsidiaries that conducted Genworth Holdings’ U.S. mortgage insurance business (these subsidiaries also owned the subsidiaries that conducted Genworth Holdings’ European mortgage insurance business). As part of the comprehensive U.S. mortgage insurance capital plan, on April 1, 2013, immediately prior to the Distribution, Genworth Holdings contributed $100 million to the U.S. mortgage insurance subsidiaries.
On April 1, 2013, in connection with the reorganization (a) New Genworth provided a full and unconditional guarantee to the trustee of Genworth Holdings’ outstanding senior notes and the holders of the senior notes, on an unsecured unsubordinated basis, of the full and punctual payment of the principal of, premium, if any and interest on, and all other amounts payable under, each outstanding series of senior notes, and the full and punctual payment of all other amounts payable by Genworth Holdings under the senior notes indenture in respect of such senior notes and (b) New Genworth provided a full and unconditional guarantee to the trustee of Genworth Holdings’ outstanding subordinated notes and the holders of the subordinated notes, on an unsecured subordinated basis, of the full and punctual payment of the principal of, premium, if any and interest on, and all other amounts payable under, the outstanding subordinated notes, and the full and punctual payment of all other amounts payable by Genworth Holdings under the subordinated notes indenture in respect of the subordinated notes.
References to “Genworth,” the “Company,” “we” or “our” in this Quarterly Report on Form 10-Q (including in the condensed consolidated financial statements and notes thereto in this report) have the following meanings, unless the context otherwise requires:
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TABLE OF CONTENTS
PART I—FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of September 30, 2013 (Unaudited) and December 31, 2012
Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2012 (Unaudited)
Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2013 and 2012 (Unaudited)
Condensed Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2013 and 2012 (Unaudited)
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012 (Unaudited)
Notes to Condensed Consolidated Financial Statements (Unaudited)
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II—OTHER INFORMATION
Item 1. Legal Proceedings
Item 1A. Risk Factors
Item 6. Exhibits
Signatures
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CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in millions, except per share amounts)
Assets
Investments:
Fixed maturity securities available-for-sale, at fair value
Equity securities available-for-sale, at fair value
Commercial mortgage loans
Restricted commercial mortgage loans related to securitization entities
Policy loans
Other invested assets
Restricted other invested assets related to securitization entities, at fair value
Total investments
Cash and cash equivalents
Accrued investment income
Deferred acquisition costs
Intangible assets
Goodwill
Reinsurance recoverable
Other assets
Separate account assets
Assets associated with discontinued operations
Total assets
Liabilities and stockholders’ equity
Liabilities:
Future policy benefits
Policyholder account balances
Liability for policy and contract claims
Unearned premiums
Other liabilities ($78 and $133 other liabilities related to securitization entities)
Borrowings related to securitization entities ($73 and $62 at fair value)
Non-recourse funding obligations
Long-term borrowings
Deferred tax liability
Separate account liabilities
Liabilities associated with discontinued operations
Total liabilities
Commitments and contingencies
Stockholders’ equity:
Class A common stock, $0.001 par value; 1.5 billion shares authorized; 583 million and 580 million shares issued as of September 30, 2013 and December 31, 2012, respectively; 494 million and 492 million shares outstanding as of September 30, 2013 and December 31, 2012, respectively
Additional paid-in capital
Accumulated other comprehensive income (loss):
Net unrealized investment gains (losses):
Net unrealized gains (losses) on securities not other-than-temporarily impaired
Net unrealized gains (losses) on other-than-temporarily impaired securities
Net unrealized investment gains (losses)
Derivatives qualifying as hedges
Foreign currency translation and other adjustments
Total accumulated other comprehensive income (loss)
Retained earnings
Treasury stock, at cost (88 million shares as of September 30, 2013 and December 31, 2012)
Total Genworth Financial, Inc.’s stockholders’ equity
Noncontrolling interests
Total stockholders’ equity
Total liabilities and stockholders’ equity
See Notes to Condensed Consolidated Financial Statements
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CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Revenues:
Premiums
Net investment income
Net investment gains (losses)
Insurance and investment product fees and other
Total revenues
Benefits and expenses:
Benefits and other changes in policy reserves
Interest credited
Acquisition and operating expenses, net of deferrals
Amortization of deferred acquisition costs and intangibles
Goodwill impairment
Interest expense
Total benefits and expenses
Income from continuing operations before income taxes
Provision for income taxes
Income from continuing operations
Income (loss) from discontinued operations, net of taxes
Net income
Less: net income attributable to noncontrolling interests
Net income available to Genworth Financial, Inc.’s common stockholders
Income from continuing operations available to Genworth Financial, Inc.’s common stockholders per common share:
Basic
Diluted
Net income available to Genworth Financial, Inc.’s common stockholders per common share:
Weighted-average common shares outstanding:
Supplemental disclosures:
Total other-than-temporary impairments
Portion of other-than-temporary impairments included in other comprehensive income (loss)
Net other-than-temporary impairments
Other investments gains (losses)
Total net investment gains (losses)
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CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Amounts in millions)
Other comprehensive income (loss), net of taxes:
Total other comprehensive income (loss)
Total comprehensive income (loss)
Less: comprehensive income attributable to noncontrolling interests
Total comprehensive income (loss) available to Genworth Financial, Inc.’s common stockholders
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CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Balances as of December 31, 2012
Repurchase of subsidiary shares
Comprehensive income (loss):
Dividends to noncontrolling interests
Stock-based compensation expense and exercises and other
Balances as of September 30, 2013
Balances as of December 31, 2011
Balances as of September 30, 2012
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Less (income) loss from discontinued operations, net of taxes
Adjustments to reconcile net income to net cash from operating activities:
Amortization of fixed maturity discounts and premiums and limited partnerships
Net investment losses (gains)
Charges assessed to policyholders
Acquisition costs deferred
Deferred income taxes
Net increase (decrease) in trading securities, held-for-sale investments and derivative instruments
Stock-based compensation expense
Change in certain assets and liabilities:
Accrued investment income and other assets
Insurance reserves
Current tax liabilities
Other liabilities and other policy-related balances
Cash from operating activities—discontinued operations
Net cash from operating activities
Cash flows from investing activities:
Proceeds from maturities and repayments of investments:
Fixed maturity securities
Proceeds from sales of investments:
Fixed maturity and equity securities
Purchases and originations of investments:
Other invested assets, net
Policy loans, net
Proceeds from sale of a subsidiary, net of cash transferred
Cash from investing activities—discontinued operations
Net cash from investing activities
Cash flows from financing activities:
Deposits to universal life and investment contracts
Withdrawals from universal life and investment contracts
Redemption and repurchase of non-recourse funding obligations
Proceeds from the issuance of long-term debt
Repayment and repurchase of long-term debt
Repayment of borrowings related to securitization entities
Dividends paid to noncontrolling interests
Other, net
Cash from financing activities—discontinued operations
Net cash from financing activities
Effect of exchange rate changes on cash and cash equivalents
Net change in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Less cash and cash equivalents of discontinued operations at end of period
Cash and cash equivalents of continuing operations at end of period
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(1) Formation of Genworth and Basis of Presentation
Genworth Holdings, Inc. (“Genworth Holdings”) (formerly known as Genworth Financial, Inc.) was incorporated in Delaware on October 23, 2003. On April 1, 2013, Genworth Holdings completed a holding company reorganization pursuant to which Genworth Holdings became a direct, 100% owned subsidiary of a new public holding company it had formed. The new public holding company was incorporated in Delaware on December 5, 2012, in connection with the reorganization, under the name Sub XLVI, Inc., and was renamed Genworth Financial, Inc. upon the completion of the reorganization.
To implement the reorganization, Genworth Holdings formed New Genworth and New Genworth, in turn, formed Sub XLII, Inc. (“Merger Sub”). The holding company structure was implemented pursuant to Section 251(g) of the General Corporation Law of the State of Delaware (“DGCL”) by the merger of Merger Sub with and into Genworth Holdings (the “Merger”). Genworth Holdings survived the Merger as a direct, wholly-owned subsidiary of New Genworth and each share of Genworth Holdings Class A Common Stock, par value $0.001 per share (“Genworth Holdings Class A Common Stock”), issued and outstanding immediately prior to the Merger and each share of Genworth Holdings Class A Common Stock held in the treasury of Genworth Holdings immediately prior to the Merger converted into one issued and outstanding or treasury, as applicable, share of New Genworth Class A Common Stock, par value $0.001 per share, having the same designations, rights, powers and preferences and the qualifications, limitations and restrictions as the Genworth Holdings Class A Common Stock being converted.
Immediately after the consummation of the Merger, New Genworth had the same authorized, outstanding and treasury capital stock as Genworth Holdings immediately prior to the Merger. Each share of New Genworth common stock outstanding immediately prior to the Merger was cancelled.
Pursuant to Section 251(g) of the DGCL, the Merger did not require a vote of the stockholders of Genworth Holdings. Effective upon the consummation of the Merger, New Genworth adopted an amended and restated certificate of incorporation and amended and restated bylaws that were identical to those of Genworth Holdings immediately prior to the consummation of the Merger (other than provisions regarding certain technical matters, as permitted by Section 251(g) of the DGCL). New Genworth’s directors and executive officers immediately after the consummation of the Merger were the same as the directors and executive officers of Genworth Holdings immediately prior to the consummation of the Merger. Immediately after the consummation of the Merger, New Genworth had, on a consolidated basis, the same assets, businesses and operations as Genworth Holdings had immediately prior to the consummation of the Merger.
On April 1, 2013, in connection with the reorganization, immediately following the consummation of the Merger, Genworth Holdings distributed to New Genworth (as its sole stockholder), through a dividend (the “Distribution”), the 84.6% membership interest in one of its subsidiaries (Genworth Mortgage Holdings, LLC (“GMHL”)) that it held directly, and 100% of the shares of another of its subsidiaries (Genworth Mortgage Holdings, Inc. (“GMHI”)), that held the remaining 15.4% of outstanding membership interests of GMHL. At the time of the Distribution, GMHL and GMHI together owned (directly or indirectly) 100% of the shares or other equity interests of all of the subsidiaries that conducted Genworth Holdings’ U.S. mortgage insurance business (these subsidiaries also owned the subsidiaries that conducted Genworth Holdings’ European mortgage insurance business). As part of the comprehensive U.S. mortgage insurance capital plan, on April 1, 2013, immediately prior to the Distribution, Genworth Holdings contributed $100 million to the U.S. mortgage insurance subsidiaries.
The accompanying condensed financial statements include on a consolidated basis the accounts of: (a) for the periods prior to April 1, 2013, Genworth Holdings and the affiliated companies in which it held a majority
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equity interest or where it was the primary beneficiary of a variable interest entity and (b) for the periods from and after April 1, 2013, New Genworth and the affiliated companies in which it held a majority voting interest or where it was the primary beneficiary of a variable interest entity. All intercompany accounts and transactions have been eliminated in consolidation.
References to “Genworth,” the “Company,” “we” or “our” in the accompanying condensed consolidated financial statements and these notes thereto have the following meanings, unless the context otherwise requires:
We have the following operating segments:
We also have Corporate and Other activities which include debt financing expenses that are incurred at the Genworth Holdings holding company level, unallocated corporate income and expenses, eliminations of inter-segment transactions and the results of other businesses that are managed outside of our operating segments.
On March 27, 2013, we announced that we had agreed to sell our wealth management business to AqGen Liberty Acquisition, Inc., a subsidiary of AqGen Liberty Holdings LLC, a partnership of Aquiline Capital
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Partners and Genstar Capital, for approximately $412 million. Historically, this business had been reported as a separate segment. As a result of the sale agreement, the financial statements and other disclosures herein have been revised to reclassify this business as discontinued operations and report its financial position, results of operations and cash flows separately for all periods presented. The sale closed on August 30, 2013 and we received net proceeds of approximately $360 million. Also included in discontinued operations was our tax and advisor unit, Genworth Financial Investment Services, which was part of our wealth management business until the closing of its sale on April 2, 2012. See note 10 for additional information related to discontinued operations.
The accompanying condensed consolidated financial statements are unaudited and have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) and rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). Preparing financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ from those estimates. These condensed consolidated financial statements include all adjustments (including normal recurring adjustments) considered necessary by management to present a fair statement of the financial position, results of operations and cash flows for the periods presented. The results reported in these condensed consolidated financial statements should not be regarded as necessarily indicative of results that may be expected for the entire year. The condensed consolidated financial statements included herein should be read in conjunction with the audited consolidated financial statements and related notes contained in our Current Report on Form 8-K filed on May 30, 2013, which reflected the reclassification of our wealth management business as discontinued operations, adjustments to correct an error related to premium refund accrual in our U.S. mortgage insurance business, the addition of a footnote in the notes to the consolidated financial statements that provides required supplemental guarantor financial information related to certain guarantees we gave in connection with the reorganization in which we became the parent company to Genworth Holdings and the addition of certain disclosures about offsetting assets and liabilities required by newly adopted accounting guidance. Certain prior year amounts have been reclassified to conform to the current year presentation.
(2) Accounting Changes
Accounting Pronouncements Recently Adopted
On July 17, 2013, we adopted new accounting guidance to provide additional flexibility in the benchmark interest rates used when applying hedge accounting. The new guidance permits the use of the Federal Funds Effective Swap Rate as a benchmark interest rate for hedge accounting purposes and removes certain restrictions on being able to apply hedge accounting for similar hedges using different benchmark interest rates. The adoption of this accounting guidance did not have a material impact on our consolidated financial statements.
On January 1, 2013, we adopted new accounting guidance for disclosures about offsetting assets and liabilities. This guidance requires an entity to disclose information about offsetting and related arrangements to enable users to understand the effect of those arrangements on its financial position. The adoption of this accounting guidance impacted our disclosures only and did not impact our consolidated results.
On January 1, 2013, we adopted new accounting guidance related to the presentation of the reclassification of items out of accumulated other comprehensive income into net income. The adoption of this accounting guidance impacted our disclosures only and did not impact our consolidated results.
Accounting Pronouncements Not Yet Adopted
In June 2013, the Financial Accounting Standards Board issued new accounting guidance on the scope, measurement and disclosure requirements for investment companies. The new guidance clarifies the
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characteristics of an investment company, provides comprehensive guidance for assessing whether an entity is an investment company, requires investment companies to measure noncontrolling ownership interest in other investment companies at fair value rather than using the equity method of accounting and requires additional disclosures. These new requirements will be effective for us on January 1, 2014 and are not expected to have a material impact on our consolidated financial statements.
(3) Earnings Per Share
Basic and diluted earnings per share are calculated by dividing each income category presented below by the weighted-average basic and diluted shares outstanding for the periods indicated:
Weighted-average shares used in basic earnings per common share calculations
Potentially dilutive securities:
Stock options, restricted stock units and stock appreciation rights
Weighted-average shares used in diluted earnings per common share calculations
Income from continuing operations:
Less: income from continuing operations attributable to noncontrolling interests
Income from continuing operations available to Genworth Financial, Inc.’s common stockholders
Basic per common share
Diluted per common share
Income (loss) from discontinued operations:
Less: income from discontinued operations, net of taxes, attributable to noncontrolling interests
Income (loss) from discontinued operations, net of taxes, available to Genworth Financial, Inc.’s common stockholders
Net income:
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(4) Investments
(a) Net Investment Income
Sources of net investment income were as follows for the periods indicated:
Fixed maturity securities—taxable
Fixed maturity securities—non-taxable
Equity securities
Cash, cash equivalents and short-term investments
Gross investment income before expenses and fees
Expenses and fees
(b) Net Investment Gains (Losses)
The following table sets forth net investment gains (losses) for the periods indicated:
Available-for-sale securities:
Realized gains
Realized losses
Net realized gains (losses) on available-for-sale securities
Impairments:
Trading securities
Net gains (losses) related to securitization entities
Derivative instruments (1)
Contingent consideration adjustment
Other
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We generally intend to hold securities in unrealized loss positions until they recover. However, from time to time, our intent on an individual security may change, based upon market or other unforeseen developments. In such instances, we sell securities in the ordinary course of managing our portfolio to meet diversification, credit quality, yield and liquidity requirements. If a loss is recognized from a sale subsequent to a balance sheet date due to these unexpected developments, the loss is recognized in the period in which we determined that we have the intent to sell the securities or it is more likely than not that we will be required to sell the securities prior to recovery. The aggregate fair value of securities sold at a loss during the three months ended September 30, 2013 and 2012 was $407 million and $228 million, respectively, which was approximately 93% and 96%, respectively, of book value. The aggregate fair value of securities sold at a loss during the nine months ended September 30, 2013 and 2012 was $1,293 million and $911 million, respectively, which was approximately 90% and 93%, respectively, of book value.
The following represents the activity for credit losses recognized in net income on debt securities where an other-than-temporary impairment was identified and a portion of other-than-temporary impairments was included in other comprehensive income (loss) (“OCI”) as of and for the periods indicated:
Beginning balance
Additions:
Other-than-temporary impairments not previously recognized
Increases related to other-than-temporary impairments previously recognized
Reductions:
Securities sold, paid down or disposed
Ending balance
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(c) Unrealized Investment Gains and Losses
Net unrealized gains and losses on available-for-sale investment securities reflected as a separate component of accumulated other comprehensive income (loss) were as follows as of the dates indicated:
Net unrealized gains (losses) on investment securities:
Subtotal
Adjustments to deferred acquisition costs, present value of future profits, sales inducements and benefit reserves
Income taxes, net
Less: net unrealized investment gains (losses) attributable to noncontrolling interests
Net unrealized investment gains (losses) attributable to Genworth Financial, Inc.
The change in net unrealized gains (losses) on available-for-sale investment securities reported in accumulated other comprehensive income (loss) was as follows as of and for the periods indicated:
Unrealized gains (losses) arising during the period:
Unrealized gains (losses) on investment securities
Adjustment to deferred acquisition costs
Adjustment to present value of future profits
Adjustment to sales inducements
Adjustment to benefit reserves
Change in unrealized gains (losses) on investment securities
Reclassification adjustments to net investment (gains) losses, net of taxes of $(6)
Change in net unrealized investment gains (losses)
Less: change in net unrealized investment gains (losses) attributable to noncontrolling interests
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Reclassification adjustments to net investment (gains) losses, net of taxes of $(10) and $(19)
(d) Fixed Maturity and Equity Securities
As of September 30, 2013, the amortized cost or cost, gross unrealized gains (losses) and fair value of our fixed maturity and equity securities classified as available-for-sale were as follows:
Fixed maturity securities:
U.S. government, agencies and government-sponsored enterprises
Tax-exempt
Government—non-U.S.
U.S. corporate
Corporate—non-U.S.
Residential mortgage-backed
Commercial mortgage-backed
Other asset-backed
Total fixed maturity securities
Total available-for-sale securities
16
As of December 31, 2012, the amortized cost or cost, gross unrealized gains (losses) and fair value of our fixed maturity and equity securities classified as available-for-sale were as follows:
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The following table presents the gross unrealized losses and fair values of our investment securities, aggregated by investment type and length of time that individual investment securities have been in a continuous unrealized loss position, as of September 30, 2013:
(Dollar amounts in millions)
Description of Securities
Subtotal, fixed maturity securities
Total for securities in an unrealized loss position
% Below cost—fixed maturity securities:
<20% Below cost
20%-50% Below cost
>50% Below cost
% Below cost—equity securities:
Total equity securities
Investment grade
Below investment grade (3)
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As indicated in the table above, the majority of the securities in a continuous unrealized loss position for less than 12 months were investment grade and less than 20% below cost. These unrealized losses were primarily attributable to lower credit ratings since acquisition for corporate securities across various industry sectors. For securities that have been in a continuous unrealized loss for less than 12 months, the average fair value percentage below cost was approximately 6% as of September 30, 2013.
Fixed Maturity Securities In A Continuous Unrealized Loss Position For 12 Months Or More
Of the $125 million of unrealized losses on fixed maturity securities in a continuous unrealized loss for 12 months or more that were less than 20% below cost, the weighted-average rating was “BBB-” and approximately 66% of the unrealized losses were related to investment grade securities as of September 30, 2013. These unrealized losses were attributable to the lower credit ratings for these securities since acquisition, primarily associated with corporate and structured securities in the finance and insurance sector. The average fair value percentage below cost for these securities was approximately 9% as of September 30, 2013. See below for additional discussion related to fixed maturity securities that have been in a continuous loss position for 12 months or more with a fair value that was more than 20% below cost.
The following tables present the concentration of gross unrealized losses and fair values of fixed maturity securities that were more than 20% below cost and in a continuous loss position for 12 months or more by asset class as of September 30, 2013:
Structured securities:
Total structured securities
Total
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For all securities in an unrealized loss position, we expect to recover the amortized cost based on our estimate of cash flows to be collected. We do not intend to sell and it is not more likely than not that we will be required to sell these securities prior to recovering our amortized cost. See the following for further discussion of gross unrealized losses by asset class.
U. S. government, agencies and government-sponsored enterprises
As indicated in the table above, $43 million of gross unrealized losses were related to a U.S. government, agencies and government-sponsored enterprises security that has been in a continuous loss position for more than 12 months and was greater than 20% below cost. The unrealized losses for the U.S. government, agencies and government-sponsored enterprises security represents a long-term, zero coupon Treasury bond. An increase in Treasury yields since the bond was purchased resulted in a decrease in the market value of this security. We expect that this security will accrete up to par value over time.
Corporate Debt Securities
The following tables present the concentration of gross unrealized losses and fair values related to corporate debt fixed maturity securities that were more than 20% below cost and in a continuous loss position for 12 months or more by industry as of September 30, 2013:
Industry:
Finance and insurance
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The total unrealized losses of $19 million for corporate fixed maturity securities presented in the tables above related to issuers in the finance and insurance sector that were 20% below cost on average. Given the current market conditions, including current financial industry events and uncertainty around global economic conditions, the fair value of these debt securities has declined due to credit spreads that have widened since acquisition. In our examination of these securities, we considered all available evidence, including the issuers’ financial condition and current industry events to develop our conclusion on the amount and timing of the cash flows expected to be collected. Based on this evaluation, we determined that the unrealized losses on these debt securities represented temporary impairments as of September 30, 2013. Of the $19 million of unrealized losses related to the finance and insurance industry, $18 million related to financial hybrid securities on which a debt impairment model was employed. Most of our hybrid securities retained a credit rating of investment grade. The fair value of these hybrid securities has been impacted by credit spreads that have widened since acquisition and reflect uncertainty surrounding the extent and duration of government involvement, potential capital restructuring of these institutions, and continued but diminishing risk that income payments may be deferred. We continue to receive our contractual payments and expect to fully recover our amortized cost.
We expect that our investments in corporate securities will continue to perform in accordance with our expectations about the amount and timing of estimated cash flows. Although we do not anticipate such events, it is at least reasonably possible that issuers of our investments in corporate securities will perform worse than current expectations. Such events may lead us to recognize write-downs within our portfolio of corporate securities in the future.
Structured Securities
Of the $74 million of unrealized losses related to structured securities that have been in an unrealized loss position for 12 months or more and were more than 20% below cost, $11 million related to other-than-temporarily impaired securities where the unrealized losses represented the portion of the other-than-temporary impairment recognized in OCI. The extent and duration of the unrealized loss position on our structured securities was primarily due to the ongoing concern and uncertainty about the residential and commercial real estate market and unemployment, resulting in credit spreads that have widened since acquisition. Additionally, the fair value of certain structured securities has been significantly impacted from high risk premiums being incorporated into the valuation as a result of the amount of potential losses that may be absorbed by the security in the event of additional deterioration in the U.S. housing market.
While we considered the length of time each security had been in an unrealized loss position, the extent of the unrealized loss position and any significant declines in fair value subsequent to the balance sheet date in our evaluation of impairment for each of these individual securities, the primary factor in our evaluation of impairment is the expected performance for each of these securities. Our evaluation of expected performance is based on the historical performance of the associated securitization trust as well as the historical performance of
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the underlying collateral. Our examination of the historical performance of the securitization trust included consideration of the following factors for each class of securities issued by the trust: i) the payment history, including failure to make scheduled payments; ii) current payment status; iii) current and historical outstanding balances; iv) current levels of subordination and losses incurred to date; and v) characteristics of the underlying collateral. Our examination of the historical performance of the underlying collateral included: i) historical default rates, delinquency rates, voluntary and involuntary prepayments and severity of losses, including recent trends in this information; ii) current payment status; iii) loan to collateral value ratios, as applicable; iv) vintage; and v) other underlying characteristics such as current financial condition.
We used our assessment of the historical performance of both the securitization trust and the underlying collateral for each security, along with third-party sources, when available, to develop our best estimate of cash flows expected to be collected. These estimates reflect projections for future delinquencies, prepayments, defaults and losses for the assets that collateralize the securitization trust and are used to determine the expected cash flows for our security, based on the payment structure of the trust. Our projection of expected cash flows is primarily based on the expected performance of the underlying assets that collateralize the securitization trust and is not directly impacted by the rating of our security. While we consider the rating of the security as an indicator of the financial condition of the issuer, this factor does not have a significant impact on our expected cash flows for each security. In limited circumstances, our expected cash flows include expected payments from reliable financial guarantors where we believe the financial guarantor will have sufficient assets to pay claims under the financial guarantee when the cash flows from the securitization trust are not sufficient to make scheduled payments. We then discount the expected cash flows using the effective yield of each security to determine the present value of expected cash flows.
Based on this evaluation, the present value of expected cash flows was greater than or equal to the amortized cost for each security. Accordingly, we determined that the unrealized losses on each of our structured securities represented temporary impairments as of September 30, 2013.
Despite the considerable analysis and rigor employed on our structured securities, it is at least reasonably possible that the underlying collateral of these investments will perform worse than current market expectations. Such events may lead to adverse changes in cash flows on our holdings of structured securities and future write-downs within our portfolio of structured securities.
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The following table presents the gross unrealized losses and fair values of our investment securities, aggregated by investment type and length of time that individual investment securities have been in a continuous unrealized loss position, as of December 31, 2012:
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The scheduled maturity distribution of fixed maturity securities as of September 30, 2013 is set forth below. Actual maturities may differ from contractual maturities because issuers of securities may have the right to call or prepay obligations with or without call or prepayment penalties.
Due one year or less
Due after one year through five years
Due after five years through ten years
Due after ten years
As of September 30, 2013, $5,529 million of our investments (excluding mortgage-backed and asset-backed securities) were subject to certain call provisions.
As of September 30, 2013, securities issued by utilities and energy, finance and insurance, and consumer—non-cyclical industry groups represented approximately 24%, 19% and 12%, respectively, of our domestic and foreign corporate fixed maturity securities portfolio. No other industry group comprised more than 10% of our investment portfolio. This portfolio is widely diversified among various geographic regions in the United States and internationally, and is not dependent on the economic stability of one particular region.
As of September 30, 2013, we did not hold any fixed maturity securities in any single issuer, other than securities issued or guaranteed by the U.S. government, which exceeded 10% of stockholders’ equity.
(e) Commercial Mortgage Loans
Our mortgage loans are collateralized by commercial properties, including multi-family residential buildings. The carrying value of commercial mortgage loans is stated at original cost net of prepayments, amortization and allowance for loan losses.
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We diversify our commercial mortgage loans by both property type and geographic region. The following tables set forth the distribution across property type and geographic region for commercial mortgage loans as of the dates indicated:
Property type:
Retail
Office
Industrial
Apartments
Mixed use/other
Unamortized balance of loan origination fees and costs
Allowance for losses
Geographic region:
Pacific
South Atlantic
Middle Atlantic
Mountain
East North Central
West North Central
New England
West South Central
East South Central
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The following tables set forth the aging of past due commercial mortgage loans by property type as of the dates indicated:
Total recorded investment
% of total commercial mortgage loans
As of September 30, 2013 and December 31, 2012, we had no commercial mortgage loans that were past due for more than 90 days and still accruing interest. We did not have any commercial mortgage loans that were past due for less than 90 days on non-accrual status as of September 30, 2013 and December 31, 2012.
As of and for the nine months ended September 30, 2013 and the year ended December 31, 2012, we modified or extended 26 and 38 commercial mortgage loans, respectively, with a total carrying value of $146 million and $279 million, respectively. All of these modifications or extensions were based on current market interest rates, did not result in any forgiveness in the outstanding principal amount owed by the borrower and were not considered troubled debt restructurings.
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The following table sets forth the allowance for credit losses and recorded investment in commercial mortgage loans as of or for the periods indicated:
Allowance for credit losses:
Charge-offs
Recoveries
Provision
Ending allowance for individually impaired loans
Ending allowance for loans not individually impaired that were evaluated collectively for impairment
Recorded investment:
Ending balance of individually impaired loans
Ending balance of loans not individually impaired that were evaluated collectively for impairment
As of September 30, 2013, we had individually impaired commercial mortgage loans included within the retail property type with a recorded investment of $1 million, an unpaid principal balance of $3 million, charge-offs of $2 million and an average recorded investment of $1 million. As of September 30, 2013, we also had individually impaired commercial mortgage loans included within the industrial property type with a recorded investment of $1 million, an unpaid principal balance of $2 million, charge-offs of $1 million and an average recorded investment of $1 million. As of December 31, 2012, we had no individually impaired commercial mortgage loans.
In evaluating the credit quality of commercial mortgage loans, we assess the performance of the underlying loans using both quantitative and qualitative criteria. Certain risks associated with commercial mortgage loans can be evaluated by reviewing both the loan-to-value and debt service coverage ratio to understand both the probability of the borrower not being able to make the necessary loan payments as well as the ability to sell the underlying property for an amount that would enable us to recover our unpaid principal balance in the event of default by the borrower. The average loan-to-value ratio is based on our most recent estimate of the fair value for the underlying property which is evaluated at least annually and updated more frequently if necessary to better indicate risk associated with the loan. A lower loan-to-value indicates that our loan value is more likely to be recovered in the event of default by the borrower if the property was sold. The debt service coverage ratio is based on “normalized” annual net operating income of the property compared to the payments required under the terms of the loan. Normalization allows for the removal of annual one-time events such as capital expenditures, prepaid or late real estate tax payments or non-recurring third-party fees (such as legal, consulting or contract fees). This ratio is evaluated at least annually and updated more frequently if necessary to better indicate risk associated with the loan. A higher debt service coverage ratio indicates the borrower is less likely to default on the loan. The debt service coverage ratio should not be used without considering other factors associated with the borrower, such as the borrower’s liquidity or access to other resources that may result in our expectation that the borrower will continue to make the future scheduled payments.
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The following tables set forth the loan-to-value of commercial mortgage loans by property type as of the dates indicated:
% of total
Weighted-average debt service coverage ratio
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The following tables set forth the debt service coverage ratio for fixed rate commercial mortgage loans by property type as of the dates indicated:
Weighted-average loan-to-value
The following tables set forth the debt service coverage ratio for floating rate commercial mortgage loans by property type as of the dates indicated:
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(f) Restricted Commercial Mortgage Loans Related To Securitization Entities
The following tables set forth additional information regarding our restricted commercial mortgage loans related to securitization entities as of the dates indicated:
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As of September 30, 2013, the total recorded investment of our restricted commercial mortgage loans of $291 million was current. Of our restricted commercial mortgage loans as of December 31, 2012, $337 million were current and $5 million were past due for more than 90 days and still accruing interest.
As of September 30, 2013 and December 31, 2012, the total recorded investment of restricted commercial mortgage loans of $291 million and $342 million, respectively, related to loans not individually impaired that were evaluated collectively for impairment. There was no provision for credit losses recorded during the three or nine months ended September 30, 2013 or 2012 related to restricted commercial mortgage loans.
In evaluating the credit quality of restricted commercial mortgage loans, we assess the performance of the underlying loans using both quantitative and qualitative criteria. The risks associated with restricted commercial mortgage loans can typically be evaluated by reviewing both the loan-to-value and debt service coverage ratio to understand both the probability of the borrower not being able to make the necessary loan payments as well as the ability to sell the underlying property for an amount that would enable us to recover our unpaid principal balance in the event of default by the borrower. The average loan-to-value ratio is based on our most recent estimate of the fair value for the underlying property which is evaluated at least annually and updated more frequently if necessary to better indicate risk associated with the loan. A lower loan-to-value indicates that our loan value is more likely to be recovered in the event of default by the borrower if the property was sold. The debt service coverage ratio is based on “normalized” annual net operating income of the property compared to the payments required under the terms of the loan. Normalization allows for the removal of annual one-time events such as capital expenditures, prepaid or late real estate tax payments or non-recurring third-party fees (such as legal, consulting or contract fees). This ratio is evaluated at least annually and updated more frequently if necessary to better indicate risk associated with the loan. A higher debt service coverage ratio indicates the borrower is less likely to default on the loan. The debt service coverage ratio should not be used without considering other factors associated with the borrower, such as the borrower’s liquidity or access to other resources that may result in our expectation that the borrower will continue to make the future scheduled payments.
The following tables set forth the loan-to-value of restricted commercial mortgage loans by property type as of the dates indicated:
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The following tables set forth the debt service coverage ratio for fixed rate restricted commercial mortgage loans by property type as of the dates indicated:
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There were no floating rate restricted commercial mortgage loans as of September 30, 2013 or December 31, 2012.
(g) Restricted Other Invested Assets Related To Securitization Entities
We have consolidated securitization entities that hold certain investments that are recorded as restricted other invested assets related to securitization entities. The consolidated securitization entities hold certain investments as trading securities whereby the changes in fair value are recorded in current period income (loss). The trading securities comprise asset-backed securities, including residual interest in certain policy loan securitization entities and highly rated bonds that are primarily backed by credit card receivables.
(5) Derivative Instruments
Our business activities routinely deal with fluctuations in interest rates, equity prices, currency exchange rates and other asset and liability prices. We use derivative instruments to mitigate or reduce certain of these risks. We have established policies for managing each of these risks, including prohibitions on derivatives market-making and other speculative derivatives activities. These policies require the use of derivative instruments in concert with other techniques to reduce or mitigate these risks. While we use derivatives to mitigate or reduce risks, certain derivatives do not meet the accounting requirements to be designated as hedging instruments and are denoted as “derivatives not designated as hedges” in the following disclosures. For derivatives that meet the accounting requirements to be designated as hedges, the following disclosures for these derivatives are denoted as “derivatives designated as hedges,” which include both cash flow and fair value hedges.
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The following table sets forth our positions in derivative instruments as of the dates indicated:
Derivative assets
Derivative liabilities
Balancesheet classification
Derivatives designated as hedges
Cash flow hedges:
Interest rate swaps
Inflation indexed swaps
Foreign currency swaps
Forward bond purchase commitments
Total cash flow hedges
Fair value hedges:
Total fair value hedges
Total derivatives designated as hedges
Derivatives not designated as hedges
Interest rate swaps related to securitization entities
Credit default swaps
Credit default swaps related to securitization entities
Equity index options
Financial futures
Equity return swaps
Other foreign currency contracts
GMWB embedded derivatives
Fixed index annuity embedded derivatives
Total derivatives not designated as hedges
Total derivatives
The fair value of derivative positions presented above was not offset by the respective collateral amounts retained or provided under these agreements. The amounts recognized for derivative counterparty collateral retained by us was recorded in other invested assets with a corresponding amount recorded in other liabilities to represent our obligation to return the collateral retained by us.
The activity associated with derivative instruments can generally be measured by the change in notional value over the periods presented. However, for GMWB and fixed index annuity embedded derivatives, the
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change between periods is best illustrated by the number of policies. The following tables represent activity associated with derivative instruments as of the dates indicated:
(Notional in millions)
(Number of policies)
Cash Flow Hedges
Certain derivative instruments are designated as cash flow hedges. The changes in fair value of these instruments are recorded as a component of OCI. We designate and account for the following as cash flow hedges when they have met the effectiveness requirements: (i) various types of interest rate swaps to convert floating rate investments to fixed rate investments; (ii) various types of interest rate swaps to convert floating rate liabilities into fixed rate liabilities; (iii) receive U.S. dollar fixed on foreign currency swaps to hedge the foreign currency cash flow exposure of foreign currency denominated investments; (iv) forward starting interest rate
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swaps to hedge against changes in interest rates associated with future fixed rate bond purchases and/or interest income; (v) forward bond purchase commitments to hedge against the variability in the anticipated cash flows required to purchase future fixed rate bonds; and (vi) other instruments to hedge the cash flows of various forecasted transactions.
The following table provides information about the pre-tax income (loss) effects of cash flow hedges for the three months ended September 30, 2013:
Classification of gain(loss) reclassified intonet income
Classification of gain(loss) recognized innet income
Interest rate swaps hedging assets
Interest rate swaps hedging liabilities
The following table provides information about the pre-tax income (loss) effects of cash flow hedges for the three months ended September 30, 2012:
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The following table provides information about the pre-tax income (loss) effects of cash flow hedges for the nine months ended September 30, 2013:
The following table provides information about the pre-tax income (loss) effects of cash flow hedges for the nine months ended September 30, 2012:
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The following tables provide a reconciliation of current period changes, net of applicable income taxes, for these designated derivatives presented in the separate component of stockholders’ equity labeled “derivatives qualifying as hedges,” for the periods indicated:
Derivatives qualifying as effective accounting hedges as of July 1
Current period increases (decreases) in fair value, net of deferred taxes of $73 and $31
Reclassification to net (income), net of deferred taxes of $4 and $9
Derivatives qualifying as effective accounting hedges as of September 30
Derivatives qualifying as effective accounting hedges as of January 1
Current period increases (decreases) in fair value, net of deferred taxes of $244 and $(12)
Reclassification to net (income), net of deferred taxes of $10 and $9
The total of derivatives designated as cash flow hedges of $1,442 million, net of taxes, recorded in stockholders’ equity as of September 30, 2013 is expected to be reclassified to future net income, concurrently with and primarily offsetting changes in interest expense and interest income on floating rate instruments and interest income on future fixed rate bond purchases. Of this amount, $37 million, net of taxes, is expected to be reclassified to net income in the next 12 months. Actual amounts may vary from this amount as a result of market conditions. All forecasted transactions associated with qualifying cash flow hedges are expected to occur by 2047. No amounts were reclassified to net income during the nine months ended September 30, 2013 in connection with forecasted transactions that were no longer considered probable of occurring.
Fair Value Hedges
Certain derivative instruments are designated as fair value hedges. The changes in fair value of these instruments are recorded in net income. In addition, changes in the fair value attributable to the hedged portion of the underlying instrument are reported in net income. We designate and account for the following as fair value hedges when they have met the effectiveness requirements: (i) interest rate swaps to convert fixed rate investments to floating rate investments; (ii) interest rate swaps to convert fixed rate liabilities into floating rate liabilities; (iii) cross currency swaps to convert non-U.S. dollar fixed rate liabilities to floating rate U.S. dollar liabilities; and (iv) other instruments to hedge various fair value exposures of investments.
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There were no pre-tax income (loss) effects of fair value hedges and related hedged items for the three months ended September 30, 2013. The following table provides information about the pre-tax income (loss) effects of fair value hedges and related hedged items for the three months ended September 30, 2012:
Classificationof gain (losses)recognized in netincome
Classificationof otherimpacts tonet income
Classificationof gain (losses)recognized innet income
The following table provides information about the pre-tax income (loss) effects of fair value hedges and related hedged items for the nine months ended September 30, 2013:
The following table provides information about the pre-tax income (loss) effects of fair value hedges and related hedged items for the nine months ended September 30, 2012:
Classification ofother impacts tonet income
The difference between the gain (loss) recognized for the derivative instrument and the hedged item presented above represents the net ineffectiveness of the fair value hedging relationships. The other impacts presented above represent the net income effects of the derivative instruments that are presented in the same
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location as the income (loss) activity from the hedged item. There were no amounts excluded from the measurement of effectiveness.
Derivatives Not Designated As Hedges
We also enter into certain non-qualifying derivative instruments such as: (i) interest rate swaps and financial futures to mitigate interest rate risk as part of managing regulatory capital positions; (ii) credit default swaps to enhance yield and reproduce characteristics of investments with similar terms and credit risk; (iii) equity index options, equity return swaps, interest rate swaps and financial futures to mitigate the risks associated with liabilities that have guaranteed minimum benefits and fixed index annuities; (iv) interest rate swaps where the hedging relationship does not qualify for hedge accounting; (v) credit default swaps to mitigate loss exposure to certain credit risk; (vi) foreign currency forward contracts and options to mitigate currency risk associated with investments and future dividends and other cash flows from certain foreign subsidiaries to our holding company; and (vii) equity index options to mitigate certain macroeconomic risks associated with certain foreign subsidiaries. Additionally, we provide GMWBs on certain variable annuities that are required to be bifurcated as embedded derivatives. We also offer fixed index annuity products and have reinsurance agreements with certain features that are required to be bifurcated as embedded derivatives.
We also have derivatives related to securitization entities where we were required to consolidate the related securitization entity as a result of our involvement in the structure. The counterparties for these derivatives typically only have recourse to the securitization entity. The interest rate swaps used for these entities are typically used to effectively convert the interest payments on the assets of the securitization entity to the same basis as the interest rate on the borrowings issued by the securitization entity. Credit default swaps are utilized in certain securitization entities to enhance the yield payable on the borrowings issued by the securitization entity and also include a settlement feature that allows the securitization entity to provide the par value of assets in the securitization entity for the amount of any losses incurred under the credit default swap.
The following table provides the pre-tax gain (loss) recognized in net income for the effects of derivatives not designated as hedges for the periods indicated:
Classification of gain (loss)recognized
in net income
Reinsurance embedded derivatives
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Derivative Counterparty Credit Risk
Most of our derivative arrangements with counterparties require the posting of collateral upon meeting certain net exposure thresholds. For derivatives related to securitization entities, there are no arrangements that require either party to provide collateral and the recourse of the derivative counterparty is typically limited to the assets held by the securitization entity and there is no recourse to any entity other than the securitization entity.
The following tables present additional information about derivative assets and liabilities subject to an enforceable master netting arrangement as of the dates indicated:
Derivative assets (1)
Derivative liabilities (2)
Net derivatives
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Except for derivatives related to securitization entities, almost all of our master swap agreements contain credit downgrade provisions that allow either party to assign or terminate derivative transactions if the other party’s long-term unsecured debt rating or financial strength rating is below the limit defined in the applicable agreement. If the downgrade provisions had been triggered as of September 30, 2013 and December 31, 2012, we could have been allowed to claim or required to disburse up to the net amounts shown in the last column of the charts above. The charts above exclude embedded derivatives and derivatives related to securitization entities as those derivatives are not subject to master netting arrangements.
Credit Derivatives
We sell protection under single name credit default swaps and credit default swap index tranches in combination with purchasing securities to replicate characteristics of similar investments based on the credit quality and term of the credit default swap. Credit default triggers for both indexed reference entities and single name reference entities follow the Credit Derivatives Physical Settlement Matrix published by the International Swaps and Derivatives Association. Under these terms, credit default triggers are defined as bankruptcy, failure to pay or restructuring, if applicable. Our maximum exposure to credit loss equals the notional value for credit default swaps. In the event of default for credit default swaps, we are typically required to pay the protection holder the full notional value less a recovery rate determined at auction.
In addition to the credit derivatives discussed above, we also have credit derivative instruments related to securitization entities that we consolidate. These derivatives represent a customized index of reference entities with specified attachment points for certain derivatives. The credit default triggers are similar to those described above. In the event of default, the securitization entity will provide the counterparty with the par value of assets held in the securitization entity for the amount of incurred loss on the credit default swap. The maximum exposure to loss for the securitization entity is the notional value of the derivatives. Certain losses on these credit default swaps would be absorbed by the third-party noteholders of the securitization entity and the remaining losses on the credit default swaps would be absorbed by our portion of the notes issued by the securitization entity.
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The following table sets forth our credit default swaps where we sell protection on single name reference entities and the fair values as of the dates indicated:
Reference entity credit rating and maturity:
AAA
Matures in less than one year
AA
Matures after five years through ten years
A
Matures after one year through five years
BBB
Total credit default swaps on single name reference entities
The following table sets forth our credit default swaps where we sell protection on credit default swap index tranches and the fair values as of the dates indicated:
Original index tranche attachment/detachment point and maturity:
7% - 15% matures after one year through five years (1)
9% - 12% matures in less than one year (2)
9% - 12% matures after one year through five years (2)
10% - 15% matures after one year through five years (3)
15% - 30% matures after five years through ten years (4)
Total credit default swap index tranches
Customized credit default swap index tranches related to securitization entities:
Portion backing third-party borrowings maturing 2017 (5)
Portion backing our interest maturing 2017 (6)
Total customized credit default swap index tranches related to securitization entities
Total credit default swaps on index tranches
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(6) Fair Value of Financial Instruments
Assets and liabilities that are reflected in the accompanying consolidated financial statements at fair value are not included in the following disclosure of fair value. Such items include cash and cash equivalents, investment securities, separate accounts, securities held as collateral and derivative instruments. Other financial assets and liabilities—those not carried at fair value—are discussed below. Apart from certain of our borrowings and certain marketable securities, few of the instruments discussed below are actively traded and their fair values must often be determined using models. The fair value estimates are made at a specific point in time, based upon available market information and judgments about the financial instruments, including estimates of the timing and amount of expected future cash flows and the credit standing of counterparties. Such estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument, nor do they consider the tax impact of the realization of unrealized gains or losses. In many cases, the fair value estimates cannot be substantiated by comparison to independent markets.
The basis on which we estimate fair value is as follows:
Commercial mortgage loans. Based on recent transactions and/or discounted future cash flows, using current market rates. Given the limited availability of data related to transactions for similar instruments, we typically classify these loans as Level 3.
Restricted commercial mortgage loans. Based on recent transactions and/or discounted future cash flows, using current market rates. Given the limited availability of data related to transactions for similar instruments, we typically classify these loans as Level 3.
Other invested assets. Based on comparable market transactions, discounted future cash flows, quoted market prices and/or estimates using the most recent data available for the related instrument. Primarily represents short-term investments and limited partnerships accounted for under the cost method. The fair value of short-term investments typically does not include significant unobservable inputs and approximate our amortized cost basis. As a result, short-term investments are classified as Level 2. Cost method limited partnerships typically include significant unobservable inputs as a result of being relatively illiquid with limited market activity for similar instruments and are classified as Level 3.
Long-term borrowings. We utilize available market data when determining fair value of long-term borrowings issued in the U.S. and Canada, which includes data on recent trades for the same or similar financial instruments. Accordingly, these instruments are classified as Level 2 measurements. In cases where market data is not available such as our Australian borrowings, we use broker quotes for which we consider the valuation methodology utilized by the third party, but the valuation typically includes significant unobservable inputs. Accordingly, we classify these borrowings where fair value is based on our consideration of broker quotes as Level 3 measurements.
Non-recourse funding obligations. We use an internal model to determine fair value using the current floating rate coupon and expected life/final maturity of the instrument discounted using the floating rate index and current market spread assumption, which is estimated based on recent transactions for these instruments or
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similar instruments as well as other market information or broker provided data. Given these instruments are private and very little market activity exists, our current market spread assumption is considered to have significant unobservable inputs in calculating fair value and, therefore, results in the fair value of these instruments being classified as Level 3.
Borrowings related to securitization entities. Based on market quotes or comparable market transactions. Some of these borrowings are publicly traded debt securities and are classified as Level 2. Certain borrowings are not publicly traded and are classified as Level 3.
Investment contracts. Based on expected future cash flows, discounted at current market rates for annuity contracts or institutional products. Given the significant unobservable inputs associated with policyholder behavior and current market rate assumptions used to discount the expected future cash flows, we classify these instruments as Level 3 except for certain funding agreement-backed notes that are traded in the marketplace as a security and are classified as Level 2.
The following represents our estimated fair value of financial assets and liabilities that are not required to be carried at fair value as of the dates indicated:
Assets:
Restricted commercial mortgage loans
Borrowings related to securitization entities
Investment contracts
Other firm commitments:
Commitments to fund limited partnerships
Ordinary course of business lending commitments
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Recurring Fair Value Measurements
We have fixed maturity, equity and trading securities, derivatives, embedded derivatives, securities held as collateral, separate account assets and certain other financial instruments, which are carried at fair value. Below is a description of the valuation techniques and inputs used to determine fair value by class of instrument.
Fixed maturity, equity and trading securities
The valuations of fixed maturity, equity and trading securities are determined using a market approach, income approach or a combination of the market and income approach depending on the type of instrument and availability of information.
We utilize certain third-party data providers when determining fair value. We consider information obtained from third-party pricing services (“pricing services”) as well as third-party broker provided prices, or broker quotes, in our determination of fair value. Additionally, we utilize internal models to determine the valuation of securities using an income approach where the inputs are based on third-party provided market inputs. While we consider the valuations provided by pricing services and broker quotes, management determines the fair value of our investment securities after considering all relevant and available information. We also use various methods to obtain an understanding of the valuation methodologies and procedures used by third-party data providers to ensure sufficient understanding to evaluate the valuation data received, including an understanding of the assumptions and inputs utilized to determine the appropriate fair value. For pricing services, we analyze the prices provided by our primary pricing services to other readily available pricing services and perform a detailed review of the assumptions and inputs from each pricing service to determine the appropriate fair value when pricing differences exceed certain thresholds. We also evaluate changes in fair value that are greater than 10% each month to further aid in our review of the accuracy of fair value measurements and our understanding of changes in fair value, with more detailed reviews performed by the asset managers responsible for the related asset class associated with the security being reviewed.
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In general, we first obtain valuations from pricing services. If a price is not supplied by a pricing service, we will typically seek a broker quote. For certain private fixed maturity securities where we do not obtain valuations from pricing services, we utilize an internal model to determine fair value since transactions for identical securities are not readily observable and these securities are not typically valued by pricing services. For all securities, excluding certain private fixed maturity securities, if neither a pricing service nor broker quotes valuation is available, we determine fair value using internal models.
For pricing services, we obtain an understanding of the pricing methodologies and procedures for each type of instrument. In general, a pricing service does not provide a price for a security if sufficient information is not readily available to determine fair value or if such security is not in the specific sector or class covered by a particular pricing service. Given our understanding of the pricing methodologies and procedures of pricing services, the securities valued by pricing services are typically classified as Level 2 unless we determine the valuation process for a security or group of securities utilizes significant unobservable inputs, which would result in the valuation being classified as Level 3.
For private fixed maturity securities, we utilize an internal model to determine fair value and utilize public bond spreads by sector, rating and maturity to develop the market rate that would be utilized for a similar public bond. We then add an additional premium, which represents an unobservable input, to the public bond spread to adjust for the liquidity and other features of our private placements. We utilize the estimated market yield to discount the expected cash flows of the security to determine fair value. In certain instances, we utilize price caps for securities where the estimated market yield results in a valuation that may exceed the amount that would be received in a market transaction. We assign each security an internal rating to determine the appropriate public bond spread that should be utilized in the valuation. While we generally consider the public bond spreads by sector and maturity to be observable inputs, we evaluate the similarities of our private placement with the public bonds, any price caps utilized and whether external ratings are available for our private placement to determine whether the spreads utilized would be considered observable inputs. During the second quarter of 2012, we began classifying private securities without an external rating as Level 3. In general, increases (decreases) in credit spreads will decrease (increase) the fair value for our fixed maturity securities. To determine the significance of unobservable inputs, we calculate the impact on the valuation from the unobservable input and will classify a security as Level 3 when the impact on the valuation exceeds 10%.
For broker quotes, we consider the valuation methodology utilized by the third party, but the valuation typically includes significant unobservable inputs. Accordingly, we classify the securities where fair value is based on our consideration of broker quotes as Level 3 measurements.
For remaining securities priced using internal models, we maximize the use of observable inputs but typically utilize significant unobservable inputs to determine fair value. Accordingly, the valuations are typically classified as Level 3.
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The following tables summarize the primary sources of data considered when determining fair value of each class of fixed maturity securities as of the dates indicated:
U.S. government, agencies and government-sponsored enterprises:
Pricing services
Internal models
Total U.S. government, agencies and government-sponsored enterprises
Tax-exempt:
Total tax-exempt
Government—non-U.S.:
Total government—non-U.S.
U.S. corporate:
Broker quotes
Total U.S. corporate
Corporate—non-U.S.:
Total corporate—non-U.S.
Residential mortgage-backed:
Total residential mortgage-backed
Commercial mortgage-backed:
Total commercial mortgage-backed
Other asset-backed:
Total other asset-backed
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The following tables summarize the primary sources of data considered when determining fair value of equity securities as of the dates indicated:
The following tables summarize the primary sources of data considered when determining fair value of trading securities as of the dates indicated:
Total trading securities
Restricted other invested assets related to securitization entities
We have trading securities related to securitization entities that are classified as restricted other invested assets and are carried at fair value. The trading securities represent asset-backed securities. The valuation for trading securities is determined using a market approach and/or an income approach depending on the availability of information. For certain highly rated asset-backed securities, there is observable market information for transactions of the same or similar instruments, which is provided to us by a third-party pricing service and is classified as Level 2. For certain securities that are not actively traded, we determine fair value after considering third-party broker provided prices or discounted expected cash flows using current yields for similar securities and classify these valuations as Level 3.
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Securities lending and derivative counterparty collateral
The fair value of securities held as collateral is primarily based on Level 2 inputs from market information for the collateral that is held on our behalf by the custodian. We determine fair value after considering prices obtained by third-party pricing services.
Contingent consideration
We have certain contingent purchase price payments and receivables related to acquisitions and sales that are recorded at fair value each period. Fair value is determined using an income approach whereby we project the expected performance of the business and compare our projections of the relevant performance metric to the thresholds established in the purchase or sale agreement to determine our expected payments or receipts. We then discount these expected amounts to calculate the fair value as of the valuation date. We evaluate the underlying projections used in determining fair value each period and update these underlying projections when there have been significant changes in our expectations of the future business performance. The inputs used to determine the discount rate and expected payments or receipts are primarily based on significant unobservable inputs and result in the fair value of the contingent consideration being classified as Level 3. An increase in the discount rate or a decrease in expected payments or receipts will result in a decrease in the fair value of contingent consideration.
The fair value of separate account assets is based on the quoted prices of the underlying fund investments and, therefore, represents Level 1 pricing.
Derivatives
We consider counterparty collateral arrangements and rights of set-off when evaluating our net credit risk exposure to our derivative counterparties. Accordingly, we are permitted to include consideration of these arrangements when determining whether any incremental adjustment should be made for both the counterparty’s and our non-performance risk in measuring fair value for our derivative instruments. As a result of these counterparty arrangements, we determined that any adjustment for credit risk would not be material and we do not record any incremental adjustment for our non-performance risk or the non-performance risk of the derivative counterparty for our derivative assets or liabilities. We determine fair value for our derivatives using an income approach with internal models based on relevant market inputs for each derivative instrument. We also compare the fair value determined using our internal model to the valuations provided by our derivative counterparties with any significant differences or changes in valuation being evaluated further by our derivatives professionals that are familiar with the instrument and market inputs used in the valuation.
Interest rate swaps. The valuation of interest rate swaps is determined using an income approach. The primary input into the valuation represents the forward interest rate swap curve, which is generally considered an observable input, and results in the derivative being classified as Level 2. For certain interest rate swaps, the inputs into the valuation also include the total returns of certain bonds that would primarily be considered an observable input and result in the derivative being classified as Level 2. For certain other swaps, there are features that provide an option to the counterparty to terminate the swap at specified dates. The interest rate volatility input used to value these options would be considered a significant unobservable input and results in the fair value measurement of the derivative being classified as Level 3. These options to terminate the swap by the counterparty are based on forward interest rate swap curves and volatility. As interest rate volatility increases, our valuation of the derivative changes unfavorably.
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Interest rate swaps related to securitization entities. The valuation of interest rate swaps related to securitization entities is determined using an income approach. The primary input into the valuation represents the forward interest rate swap curve, which is generally considered an observable input, and results in the derivative being classified as Level 2.
Inflation indexed swaps. The valuation of inflation indexed swaps is determined using an income approach. The primary inputs into the valuation represent the forward interest rate swap curve, the current consumer price index and the forward consumer price index curve, which are generally considered observable inputs, and results in the derivative being classified as Level 2.
Foreign currency swaps. The valuation of foreign currency swaps is determined using an income approach. The primary inputs into the valuation represent the forward interest rate swap curve and foreign currency exchange rates, both of which are considered an observable input, and results in the derivative being classified as Level 2.
Credit default swaps. We have both single name credit default swaps and index tranche credit default swaps. For single name credit default swaps, we utilize an income approach to determine fair value based on using current market information for the credit spreads of the reference entity, which is considered observable inputs based on the reference entities of our derivatives and results in these derivatives being classified as Level 2. For index tranche credit default swaps, we utilize an income approach that utilizes current market information related to credit spreads and expected defaults and losses associated with the reference entities that comprise the respective index associated with each derivative. There are significant unobservable inputs associated with the timing and amount of losses from the reference entities as well as the timing or amount of losses, if any, that will be absorbed by our tranche. Accordingly, the index tranche credit default swaps are classified as Level 3. As credit spreads widen for the underlying issuers comprising the index, the change in our valuation of these credit default swaps will be unfavorable.
Credit default swaps related to securitization entities. Credit default swaps related to securitization entities represent customized index tranche credit default swaps and are valued using a similar methodology as described above for index tranche credit default swaps. We determine fair value of these credit default swaps after considering both the valuation methodology described above as well as the valuation provided by the derivative counterparty. In addition to the valuation methodology and inputs described for index tranche credit default swaps, these customized credit default swaps contain a feature that permits the securitization entity to provide the par value of underlying assets in the securitization entity to settle any losses under the credit default swap. The valuation of this settlement feature is dependent upon the valuation of the underlying assets and the timing and amount of any expected loss on the credit default swap, which is considered a significant unobservable input. Accordingly, these customized index tranche credit default swaps related to securitization entities are classified as Level 3. As credit spreads widen for the underlying issuers comprising the customized index, the change in our valuation of these credit default swaps will be unfavorable.
Equity index options. We have equity index options associated with various equity indices. The valuation of equity index options is determined using an income approach. The primary inputs into the valuation represent forward interest rate volatility and time value component associated with the optionality in the derivative, which are considered significant unobservable inputs in most instances. The equity index volatility surface is determined based on market information that is not readily observable and is developed based upon inputs received from several third-party sources. Accordingly, these options are classified as Level 3. As equity index volatility increases, our valuation of these options changes favorably.
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Financial futures. The fair value of financial futures is based on the closing exchange prices. Accordingly, these financial futures are classified as Level 1. The period end valuation is zero as a result of settling the margins on these contracts on a daily basis.
Equity return swaps. The valuation of equity return swaps is determined using an income approach. The primary inputs into the valuation represent the forward interest rate swap curve and underlying equity index values, which are generally considered observable inputs, and results in the derivative being classified as Level 2.
Forward bond purchase commitments. The valuation of forward bond purchase commitments is determined using an income approach. The primary input into the valuation represents the current bond prices and interest rates, which are generally considered an observable input, and results in the derivative being classified as Level 2.
Other foreign currency contracts. We have certain foreign currency options classified as other foreign currency contracts. The valuation of foreign currency options is determined using an income approach. The primary inputs into the valuation represent the forward interest rate swap curve, foreign currency exchange rates, forward interest rate, foreign currency exchange rate volatility, foreign equity index volatility and time value component associated with the optionality in the derivative. As a result of the significant unobservable inputs associated with the forward interest rate, foreign currency exchange rate volatility and foreign equity index volatility inputs, the derivative is classified as Level 3. As foreign currency exchange rate volatility and foreign equity index volatility increases, the change in our valuation of these options will be favorable for purchase options and unfavorable for options sold. We also have foreign currency forward contracts where the valuation is determined using an income approach. The primary inputs into the valuation represent the forward foreign currency exchange rates, which are generally considered observable inputs and results in the derivative being classified as Level 2.
We are required to bifurcate an embedded derivative for certain features associated with annuity products and related reinsurance agreements where we provide a GMWB to the policyholder and are required to record the GMWB embedded derivative at fair value. The valuation of our GMWB embedded derivative is based on an income approach that incorporates inputs such as forward interest rates, equity index volatility, equity index and fund correlation, and policyholder assumptions such as utilization, lapse and mortality. In addition to these inputs, we also consider risk and expense margins when determining the projected cash flows that would be determined by another market participant. While the risk and expense margins are considered in determining fair value, these inputs do not have a significant impact on the valuation. We determine fair value using an internal model based on the various inputs noted above. The resulting fair value measurement from the model is reviewed by the product actuarial, risk and finance professionals each reporting period with changes in fair value also being compared to changes in derivatives and other instruments used to mitigate changes in fair value from certain market risks, such as equity index volatility and interest rates.
For GMWB liabilities, non-performance risk is integrated into the discount rate. Our discount rate used to determine fair value of our GMWB liabilities includes market credit spreads above U.S. Treasury rates to reflect an adjustment for the non-performance risk of the GMWB liabilities. As of September 30, 2013 and December 31, 2012, the impact of non-performance risk resulted in a lower fair value of our GMWB liabilities of $59 million and $89 million, respectively.
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To determine the appropriate discount rate to reflect the non-performance risk of the GMWB liabilities, we evaluate the non-performance risk in our liabilities based on a hypothetical exit market transaction as there is no exit market for these types of liabilities. A hypothetical exit market can be viewed as a hypothetical transfer of the liability to another similarly rated insurance company which would closely resemble a reinsurance transaction. Another hypothetical exit market transaction can be viewed as a hypothetical transaction from the perspective of the GMWB policyholder. In determining the appropriate discount rate to incorporate non-performance risk of the GMWB liabilities, we also considered the impacts of state guarantees embedded in the related insurance product as a form of inseparable third-party guarantee. We believe that a hypothetical exit market participant would use a similar discount rate as described above to value the liabilities.
For equity index volatility, we determine the projected equity market volatility using both historical volatility and projected equity market volatility with more significance being placed on projected near-term volatility and recent historical data. Given the different attributes and market characteristics of GMWB liabilities compared to equity index options in the derivative market, the equity index volatility assumption for GMWB liabilities may be different from the volatility assumption for equity index options, especially for the longer dated points on the curve.
Equity index and fund correlations are determined based on historical price observations for the fund and equity index.
For policyholder assumptions, we use our expected lapse, mortality and utilization assumptions and update these assumptions for our actual experience, as necessary. For our lapse assumption, we adjust our base lapse assumption by policy based on a combination of the policyholder’s current account value and GMWB benefit.
We classify the GMWB valuation as Level 3 based on having significant unobservable inputs, with equity index volatility and non-performance risk being considered the more significant unobservable inputs. As equity index volatility increases, the fair value of the GMWB liabilities will increase. Any increase in non-performance risk would increase the discount rate and would decrease the fair value of the GMWB liability. Additionally, we consider lapse and utilization assumptions to be significant unobservable inputs. An increase in our lapse assumption would decrease the fair value of the GMWB liability, whereas an increase in our utilization rate would increase the fair value.
We evaluate the inputs and methodologies used to determine fair value based on how we expect a market participant would determine exit value. As stated above, there is no exit market or market participants for the GMWB embedded derivatives. Accordingly, we evaluate our inputs and resulting fair value based on a hypothetical exit market and hypothetical market participants. A hypothetical exit market could be viewed as a transaction that would closely resemble reinsurance. While reinsurance transactions for this type of product are not an observable input, we consider this type of hypothetical exit market, as appropriate, when evaluating our inputs and determining that our inputs are consistent with that of a hypothetical market participant.
We offer fixed indexed annuity products where interest is credited to the policyholder’s account balance based on equity index changes. This feature is required to be bifurcated as an embedded derivative and recorded at fair value. Fair value is determined using an income approach where the present value of the excess cash flows above the guaranteed cash flows is used to determine the value attributed to the equity index feature. The inputs used in determining the fair value include policyholder behavior (lapses and withdrawals), near-term equity index volatility, expected future interest credited, forward interest rates and an adjustment to the discount rate to incorporate non-performance risk and risk margins. As a result of our assumptions for policyholder behavior and expected future interest credited being considered significant unobservable inputs, we classify these instruments
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as Level 3. As lapses and withdrawals increase, the value of our embedded derivative liability will decrease. As expected future interest credited decreases, the value of our embedded derivative liability will decrease.
We record certain borrowings related to securitization entities at fair value. The fair value of these borrowings is determined using either a market approach or income approach, depending on the instrument and availability of market information. Given the unique characteristics of the securitization entities that issued these borrowings as well as the lack of comparable instruments, we determine fair value considering the valuation of the underlying assets held by the securitization entities and any derivatives, as well as any unique characteristics of the borrowings that may impact the valuation. After considering all relevant inputs, we determine fair value of the borrowings using the net valuation of the underlying assets and derivatives that are backing the borrowings. Accordingly, these instruments are classified as Level 3. Increases in the valuation of the underlying assets or decreases in the derivative liabilities will result in an increase in the fair value of these borrowings.
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The following tables set forth our assets and liabilities by class of instrument that are measured at fair value on a recurring basis as of the dates indicated:
Other invested assets:
Derivative assets:
Total derivative assets
Securities lending collateral
Derivatives counterparty collateral
Total other invested assets
Reinsurance recoverable (1)
Liabilities
Policyholder account balances:
GMWB embedded derivatives (2)
Total policyholder account balances
Derivative liabilities:
Total derivative liabilities
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Other assets (1)
Reinsurance recoverable (2)
GMWB embedded derivatives (3)
We review the fair value hierarchy classifications each reporting period. Changes in the observability of the valuation attributes may result in a reclassification of certain financial assets or liabilities. Such reclassifications
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are reported as transfers between levels at the beginning fair value for the reporting period in which the changes occur. Given the types of assets classified as Level 1, which primarily represents mutual fund investments, we typically do not have any transfers between Level 1 and Level 2 measurement categories and did not have any such transfers during any period presented.
Our assessment of whether or not there were significant unobservable inputs related to fixed maturity securities was based on our observations obtained through the course of managing our investment portfolio, including interaction with other market participants, observations related to the availability and consistency of pricing and/or rating, and understanding of general market activity such as new issuance and the level of secondary market trading for a class of securities. Additionally, we considered data obtained from third-party pricing sources to determine whether our estimated values incorporate significant unobservable inputs that would result in the valuation being classified as Level 3.
The following tables present additional information about assets measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value as of or for the dates indicated:
U.S. government, agencies and government- sponsored enterprises
U.S. corporate (1)
Corporate—non-U.S. (1)
Residential mortgage- backed
Commercial mortgage- backed
Other asset-backed (1)
Total Level 3 assets
The transfers into and out of Level 3 were primarily related to private fixed rate U.S. corporate, corporate—non-U.S. and structured securities. For private fixed rate U.S. corporate securities, the transfers into and out of Level 3 resulted from a change in the observability
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Other assets (2)
Reinsurance recoverable (3)
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The following table presents the gains and losses included in net income from assets measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value and the related income statement line item in which these gains and losses were presented for the periods indicated:
Total realized and unrealized gains (losses) included in net income:
Total gains (losses) included in net income attributable to assets still held:
The amount presented for unrealized gains (losses) included in net income for available-for-sale securities represents impairments and accretion on certain fixed maturity securities.
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The following tables present additional information about liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value as of or for the dates indicated:
GMWB embedded derivatives (1)
Total Level 3 liabilities
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Total policyholder accountbalances
Credit default swaps related to securitizationentities
Total derivativeliabilities
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The following table presents the gains and losses included in net (income) from liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value and the related income statement line item in which these gains and losses were presented for the periods indicated:
Total realized and unrealized (gains) losses included in net (income):
Net investment (gains) losses
Total (gains) losses included in net (income) attributable to liabilities still held:
Purchases, sales, issuances and settlements represent the activity that occurred during the period that results in a change of the asset or liability but does not represent changes in fair value for the instruments held at the beginning of the period. Such activity primarily consists of purchases, sales and settlements of fixed maturity, equity and trading securities and purchases, issuances and settlements of derivative instruments.
Issuances and settlements presented for policyholder account balances represent the issuances and settlements of embedded derivatives associated with our GMWB liabilities where: issuances are characterized as the change in fair value associated with the product fees recognized that are attributed to the embedded derivative to equal the expected future benefit costs upon issuance and settlements are characterized as the change in fair value upon exercising the embedded derivative instrument, effectively representing a settlement of the embedded derivative instrument. We have shown these changes in fair value separately based on the classification of this activity as effectively issuing and settling the embedded derivative instrument with all remaining changes in the fair value of these embedded derivative instruments being shown separately in the category labeled “included in net (income)” in the tables presented above.
Certain classes of instruments classified as Level 3 are excluded below as a result of not being material or due to limitations in being able to obtain the underlying inputs used by certain third-party sources, such as broker quotes, used as an input in determining fair value. The following table presents a summary of the significant
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unobservable inputs used for certain fair value measurements that are based on internal models and classified as Level 3 as of September 30, 2013:
Valuation technique
Unobservable input
Credit default swaps (1)
Non-performance risk
(credit spreads)
(7) Commitments and Contingencies
(a) Litigation
We face the risk of litigation and regulatory investigations and actions in the ordinary course of operating our businesses, including the risk of class action lawsuits. Our pending legal and regulatory actions include proceedings specific to us and others generally applicable to business practices in the industries in which we operate. In our insurance operations, we are, have been, or may become subject to class actions and individual suits alleging, among other things, issues relating to sales or underwriting practices, increases to in-force long-term care insurance premiums, payment of contingent or other sales commissions, claims payments and procedures, product design, product disclosure, administration, additional premium charges for premiums paid on a periodic basis, denial or delay of benefits, charging excessive or impermissible fees on products, recommending unsuitable products to customers, our pricing structures and business practices in our mortgage insurance businesses, such as captive reinsurance arrangements with lenders and contract underwriting services, violations of the Real Estate Settlement and Procedures Act of 1974 (“RESPA”) or related state anti-inducement laws, and mortgage insurance policy rescissions and curtailments, and breaching fiduciary or other duties to customers, including but not limited to breach of customer information. Plaintiffs in class action and other lawsuits against us may seek very large or indeterminate amounts which may remain unknown for substantial
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periods of time. In our investment-related operations, we are subject to litigation involving commercial disputes with counterparties. We are also subject to litigation arising out of our general business activities such as our contractual and employment relationships. In addition, we are also subject to various regulatory inquiries, such as information requests, subpoenas, books and record examinations and market conduct and financial examinations from state, federal and international regulators and other authorities. A substantial legal liability or a significant regulatory action against us could have an adverse effect on our business, financial condition and results of operations. Moreover, even if we ultimately prevail in the litigation, regulatory action or investigation, we could suffer significant reputational harm, which could have an adverse effect on our business, financial condition or results of operations.
As previously disclosed, in January 2012, we, along with other mortgage insurance companies, received an information request from the Consumer Financial Protection Bureau (“CFPB”) requesting information from our U.S. mortgage insurance subsidiaries with respect to reinsurance arrangements, including captive reinsurance transactions, as part of the CFPB’s review of such arrangements in the mortgage insurance industry. The CFPB further sent to us and other mortgage insurance companies a Civil Investigative Demand, dated June 20, 2012 (the “CFPB Demand”), seeking production of specified documents and responses to questions set forth in the CFPB Demand. In April 2013, Genworth Mortgage Insurance Corporation (“GEMICO”), our principal U.S. mortgage insurance subsidiary, and other mortgage insurance companies agreed to settle with the CFPB to end the agency’s review. As part of the settlement, GEMICO (and its affiliates, officers, employees and certain other related parties) are enjoined from entering into or revising certain reinsurance arrangements and violating any provisions of RESPA for a period of 10 years and GEMICO paid approximately $4 million.
As previously disclosed, beginning in December 2011 and continuing through January 2013, one of our U.S. mortgage insurance subsidiaries was named along with several other mortgage insurance participants and mortgage lenders as a defendant in twelve putative class action lawsuits alleging that certain “captive reinsurance arrangements” were in violation of RESPA. The Barlee case was dismissed by the Court with prejudice as to our subsidiary and certain other defendants on February 27, 2013. In the Riddle case, the defendants’ motion to dismiss was denied, but the Court limited discovery at this stage to issues surrounding the statute of limitations. The Manners case was voluntarily dismissed by the plaintiffs in March 2013. In the Moriba BAcase, the Court denied defendants’ motion to dismiss by order dated June 26, 2013. In the White case, plaintiffs filed a second amended complaint to address the deficiencies that the Court identified in previously dismissing the action. On July 22, 2013, our mortgage insurance subsidiary moved to dismiss the second amended complaint. In the Hill case, the defendants’ motion to dismiss was denied on June 27, 2013, but the Court limited discovery at this stage to issues surrounding the statute of limitations. In the Samp and Orange cases, the plaintiffs have appealed the dismissals to the U.S. Court of Appeals for the Ninth Circuit. The Menichino case was dismissed by the Court without prejudice as to our subsidiary and certain other defendants on July 19, 2013. In the Riddle case, on July 19, 2013, we moved for summary judgment dismissing the case. We intend to vigorously defend the remaining actions.
As previously disclosed, in April 2012, two of our U.S. mortgage insurance subsidiaries were named as respondents in two arbitrations, one brought by Bank of America, N.A. and one brought by Countrywide Home Loans, Inc. and Bank of America, N.A. as claimants. Claimants allege breach of contract and breach of the covenant of good faith and fair dealing, and seek a declaratory judgment relating to our subsidiaries’ mortgage insurance claims handling practices in connection with denying, curtailing or rescinding coverage of mortgage insurance. Claimants and our subsidiaries are engaged in settlement negotiations regarding a potential resolution of certain, and potentially all, aspects of the disputes. We currently believe we may be able to resolve this matter for significantly less than $834 million, the previously-disclosed amount of claimed damages in this matter.
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At this time, we cannot determine or predict the ultimate outcome of any of the pending legal and regulatory matters specifically identified above or the likelihood of potential future legal and regulatory matters against us. In light of the inherent uncertainties involved in these matters, no amounts have been accrued. We also are not able to provide an estimate or range of possible losses related to these matters.
(b) Commitments
As of September 30, 2013, we were committed to fund $67 million in limited partnership investments, $58 million in U.S. commercial mortgage loans and $8 million in private placement investments.
(8) Borrowings and Other Financings
Revolving Credit Facility
On September 26, 2013, Genworth Holdings entered into a $300 million multicurrency revolving credit facility, which matures in September 2016, with a $100 million sublimit for letters of credit. The proceeds of the loans may be used for working capital and general corporate purposes. The obligations under the credit agreement are unsecured and payment of Genworth Holdings’ obligations is fully and unconditionally guaranteed by New Genworth. As of September 30, 2013, there were no amounts outstanding under the credit facility.
Long-Term Borrowings
The following table sets forth total long-term borrowings as of the dates indicated:
5.75% Senior Notes, due 2014 (1)
4.59% Senior Notes, due 2015 (2)
4.95% Senior Notes, due 2015 (1)
8.625% Senior Notes, due 2016 (1)
6.52% Senior Notes, due 2018 (1)
5.68% Senior Notes, due 2020 (2)
7.70% Senior Notes, due 2020 (1)
7.20% Senior Notes, due 2021 (1)
7.625% Senior Notes, due 2021 (1)
Floating Rate Junior Notes, due 2021 (3)
4.90% Senior Notes, due 2023 (1)
6.50% Senior Notes, due 2034 (1)
6.15% Junior Notes, due 2066
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During 2013, Genworth Holdings repurchased $15 million aggregate principal amount of the 5.75% senior notes that mature in 2014, plus accrued and unpaid interest. In June 2013, Genworth Holdings repurchased $4 million aggregate principal amount of the 4.95% senior notes that mature in 2015 (the “2015 Notes”), plus accrued and unpaid interest.
In August 2013, Genworth Holdings issued $400 million aggregate principal amount of senior notes, with an interest rate of 4.90% per year payable semi-annually, and maturing in 2023 (“2023 Notes”). The 2023 Notes are Genworth Holdings’ direct, unsecured obligations and will rank equally in right of payment with all of its existing and future unsecured and unsubordinated obligations. The 2023 Notes are fully and unconditionally guaranteed on an unsecured and unsubordinated basis by New Genworth. The net proceeds of $395 million from the issuance of the 2023 Notes, together with cash on hand at Genworth Holdings, were used to redeem all $346 million of the remaining outstanding aggregate principal amount of Genworth Holdings’ 2015 Notes, plus accrued and unpaid interest on such notes, and a pre-tax make-whole expense of approximately $30 million.
(9) Segment Information
We currently operate through three divisions: U.S. Life Insurance, Global Mortgage Insurance and Corporate and Other. Under these divisions, there are five operating business segments. The U.S. Life Insurance Division includes the U.S. Life Insurance segment. The Global Mortgage Insurance Division includes the International Mortgage Insurance and U.S. Mortgage Insurance segments. The Corporate and Other Division includes the International Protection and Runoff segments and Corporate and Other activities. Our operating business segments are as follows: (1) U.S. Life Insurance, which includes our life insurance, long-term care insurance and fixed annuities businesses; (2) International Mortgage Insurance, which includes mortgage insurance-related products and services; (3) U.S. Mortgage Insurance, which includes mortgage insurance-related products and services; (4) International Protection Insurance, which includes our lifestyle protection insurance business; and (5) Runoff, which includes the results of non-strategic products which are no longer actively sold. Our non-strategic products primarily include our variable annuity, variable life insurance, institutional, corporate-owned life insurance and other accident and health insurance products. Institutional products consist of: funding agreements, FABNs and GICs.
We also have Corporate and Other activities which include debt financing expenses that are incurred at the Genworth Holdings holding company level, unallocated corporate income and expenses, eliminations of inter-segment transactions and the results of other businesses that are managed outside of our operating segments. Effective April 1, 2013 (immediately prior to the holding company reorganization), Genworth Holdings completed the sale of its reverse mortgage business (which had been part of Corporate and Other activities) for total proceeds of $22 million. The gain on the sale was not significant.
We use the same accounting policies and procedures to measure segment income (loss) and assets as our consolidated net income (loss) and assets. Our chief operating decision maker evaluates segment performance and allocates resources on the basis of “net operating income (loss).” We define net operating income (loss) as income (loss) from continuing operations excluding the after-tax effects of income attributable to noncontrolling interests, net investment gains (losses), goodwill impairments, gains (losses) on the sale of businesses and infrequent or unusual non-operating items. We exclude net investment gains (losses) and infrequent or unusual non-operating items because we do not consider them to be related to the operating performance of our segments and Corporate and Other activities. A component of our net investment gains (losses) is the result of impairments, the size and timing of which can vary significantly depending on market credit cycles. In addition, the size and timing of other investment gains (losses) can be subject to our discretion and are influenced by
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market opportunities, as well as asset-liability matching considerations. Goodwill impairments and gains (losses) on the sale of businesses are also excluded from net operating income (loss) because, in our opinion, they are not indicative of overall operating trends. Other non-operating items are also excluded from net operating income (loss) if, in our opinion, they are not indicative of overall operating trends.
There were no infrequent or unusual items excluded from net operating income (loss) during the periods presented other than a $13 million after-tax expense recorded in the second quarter of 2013 related to restructuring costs. In June 2013, we announced an expense reduction plan as we continue to work on improving the operating performance of our businesses resulting in a pre-tax non-operating charge of $20 million reflecting severance, outplacement and other associated costs. This plan eliminated approximately 400 positions, including 150 open positions that will not be filled, and will reduce related information technology and program spend.
While some of these items may be significant components of net income (loss) available to Genworth Financial, Inc.’s common stockholders in accordance with U.S. GAAP, we believe that net operating income (loss), and measures that are derived from or incorporate net operating income (loss), are appropriate measures that are useful to investors because they identify the income (loss) attributable to the ongoing operations of the business. Management also uses net operating income (loss) as a basis for determining awards and compensation for senior management and to evaluate performance on a basis comparable to that used by analysts. However, the items excluded from net operating income (loss) have occurred in the past and could, and in some cases will, recur in the future. Net operating income (loss) is not a substitute for net income (loss) available to Genworth Financial, Inc.’s common stockholders determined in accordance with U.S. GAAP. In addition, our definition of net operating income (loss) may differ from the definitions used by other companies.
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The following is a summary of revenues for our segments and Corporate and Other activities for the periods indicated:
U.S. Life Insurance segment:
Life insurance
Long-term care insurance
Fixed annuities
U.S. Life Insurance segment’s revenues
International Mortgage Insurance segment:
Canada
Australia
Other Countries
International Mortgage Insurance segment’s revenues
U.S. Mortgage Insurance segment’s revenues
International Protection segment’s revenues
Runoff segment’s revenues
Corporate and Other’s revenues
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The following is a summary of net operating income (loss) for our segments and Corporate and Other activities and a reconciliation of net operating income (loss) for our segments and Corporate and Other activities to net income for the periods indicated:
U.S. Life Insurance segment’s net operating income
International Mortgage Insurance segment’s net operating income
U.S. Mortgage Insurance segment’s net operating income (loss)
International Protection segment’s net operating income
Runoff segment’s net operating income (loss)
Corporate and Other’s net operating loss
Net operating income
Net investment gains (losses), net of taxes and other adjustments
Expenses related to restructuring, net of taxes
Goodwill impairment, net of taxes
Add: net income attributable to noncontrolling interests
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The following is a summary of total assets for our segments and Corporate and Other activities as of the dates indicated:
U.S. Life Insurance
International Mortgage Insurance
U.S. Mortgage Insurance
International Protection
Runoff
Corporate and Other
Segment assets from continuing operations
(10) Changes in Accumulated Other Comprehensive Income (Loss)
The following tables show the changes in accumulated OCI, net of taxes, by component as of and for the periods indicated:
Balances as of July 1, 2013
OCI before reclassifications
Amounts reclassified from OCI
Current period OCI
Balances as of September 30, 2013 before noncontrolling interests
Less: change in OCI attributable to noncontrolling interests
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Balances as of July 1, 2012
Balances as of September 30, 2012 before noncontrolling interests
Balances as of January 1, 2013
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Balances as of January 1, 2012
The foreign currency translation and other adjustments balance included $26 million and $20 million, respectively, net of taxes of $13 million and $11 million, respectively, related to a net unrecognized postretirement benefit obligation as of September 30, 2013 and 2012. Amount also included taxes of $50 million and $48 million, respectively, related to foreign currency translation adjustments as of September 30, 2013 and 2012.
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The following table shows reclassifications out of accumulated other comprehensive income (loss), net of taxes, for the periods presented:
Affected line item in the
consolidated statements
of income
Unrealized gains (losses) on investments (1)
Derivatives qualifying as hedges:
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(11) Discontinued Operations
The assets and liabilities associated with discontinued operations prior to the sale have been segregated in our consolidated balance sheets. The major assets and liability categories were as follows as of the dates indicated:
Other liabilities
Summary operating results of discontinued operations were as follows for the periods indicated:
Revenues
Income (loss) before income taxes
During the three months ended March 31, 2013, in connection with the agreement to sell the wealth management business, we recognized a goodwill impairment of $13 million as a result of the carrying value for the business exceeding fair value. Additionally, we agreed to settle our contingent consideration liability related to our purchase of Altegris Capital, LLC in 2010 for approximately $40 million, which resulted in a loss of approximately $5 million from the change in fair value of this liability. In accordance with the accounting guidance for groups of assets that are held-for-sale, we recorded an additional loss of approximately $9 million to record the carrying value of the business at its fair value less costs to sell. During the three months ended September 30, 2013, we recognized an additional after-tax loss on the sale of $2 million at closing, which was based on carrying value and working capital at close, as well as expenses associated with the sale.
(12) Condensed Consolidating Financial Information
On April 1, 2013, in connection with the reorganization: (a) New Genworth provided a full and unconditional guarantee to the trustee of Genworth Holdings’ outstanding senior notes and the holders of the
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senior notes, on an unsecured unsubordinated basis, of the full and punctual payment of the principal of, premium, if any and interest on, and all other amounts payable under, each outstanding series of senior notes, and the full and punctual payment of all other amounts payable by Genworth Holdings under the senior notes indenture in respect of such senior notes and (b) New Genworth provided a full and unconditional guarantee to the trustee of Genworth Holdings’ outstanding subordinated notes and the holders of the subordinated notes, on an unsecured subordinated basis, of the full and punctual payment of the principal of, premium, if any and interest on, and all other amounts payable under, the outstanding subordinated notes, and the full and punctual payment of all other amounts payable by Genworth Holdings under the subordinated notes indenture in respect of the subordinated notes. On August 8, 2013, New Genworth provided a full and unconditional guarantee to the trustee of Genworth Holdings’ 2023 Notes and the holders of the 2023 Notes on an unsecured unsubordinated basis, of the full and punctual payment of the principal of, premium, if any and interest on, and all other amounts payable under, the 2023 Notes, and the full and punctual payment of all other amounts payable by Genworth Holdings under the senior notes indenture in respect of such 2023 Notes.
The following condensed consolidating financial information of New Genworth and its direct and indirect subsidiaries have been prepared pursuant to rules regarding the preparation of consolidating financial information of Regulation S-X. The condensed consolidating financial information has been prepared as if the guarantee had been in place during all periods presented herein.
The condensed consolidating financial information presents the condensed consolidating balance sheet information as of September 30, 2013 and December 31, 2012, the condensed consolidating income statement information and the condensed consolidating comprehensive income statement information for the three and nine months ended September 30, 2013 and 2012 and the condensed consolidating cash flow statement information for the nine months ended September 30, 2013 and 2012.
The condensed consolidating financial information reflects New Genworth (“Parent Guarantor”), Genworth Holdings (“Issuer”) and each of New Genworth’s other direct and indirect subsidiaries (“All Other Subsidiaries”) on a combined basis, none of which guarantee the senior notes or subordinated notes, as well as the eliminations necessary to present New Genworth’s financial information on a consolidated basis and total consolidated amounts.
The accompanying condensed consolidating financial information is presented based on the equity method of accounting for all periods presented. Under this method, investments in subsidiaries are recorded at cost and adjusted for the subsidiaries’ cumulative results of operations, capital contributions and distributions, and other changes in equity. Elimination entries include consolidating and eliminating entries for investments in subsidiaries and intercompany activity.
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The following table presents the condensed consolidating balance sheet information as of September 30, 2013:
Investments
Investments in subsidiaries
Intercompany notes receivable
Intercompany notes payable
Common stock
Accumulated other comprehensive income (loss)
Treasury stock, at cost
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The following table presents the condensed consolidating balance sheet information as of December 31, 2012:
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The following table presents the condensed consolidating income statement information for the three months ended September 30, 2013:
Income (loss) from continuing operations before income taxes and equity in income of subsidiaries
Provision (benefit) for income taxes
Equity in income of subsidiaries
Income (loss) from continuing operations
Net income (loss)
Net income (loss) available to Genworth Financial, Inc.’s common stockholders
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The following table presents the condensed consolidating income statement information for the three months ended September 30, 2012:
Income from discontinued operations, net of taxes
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The following table presents the condensed consolidating income statement information for the nine months ended September 30, 2013:
Loss from discontinued operations, net of taxes
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The following table presents the condensed consolidating income statement information for the nine months ended September 30, 2012:
Income (loss) from continuing operations, net of taxes
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The following table presents the condensed consolidating comprehensive income statement information for the three months ended September 30, 2013:
Other comprehensive income (loss):
The following table presents the condensed consolidating comprehensive income statement information for the three months ended September 30, 2012:
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The following table presents the condensed consolidating comprehensive income statement information for the nine months ended September 30, 2013:
The following table presents the condensed consolidating comprehensive income statement information for the nine months ended September 30, 2012:
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The following table presents the condensed consolidating cash flow statement information for the nine months ended September 30, 2013:
Less income from discontinued operations, net of taxes
Equity in income from subsidiaries
Dividends from subsidiaries
Capital contributions to subsidiaries
Proceeds from intercompany notes payable
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The following table presents the condensed consolidating cash flow statement information for the nine months ended September 30, 2012:
Net increase (decrease) in trading securities, held- for-sale investments and derivative instruments
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Our insurance company subsidiaries are restricted by state and foreign laws and regulations as to the amount of dividends they may pay to their parent without regulatory approval in any year, the purpose of which is to protect affected insurance policyholders, depositors and investors. Any dividends in excess of limits are deemed “extraordinary” and require approval. Based on estimated statutory results as of December 31, 2012, in accordance with applicable dividend restrictions, our subsidiaries could pay dividends of approximately $1.1 billion to us in 2013 without obtaining regulatory approval, and the remaining net assets are considered restricted. While the $1.1 billion is unrestricted, we do not expect our insurance subsidiaries to pay dividends to us in 2013 at this level as they retain capital for growth and to meet capital requirements and desired thresholds. As of December 31, 2012, Genworth Financial’s and Genworth Holdings’ subsidiaries had restricted net assets of $15.4 billion and $16.7 billion, respectively.
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The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included herein and with our Current Report on Form 8-K filed on May 30, 2013.
Introductory note
On March 27, 2013, we announced that we had agreed to sell our wealth management business to AqGen Liberty Acquisition, Inc., a subsidiary of AqGen Liberty Holdings LLC, a partnership of Aquiline Capital Partners and Genstar Capital, for approximately $412 million, and the sale closed on August 30, 2013. As a result, this business has been accounted for as discontinued operations and its financial position and results of operations are separately reported for all periods presented. Our wealth management business, previously a separate segment, is separately reported as discontinued operations and all prior periods reflected herein have been re-presented. See note 11 of the financial statements in “Item 1—Financial Statements” for additional information.
On April 1, 2013, we completed a holding company reorganization pursuant to which, among other things: (a) Genworth Holdings became a direct, 100% owned subsidiary of New Genworth; (b) Genworth Holdings made a distribution to New Genworth (directly or indirectly) of 100% of the shares and equity interests of two entities that together owned (directly or indirectly) 100% of the shares or other equity interests of all of the subsidiaries that conducted Genworth Holdings’ U.S. mortgage insurance business; (c) New Genworth provided a full and unconditional guarantee to the trustee of Genworth Holdings’ outstanding senior notes and the holders of the senior notes, on an unsecured unsubordinated basis, of the full and punctual payment of the principal of, premium, if any and interest on, and all other amounts payable under, each outstanding series of senior notes, and the full and punctual payment of all other amounts payable by Genworth Holdings under the senior notes indenture in respect of such senior notes; and (d) New Genworth provided a full and unconditional guarantee to the trustee of Genworth Holdings’ outstanding subordinated notes and the holders of the subordinated notes, on an unsecured subordinated basis, of the full and punctual payment of the principal of, premium, if any and interest on, and all other amounts payable under, the outstanding subordinated notes, and the full and punctual payment of all other amounts payable by Genworth Holdings under the subordinated notes indenture in respect of the subordinated notes. See “Note Regarding this Quarterly Report” on page 2 for additional information.
Cautionary note regarding forward-looking statements
This report contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by words such as “expects,” “intends,” “anticipates,” “plans,” “believes,” “seeks,” “estimates,” “will” or words of similar meaning and include, but are not limited to, statements regarding the outlook for our future business and financial performance. Forward-looking statements are based on management’s current expectations and assumptions, which are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. Actual outcomes and results may differ materially due to global political, economic, business, competitive, market, regulatory and other factors and risks, including, but not limited to, the following:
Risks relating to our businesses, including downturns and volatility in global economies and equity and credit markets; downgrades or potential downgrades in our financial strength or credit ratings; interest rate fluctuations and levels; adverse capital and credit market conditions; the valuation of fixed maturity, equity and trading securities; defaults, downgrades or other events impacting the value of our fixed maturity securities portfolio; defaults on our commercial mortgage loans or the mortgage loans underlying our investments in commercial mortgage-backed securities and volatility in performance; goodwill impairments; defaults by counterparties to reinsurance arrangements or derivative instruments; an adverse change in risk-based capital and other regulatory requirements; insufficiency of reserves and required increases to reserve liabilities; legal constraints on dividend distributions by our
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subsidiaries; competition; availability, affordability and adequacy of reinsurance; loss of key distribution partners; regulatory restrictions on our operations and changes in applicable laws and regulations; legal or regulatory investigations or actions; the failure of or any compromise of the security of our computer systems and confidential information contained therein; the occurrence of natural or man-made disasters or a pandemic; the effect of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act; changes in accounting and reporting standards issued by the Financial Accounting Standards Board or other standard-setting bodies and insurance regulators; impairments of or valuation allowances against our deferred tax assets; changes in expected morbidity or mortality rates; accelerated amortization of deferred acquisition costs and present value of future profits; ability to increase premiums on certain in-force and future long-term care insurance products by enough or quickly enough, including the current rate actions and any future rate actions; medical advances, such as genetic research and diagnostic imaging, and related legislation; unexpected changes in persistency rates; ability to continue to implement actions to mitigate the impact of statutory reserve requirements; the failure of demand for long-term care insurance to increase; political and economic instability or changes in government policies; fluctuations in foreign exchange rates and international securities markets; unexpected changes in unemployment rates; unexpected increases in international mortgage insurance default rates or severity of defaults; the significant portion of high loan-to-value insured international mortgage loans which generally result in more and larger claims than lower loan-to-value ratios; competition with government-owned and government-sponsored enterprises (“GSEs”) offering mortgage insurance; changes in international regulations reducing demand for mortgage insurance; increases in U.S. mortgage insurance default rates; failure to meet, or have waived to the extent needed, the minimum statutory capital requirements and hazardous financial condition standards; uncertain results of continued investigations of insured U.S. mortgage loans; possible rescissions of coverage and the results of objections to our rescissions; the extent to which loan modifications and other similar programs may provide benefits to us; unexpected changes in unemployment and underemployment rates in the United States; further deterioration in economic conditions or a further decline in home prices in the United States; problems associated with foreclosure process defects in the United States that may defer claim payments; changes to the role or structure of Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”); competition with government-owned and government-sponsored enterprises offering U.S. mortgage insurance; changes in regulations that affect our U.S. mortgage insurance business; the influence of Fannie Mae, Freddie Mac and a small number of large mortgage lenders and investors; decreases in the volume of high loan-to-value mortgage originations or increases in mortgage insurance cancellations in the United States; increases in the use of alternatives to private mortgage insurance in the United States and reductions by lenders in the level of coverage they select; the impact of the use of reinsurance with reinsurance companies affiliated with our U.S. mortgage lending customers; legal actions under the Real Estate Settlement Procedures Act of 1974 (“RESPA”); potential liabilities in connection with our U.S. contract underwriting services; and the impact on the statutory capital and risk-to-capital ratios of our U.S. mortgage insurance business from variations in the valuation of affiliate investments;
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We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise.
Overview
Our business
We are a leading financial services company dedicated to providing insurance, investment and financial solutions to our customers, with a presence in more than 25 countries. We have the following operating segments:
We also have Corporate and Other activities which include debt financing expenses that are incurred at Genworth Holdings holding company level, unallocated corporate income and expenses, eliminations of inter-segment transactions and the results of other non-core businesses that are managed outside of our operating segments, including discontinued operations.
Business trends and conditions
Our business is, and we expect will continue to be, influenced by a number of industry-wide and product-specific trends and conditions.
General conditions and trends affecting our businesses
Financial and economic environment. The stability of both the financial markets and global economies in which we operate impacts the sales, revenue growth and profitability trends of our businesses. While equity and
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credit markets improved and interest rate spreads were generally stable during the first quarter of 2013, market volatility increased in the second and third quarters of 2013 and during the third quarter of 2013, credit spreads were moderately tighter in most asset classes. Although the U.S. and several international financial markets experienced some improvement during the first nine months of 2013, the European debt crisis and concerns regarding global economies continued to impact the rate and strength of recovery.
The U.S. housing market showed signs of recovery during 2012 with home prices rising in a number of regions and cities, but ongoing weakness in the U.S. economy continued to impact the rate of recovery. Unemployment and underemployment levels in the United States remained elevated in the first nine months of 2013. We expect unemployment and underemployment levels in the United States to remain at elevated levels for an extended period and gradually decrease over time. In Canada, stable economic conditions have persisted with housing affordability benefiting from low interest rates and employment growth and average home prices increased modestly during the first nine months of 2013. The unemployment rate in Canada decreased slightly during the first nine months of 2013 and remains near its lowest level since December 2008. In Australia, the overall housing market generally improved as modest economic growth and low interest rates persisted, coupled with average home prices increasing across most regions during the first nine months of 2013, particularly in the third quarter of 2013 when it grew at the highest rate since early 2010. Unemployment in Australia increased slightly during the first six months of 2013, reaching its highest level in three years, but declined slightly in September 2013. Europe remained a challenging region with slow growth or a declining economic environment with lower lending activity and reduced consumer spending, particularly in Greece, Spain, Portugal, Ireland and Italy, in part as a result of the European debt crisis and actual or anticipated austerity measures, but certain areas within Europe have shown a modest level of improvement during the third quarter of 2013. The Chinese economy has experienced significant growth over the past decade, but this growth slowed during the first half of 2013 as the new Chinese administration began to implement economic and credit market reforms. Gross domestic product in China improved slightly in the third quarter of 2013, but given the relative size of the Chinese economy, the impact of a significant change in the pace of economic expansion in China could impact global economies, partly as a result of lower commodity imports, particularly those from the Asia Pacific region, including Australia. See “—Trends and conditions affecting our segments” below for a discussion regarding the impacts the financial markets and global economies have on our businesses.
Declining, slow or varied levels of economic growth, coupled with uncertain financial markets and economic outlooks, changes in government policy, regulatory reforms and other changes in market conditions, influenced, and we believe will continue to influence, investment and spending decisions by consumers and businesses as they adjust their consumption, debt, capital and risk profiles in response to these conditions. These trends change as investor confidence in the markets and the outlook for some consumers and businesses shift. As a result, our sales, revenues and profitability trends of certain insurance and investment products have been and could be further impacted negatively or positively going forward. In particular, factors such as government spending, monetary policies, the volatility and strength of the capital markets, anticipated tax policy changes and the impact of global financial regulation reform will continue to affect economic and business outlooks and consumer behaviors moving forward.
The U.S. and international governments, Federal Reserve, other central banks and other legislative and regulatory bodies have taken certain actions to support the economy and capital markets, influence interest rates, influence housing markets and mortgage servicing and provide liquidity to promote economic growth. These include various mortgage restructuring programs implemented or under consideration by the GSEs, lenders, servicers and the U.S. government. Outside of the United States, various governments and central banks have taken and continue to take actions to stimulate economies, stabilize financial systems and improve market liquidity. In aggregate, these actions had a positive effect in the short term on these countries and their markets; however, there can be no assurance as to the future level of impact these types of actions may have on the economic and financial markets, including levels of volatility. A delayed economic recovery period, a U.S. or global recession or regional or global financial crisis could materially and adversely affect our business, financial condition and results of operations.
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We manage our product offerings, liquidity, investment and asset-liability management strategies to moderate risk especially during periods of strained economic and financial market conditions. In addition, we continue to review our product and distribution management strategies to align with our strengths, profitability targets and risk tolerance.
Credit and investment markets. The potential tapering of the U.S. Federal Reserve’s Long Term Securities Asset Purchase Program drove fixed-income market volatility beginning in June 2013 and early in the third quarter of 2013. The perception of a less accommodative Federal Reserve resulted in a meaningful increase in U.S. Treasury yields in the third quarter of 2013. Credit spreads in most asset classes widened with falling Treasury prices early in the third quarter of 2013, though most credit sector spreads either partially retraced or stabilized as markets digested the possibility of a new interest rate regime.
On September 18, 2013, the Federal Reserve announced that it would not begin tapering its bond purchase program, citing inconsistent economic data and uncertainty around U.S. fiscal policy. This announcement subsequently drove interest rates meaningfully lower and credit spreads moderately tighter in most asset classes.
In general, emerging market and municipal securities underperformed other fixed-income instruments, and issuances slowed versus expectations at the beginning of 2013 amid interest rate policy uncertainty. Despite the volatility during the third quarter of 2013, spreads for most fixed-income products remain consistent with levels than were prevalent at the end of 2012.
We recorded net other-than-temporary impairments of $22 million during the nine months ended September 30, 2013 compared to $85 million during the nine months ended September 30, 2012. Impairments have decreased across almost all asset classes from an improving economy. Increases in interest rates have lowered the value of our investments and derivatives, resulting in decreases in net unrealized investment gains on securities of $1,567 million and derivatives qualifying as hedges of $467 million in other comprehensive income for the nine months ended September 30, 2013. Economic conditions will continue to impact the valuation of our investment portfolios and the amount of other-than-temporary impairments.
Looking ahead, we believe the current credit environment provides us with opportunities to invest across a variety of asset classes, but our returns will continue to be pressured because of low interest rates. The current environment will also provide opportunities to continue execution of various risk management disciplines involving further diversification within the investment portfolio. See “—Investments and Derivative Instruments” for additional information on our investment portfolio.
Trends and conditions affecting our segments
Life insurance. Results of our life insurance business are impacted by sales, competitor actions, mortality, persistency, investment yields, expenses, reinsurance and statutory reserve requirements. Additionally, sales of our products and persistency of our insurance in-force are dependent on competitive product features and pricing, underwriting, distribution and customer service. Shifts in consumer demand, competitors’ actions, relative pricing, return on capital or reinsurance decisions and other factors, such as regulatory matters affecting life insurance policy reserve levels, can also affect our sales levels.
Life insurance sales decreased 72% during the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012 largely attributable to our term universal life insurance product as we discontinued sales of this product in the fourth quarter of 2012. Sales levels were also lower than expected primarily as a result of slower growth in sales from our universal and term life insurance products reflecting actions taken to transition our portfolio. We plan to continue to broaden our life insurance product portfolio, modify pricing and improve service delivery platforms. This may include further re-pricing of our life insurance products or introducing new universal life insurance offerings, which may continue to include optional long-term
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care insurance riders. Collectively, these changes are expected to result in a broader set of profitable and competitive product offerings and we expect sales to increase over time.
Throughout 2012 and continuing into 2013, we experienced favorable mortality results in our term universal and term life insurance products as compared to priced mortality assumptions. Mortality levels may deviate each period from historical trends because of a variety of factors. We have experienced lower persistency in 2013 as compared to pricing assumptions for our 10-year term life insurance policies as they go through their post-level rate period. We expect this trend in persistency to continue as these 10-year term life insurance policies approach their post-level rate period and then moderate thereafter. As our 15-year term life insurance policies written in 1999 and 2000 approach their post-level rate period, if this block experiences lower persistency compared to pricing, we could expect additional amortization of deferred acquisition costs and lower profitability in our term life insurance products.
Regulations XXX and AXXX require insurers to establish additional statutory reserves for term life insurance policies with long-term premium guarantees and for certain universal life insurance policies with secondary guarantees. This increases the capital required to write these products. We have committed funding sources for approximately 95% of our anticipated peak level reserves currently required under Regulations XXX and AXXX. The National Association of Insurance Commissioners (“NAIC”) adopted revised statutory reserving requirements for new and in-force secondary guarantee universal life business subject to Actuarial Guideline 38 (more commonly known as “AG 38”) provisions, effective December 31, 2012. These requirements reflected a compromise reached and developed by a NAIC Joint Working Group which included regulators from several states, including New York. The financial impact related to the revised statutory reserving requirements on our in-force reserves subject to the new guidance was not significant as of December 31, 2012. On September 11, 2013, the New York Department of Financial Services (“NYDFS”) announced that it no longer supported the compromise reached by the NAIC Working Group and that it would require New York licensed companies, including our New York domiciled insurance subsidiary, to use an alternative interpretation of AG 38 for universal life insurance products with secondary guarantees. We are working with the NYDFS to determine the impact of this requirement which, although uncertain at this time, will require us to increase statutory reserves of our New York domiciled insurance subsidiary as of December 31, 2013 for universal life insurance products with secondary guarantees previously sold in New York, but we do not expect to be below minimum capital requirements. Additionally, we no longer actively sell universal life insurance products with secondary guarantees in New York.
Long-term care insurance. Results of our long-term care insurance business are influenced by sales, competitor actions, morbidity, mortality, persistency, investment yields, expenses and reinsurance. Additionally, sales of our products are impacted by the relative competitiveness of our offerings based on product features, pricing and commission levels, including the impact of in-force rate actions on distribution and consumer demand.
Our long-term care insurance sales decreased 31% during the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012. The lower sales reflected various price and benefit actions taken in the second half of 2012 to improve product profitability and reduce risk. These actions included elimination of certain lifetime benefits coverage and limited pay options, further tightening of underwriting and lowering of first-year commissions in certain channels, as well as a reduction or suspension of certain discounts, which effectively increased average pricing by more than 20% on the products impacted. In 2013, we took additional steps to further improve our profit and risk profile with the introduction of a new product and the suspension of sales of our individual long-term care product in California. As of September 30, 2013, this new product, which includes gender distinct pricing for single applicants and blood and lab underwriting requirements for all applicants, has been launched in 32 states. We have approvals in 15 additional states and plan to have the majority of these states launched in the fourth quarter of 2013 or the first quarter of 2014. The California actions, which became effective March 21, 2013, addressed an earlier generation product that was still being sold that did not have the benefits and pricing changes associated with our newer products. We received approval from California for a new individual long-term care insurance product which we launched in the third quarter of 2013.
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Also, in an effort to improve our returns, effective June 1, 2013, we no longer offer AARP-branded long-term care insurance products. Existing insureds’ coverage will not be affected by this change.
We will continue to focus on managing long-term care insurance product profitability and reducing risk, including implementation of new product pricing and benefit changes in addition to premium rate increases on our in-force business. We have also utilized reinsurance in the form of coinsurance to manage risk and limit capital allocated to this business. New business reinsurance levels vary and are dependent on a number of factors, including price, risk tolerance and capital levels. Over time, there can be no assurance that affordable reinsurance will continue to be available.
The annual loss ratios of our long-term care insurance business have ranged from 62% to 68% over the last five years and have been increasing over the past several years. We experience volatility in our loss ratios, which has produced loss ratios outside of the annual range, from period-to-period caused by variances in terminations, claim severity and changes in claim counts. In addition, we evaluate claim reserves (including the underlying assumptions, e.g., morbidity) and refine our estimates from time to time which may also cause volatility in our operating results and loss ratios.
In spite of the rise in interest rates in the current year, the continued low interest rate environment has put pressure on the profitability and returns of our long-term care insurance business. We seek to manage the impact of low interest rates through asset-liability management and hedging long-term care insurance product cash flows. We recently expanded our hedging strategy in connection with our new long-term care insurance product launched on April 15, 2013 in order to help mitigate interest rate risk.
As a result of ongoing challenges in our long-term care insurance business, we continue pursuing initiatives to improve the risk and profitability profile of our business including: price increases on our in-force liabilities; product refinements; changes to our current product offerings in certain states; investing in care coordination capabilities and service offerings; refining underwriting requirements; maintaining tight expense management; actively exploring additional reinsurance strategies; executing effective investment strategies; and considering other actions to improve the performance of the overall block. These efforts have included evaluating the need for future in-force premium rate increases on issued policies. In the third quarter of 2012, we initiated a round of long-term care insurance in-force premium rate increases with the goal of achieving an average premium increase in excess of 50% on the older generation policies and an average premium increase in excess of 25% on an earlier series of new generation policies when fully implemented in 2017. Subject to regulatory approval, this premium rate increase is expected to generate approximately $200 million to $300 million of additional annual premiums when fully implemented. We also expect our reserve levels, and thus our expected profitability, to be impacted by policyholder behavior which could include taking reduced benefits or non-forfeiture options within their policy coverage. The goal of our rate actions is to mitigate losses on the older generation products and help offset higher than priced-for loss ratios due to unfavorable business mix and lower lapse rates than expected on certain newer generation products which remain profitable but with returns lower than in pricing assumptions. As of September 30, 2013, this round of rate actions had been approved in 31 states representing approximately $155 million to $160 million of the targeted premium increase. In the third quarter of 2013, we initiated premium rate increases ranging between 6% and 13% on more than $800 million in annualized in-force premiums on another series of new generation policies. The premium rate increases on these policies will help offset higher than priced-for loss ratios, primarily due to improvements in life expectancy and lower than anticipated lapse rates. The approval process of an in-force rate increase and the amount of the rate increase approved varies by state. In certain states, the decision to approve or disapprove a rate increase can take several years. Upon approval, insureds are provided with written notice of the increase and increases are generally applied on the insured’s policy anniversary date. Therefore, the benefits of any rate increase are not fully realized until the implementation cycle is complete.
Changes in regulations or government programs, including long-term care insurance rate action legislation, could impact our long-term care insurance business positively or negatively. As such, we continue to actively monitor regulatory developments.
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Fixed annuities. Results of our fixed annuities business are affected by investment performance, interest rate levels, slope of the interest rate yield curve, net interest spreads, mortality, policyholder surrenders, expense and commission levels, new product sales, competitor actions and competitiveness of our offerings. Our competitive position within many of our distribution channels and our ability to grow this business depends on many factors, including product offerings and relative pricing.
In fixed annuities, sales may fluctuate as a result of consumer demand, competitor actions, changes in interest rates, credit spreads, relative pricing, return on capital decisions, and our approach to managing risk. We monitor and change prices and crediting rates on fixed annuities to maintain spreads and targeted returns. We have targeted distributors and producers and maintained sales capabilities that align with our strategy. We expect to continue to manage these distribution relationships while selectively adding or shifting towards other product offerings, including fixed indexed annuities.
Refinements of product offerings and related pricing, including use of reduced commission structures and changes in investment strategies, support our objective of achieving appropriate risk-adjusted returns. Fixed annuity sales decreased 7% during the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012 due to pressure from the low interest rate environment in the first half of 2013. However, sales have increased in the third quarter of 2013 as compared to the first two quarters of 2013 primarily attributable to competitive pricing while maintaining targeted returns and from an increase in interest rates and credit spreads.
Results of our international mortgage insurance business are affected by changes in regulatory environments, employment levels, consumer borrowing behavior, lender mortgage-related strategies, including lender servicing practices, and other economic and housing market influences, including interest rate trends, home price appreciation or depreciation, mortgage origination volume, levels and aging of mortgage delinquencies and movements in foreign currency exchange rates.
Canada and Australia comprise approximately 98% of our international mortgage insurance primary risk in-force and had estimated average effective flow loan-to-value ratios of 55% and 65%, respectively. These established markets will continue to be key drivers of revenues and earnings in our international mortgage insurance business.
Our participation or entry in other international markets remains selective. During the second quarter of 2012, we became a minority shareholder of a newly-formed joint venture partnership in India. The joint venture offers mortgage guarantees against borrower defaults on housing loans from mortgage lenders in India. This joint venture had a minimal financial impact during 2012 and the first nine months of 2013 and is expected to have a similar minimal financial impact during the next several years.
In Canada, stable economic conditions have persisted with housing affordability benefiting from low interest rates and employment growth. The unemployment rate remained relatively steady during 2012 and decreased slightly during the first nine months of 2013. The current unemployment rate remains near its lowest level since December 2008 and is expected to stay near current levels for the remainder of 2013. Additionally, average home prices increased modestly during 2012 and the first nine months of 2013. As a result, we expect home prices to remain flat or decrease modestly for the remainder of 2013, as a balanced housing market persists and consumers exercise restraint with debt levels. However, some market observers have expressed concerns about the strength of the Canadian housing market, and we will continue to closely monitor the market. The Bank of Canada has maintained the overnight rate at 1.0% during the last three years and we expect this rate to be maintained at or near this level through the remainder of 2013.
Over the past several years, the Canadian government implemented a series of revisions to the mortgage insurance eligibility rules. The latest set of revisions, which became effective in early July 2012, eliminated high loan-to-value refinancing transactions and imposed more stringent qualifying criteria for insured mortgages by reducing the maximum amortization period to 25 years from 30 years. These changes have reduced the premium
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opportunity for residential mortgage insurance, particularly for high loan-to-value refinance transactions. As a result, purchase transactions, which normally have higher premium rates compared to refinancing, currently comprise a higher percentage of our business and we expect this to continue in the future.
Flow new insurance written in Canada in 2012 decreased modestly compared to 2011 primarily due to a smaller market, particularly for high loan-to-value refinance transactions, as a result of recent revisions to mortgage insurance eligibility rules. During the third quarter of 2013, flow new insurance written increased compared to the first and second quarters of 2013 primarily from a seasonally larger mortgage originations market which typically peaks in the spring and summer months. The current quarter volume, however, was below the volume experienced in the third quarter of 2012 as a result of the recent revisions to mortgage insurance eligibility rules. As our large 2007 and 2008 book years are mostly past their peak earnings period, earned premiums in Canada declined in the first nine months of 2013 compared to the first nine months of 2012.
During 2012, losses in Canada decreased from levels experienced during 2011 as the total number of delinquencies and the proportion of new higher severity delinquencies from Alberta declined, and we continued to realize benefits from our loss mitigation activities. In Alberta, the economy and housing market conditions have improved in recent quarters, with Alberta reporting one of the lowest unemployment rates of all Canadian provinces at the end of the third quarter of 2013. Losses decreased sequentially during each of the first three quarters of 2013 as the proportion of new delinquencies from Alberta further declined.
Legislation that was passed in June 2011 by the Canadian government to formalize existing mortgage insurance arrangements with private mortgage insurers, and terminate the existing agreement with the Canadian government, became effective on January 1, 2013. This action included the elimination of the Canadian government guarantee fund and exit fees related to it. The new legislation does not change the current government guarantee of 90% provided on mortgages we insure and, therefore, during the first nine months of 2013, we did not experience any significant impact to our levels of new business as a result of this legislation. Based on the provisions of this legislation, as clarified by the final regulations released in the fourth quarter of 2012, the assets held in the Canadian government guarantee fund were returned to us on January 1, 2013 and the exit fee liability was extinguished. The reversal of the exit fee resulted in a benefit of approximately $78 million to net operating income in the fourth quarter of 2012. As a result of the elimination of the guarantee fund, we are required to hold higher regulatory capital; however, the increase in required capital has been offset by the increase in available capital that resulted from the guarantee fund assets reverting back to us.
In Australia, the overall economy continued to expand during the first nine months of 2013, though at a more modest pace than in prior periods, with ongoing evidence of variation in economic activity across sectors and regions. At the same time, housing affordability improved driven primarily by lower interest rates. The unemployment rate increased slightly during 2012 and the first six months of 2013, reaching its highest level in three years. However, the unemployment rate declined slightly in September 2013. The unemployment rate is expected to remain stable or increase modestly from current levels through the remainder of 2013. The overall housing market in Australia remained relatively stable during 2012. During the first nine months of 2013, average home prices improved across all regions and during the third quarter of 2013 grew at the highest rate since early 2010. We expect average national home prices to remain at or near current levels for the remainder of 2013. Since the fourth quarter of 2011, the Reserve Bank of Australia has gradually lowered the official cash rate from 4.75% to 2.50%, in several separate decisions with the latest interest rate cut occurring in August 2013, as Australian and global economic conditions were somewhat weaker than expected. This historically low level of interest rates is now below the low point reached during the global financial crisis when rates were cut to 3.00%. While we do not expect cash rates to be reduced significantly from the current level through the remainder of 2013, the Reserve Bank of Australia has indicated that it will continue to monitor the outlook and adjust policy as needed to support the broader economy.
Total mortgage market activity in Australia improved during 2012 and in the first half of 2013 as consumer confidence improved and affordability rose to its highest level in recent years. This growth was also reflected in the higher loan-to-value mortgage origination market, and has underpinned improving levels of flow new
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insurance written throughout 2012 and into 2013. Earned premiums in Australia have increased during the first nine months of 2013 as compared to the first nine months of 2012 primarily as a result of higher written premiums, the seasoning of our in-force block of business and lower ceded reinsurance premiums.
During the first quarter of 2012, we strengthened reserves $82 million to reflect an observed change in the rate of conversion from later stage delinquency to claim as well as a higher average paid claim amount. The higher losses were most pronounced in sub-segments of the Queensland region, whose economy has been pressured, as well as our 2007 and 2008 books of business which have higher concentrations of self-employed borrowers. The reserve strengthening recognized that we expected to see an elevated number of claims paid and higher average claim amount in the near term. While these factors did impact the level of losses for the remainder of 2012, their effect was partly offset by a lower number of new delinquencies, net of cures. The overall delinquency rate decreased during 2012 ending the year at its lowest level since the end of 2008 and has declined slightly during the first nine months of 2013. The level and number of paid claims have declined since the third quarter of 2012 and reserves continue to be largely in line with the trends we anticipated when we strengthened reserves in the first quarter of 2012. During the first quarter of 2013, losses were higher compared to the fourth quarter of 2012, which was in line with our expectations for a first quarter seasonal decline in cures. During the second quarter of 2013, losses declined sequentially driven by a seasonal recovery in cures and increased borrower sales activity which reduced claims paid and claims severity. During the third quarter of 2013, losses declined sequentially driven by lower net new delinquencies as a result of the stable economy and low interest rate environment.
We previously announced a plan to pursue a sale of up to 40% of our Australian mortgage insurance business subject to market conditions, valuation considerations including business performance in Australia, and regulatory approvals. Executing the planned sale, including through an initial public offering (“IPO”), remains a key priority in reducing our exposure to mortgage insurance risk, rebalancing the capital among our three main mortgage insurance platforms and generating capital. In Australia, there is concentration among a small group of banks that write most of the mortgages. These banks continue to evaluate the utilization of mortgage insurance in connection with the implementation of the bank capital standards in Australia introduced by the Basel Committee, and this could impact both the size of the private mortgage insurance market in Australia and our market share. The response of banks to the new capital standards will develop over time and this response could impact our Australian mortgage insurance business. As execution of an IPO is subject to market conditions, valuation considerations, including business performance, and regulatory considerations, we now believe it is more likely that there will be better execution opportunities in 2014 and, therefore, we will not execute the IPO in 2013.
On February 4, 2013, Moody’s Investors Services Inc. (“Moody’s) announced the conclusion of its review of Australian mortgage insurers, resulting in the downgrade of the leading mortgage insurers in Australia. As a result, Moody’s downgraded the financial strength rating of our Australian mortgage insurance business to “A3” from “A1,” with a stable outlook. On June 25, 2013, Standard & Poor’s Financial Services LLC (“S&P”) reaffirmed the “AA-” financial strength rating of our Australian mortgage insurance business, with a negative outlook.
The overall economic environment in Europe continues to be dominated by concerns about the fiscal health of specific countries and regions, which has created uncertainty about the timing and speed of economic recovery and renewed concerns about a lingering economic recession. While regional differences exist, the overall business climate and the economic growth outlook in Europe remain pressured from the combination of fiscal austerity, persistent high unemployment rates and low business and consumer confidence. As a result, we have seen an elevated number of delinquencies and lower cures driven by prolonged economic stress, most notably in Ireland, but also in other parts of Europe, contributing to increased loss reserves in our European mortgage insurance business. In Ireland, which represents approximately 2% of our insurance in-force in our international mortgage insurance business and 37% of our insurance in-force in Other Countries, we experienced increased delinquencies and reserves at the beginning of 2012, driven by prolonged economic and housing market stress. During the remainder of 2012, we observed a moderate improvement in outstanding delinquencies primarily
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driven by our loss mitigation efforts and lower number of new delinquencies. During the first nine months of 2013, new delinquencies remained at levels similar to those experienced in the second half of 2012. We are actively working with lenders and have significantly reduced our exposure and new business volumes from certain European countries as we seek opportunities to manage and mitigate our risk profile in Europe.
Over the past several years, our global loss mitigation operations have enhanced both their capabilities and resources devoted to finding solutions that cure delinquencies and help keep borrowers in their homes. These efforts include lender mortgage-related strategies, such as loan modification programs designed to help borrowers maintain mortgage payments while they are experiencing personal hardships. These programs allow lenders to maintain their relationship with a borrower while retaining an interest earning asset. In addition, we have developed asset management strategies designed to efficiently dispose of properties when a borrower’s hardship cannot be cured. Such efforts include actively partnering with the lender and borrower to optimize the transition process and taking early possession of properties to mitigate claim payments. As a result, these types of loss mitigation activities have had a favorable impact on our financial results as well as our relationships in the marketplace.
Results of our U.S. mortgage insurance business are affected by competitor actions, unemployment, underemployment and other economic and housing market trends, including interest rates, home prices, mortgage origination volume mix and practices, the levels and aging of mortgage delinquencies as the same may be affected by seasonal variations, the inventory of unsold homes, lender modification and other servicing efforts and resolution of pending or any future litigation. These economic and housing market trends are continuing to be adversely affected by ongoing weakness and uncertainty in the domestic economy and related levels of unemployment and underemployment. Over time, this has resulted in increased foreclosures, more borrowers seeking loan modifications and elevated housing inventories which contributed to the downward pressure on home values. Overall, we believe that home values reached their lowest levels and expect slow and modest growth on average in these values through the end of 2013 and into 2014. At the same time, we also expect unemployment and underemployment levels to remain at elevated levels for an extended period and gradually decrease over time. Currently, we expect our U.S. mortgage insurance business to be modestly profitable in the year ending December 31, 2013, and expect that its results for the year ending December 31, 2014 should continue to improve over 2013. We continue to expect seasonality in the fourth quarter of 2013, which could cause our U.S. mortgage insurance business to report a modest net loss in the fourth quarter of 2013. Our profitability expectations are subject to the continued recovery of the U.S. housing market, the extent of seasonality that has been historically experienced in the second half of the year, and certain other items such as the cost of resolution of pending litigation.
Prior to 2012, the convergence of a weak housing market, tightened lending standards, the lack of consumer confidence and the lack of liquidity in some mortgage securitization markets, along with volatility in mortgage interest rates, have come together to drive a smaller mortgage origination market. Within the private mortgage insurance market, the mortgage insurance penetration rate and overall market size was driven down over previous periods by growth in the Federal Housing Administration (“FHA”) originations, associated with multiple pricing, underwriting and loan size factors, and the negative impact of GSE market fees and loan level pricing which made private mortgage insurance solutions less competitive with FHA solutions. From 2011 through the current period, the private mortgage insurance industry saw its purchase and refinance penetration rates increase as private mortgage insurance competitiveness improved versus the FHA alternative driven in part by FHA price and risk management actions. In addition, the FHA price increase, which was effective April 1, 2013, continues to have a favorable impact on private mortgage insurance competitiveness going forward. This pattern has been offset in part by increased GSE loan level fees which can make private mortgage insurance less attractive. Further GSE fee increases could limit the demand for or competitiveness of private mortgage insurance. Considering both of these trends, we still believe the industry is likely to regain market share over time.
Driven by mortgage originations and mortgage insurance penetration, the overall insured market was larger in the first nine months of 2013 compared to the same period in the prior year. Our U.S. mortgage insurance
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market share remained flat from the prior quarter and continued to be driven in part by the impact of competitor pricing and underwriting guidelines. Even though home affordability is above historical levels, recent rising interest rates may slow purchase mortgage originations and in particular refinancing activities, which are more sensitive to interest rate levels. Continued rising mortgage interest rates may slow the housing recovery. Meanwhile, we continue to manage the quality of new business through prudent underwriting guidelines, which we modify from time to time when circumstances warrant in a manner we expect will limit the amount of coverage we write on riskier loans. In October 2013, and in addition to the pricing and guideline changes that we announced in September 2013, we announced further reduced pricing and expanded underwriting guidelines that are more in line with industry prices and guideline standards, which we believe will increase our competitiveness in the mortgage insurance market while maintaining what we believe will be a profitable book of business. As of September 30, 2013, loans modified through the Home Affordable Refinance Program (“HARP”), accounted for approximately $1.4 billion of insurance in the third quarter of 2013, and are treated as a modification of the coverage on existing insurance in-force rather than new insurance written. Loans modified through HARP have extended amortization periods and reduced interest rates which reduce borrower’s monthly payments. Over time, these modified loans are expected to result in extended premium streams and a lower incidence of default. We also continue to believe that the mortgage insurance industry level of market penetration and eventual market size will continue to be affected by any actions taken by the GSEs, the FHA or the U.S. government impacting housing or housing finance policy, underwriting standards, loan limits or related reforms.
In June 2013, the Federal Housing Finance Agency announced strategic priorities for the GSEs and indicated that there could be changes to the GSE eligibility standards. These new eligibility standards could increase capital or asset requirements for mortgage insurers, including our U.S. mortgage insurance business. Currently, we do not know what these new eligibility standards will be or when they may be implemented. The NAIC is also reviewing the minimum capital and surplus requirements for mortgage insurers, although it has not established a date by which it must make proposals to change such requirements. However, as we learn more specific information about these activities, we continue to assess the potential impact, if any, that these new standards and requirements may have on our U.S. mortgage insurance business and evaluate the options potentially available to meet these new GSE and/or NAIC requirements. The options we are evaluating include using earnings growth from our U.S. mortgage insurance business, part of available deferred tax assets, capital benefit relief from additional reinsurance transactions in our U.S. mortgage insurance business, proceeds from a third-party capital raise by our U.S. mortgage insurance subsidiaries, available proceeds from the partial IPO of our Australia mortgage insurance business (if we execute that transaction), proceeds from the issuance of new debt, equity or convertible, exchangeable or other hybrid securities at the New Genworth and/or Genworth Holdings levels and any other options that may be available to us.
Recently, Fannie Mae announced that, effective July 2013, it will no longer purchase loans with down payments of less than five percent (subject to certain limited exceptions). Freddie Mac has had a similar policy in place since June 2011. This decision could limit the demand for private mortgage insurance on loans with down payments below 95%. In addition, FHFA disclosed recently that it is reducing GSE loan limits and at the same time increasing guarantee fees. While the FHFA has not disclosed the amounts relating to the changes, these actions could also limit demand for mortgage loans with private mortgage insurance coverage. In August 2013, U.S. federal regulators issued a notice of revised proposed rules to implement the credit risk retention provision under Dodd-Frank. The revised rules propose to define Qualified Residential Mortgages (“QRMs”) to include low down payment mortgage loans, which is consistent with the definition of QRMs that is already adopted by the Consumer Finance Protection Bureau (“CFPB”). If finalized, this rule would have the effect of including many low down payment mortgage loans within the definition of QRM, which could increase the demand for mortgage loans with private mortgage insurance coverage.
While we continue to experience an ongoing long-term decrease in the level of new delinquencies, overall pressure on the housing market continues to adversely affect the performance of our portfolio, particularly our 2005 through 2008 book years that we believe peaked in their delinquency development during the first quarter of 2010. Albeit at a lower level, delinquencies for these book years continue to drive the level of new delinquencies reported to us. Beginning in mid-2010, we saw an increase in foreclosure starts as well as an
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increase in our paid claims as late stage delinquency loans go through foreclosure. While foreclosure starts remain elevated through current periods, we are seeing a decline in the number of foreclosure starts. This decrease in the number of foreclosure starts, along with the declining rate at which foreclosures are initiated, were consistent with the current lower level of early stage or pre-foreclosure delinquencies within our delinquency inventory. In addition, we saw material differences in performance among loan servicers regarding the ability to modify loans. Suspensions and delays of foreclosure actions in response to problems associated with lender and servicer foreclosure process changes and defects have caused, and could further cause, claim payments to be deferred to later periods and potentially have an adverse impact on the timing of a recovery of the U.S. residential mortgage market. Several major servicers reached agreement in principle in February 2012 with the U.S. Department of Justice, various federal agencies and 49 state attorneys general on servicing practices, and this could adversely affect timelines for claims submissions or administration actions. In addition, the recent joint announcement in early January 2013 by two key federal regulators of a negotiated agreement with 10 mortgage servicing firms would affect more than 3.8 million consumers who allegedly were wrongfully foreclosed upon during 2009 and 2010. Brokered by the Federal Reserve and the Office of the Comptroller of the Currency, mortgage servicing firms agreed to jointly pay foreclosed consumers $3.3 billion and allot another $5.2 billion for loan modifications and other services. The effect on us of these agreements remains uncertain at this time.
Expanded efforts in the mortgage servicing market to modify loans and improved performance of our 2009 through 2013 book years compared with the performance of prior book years, coupled with burn-out of our 2005 through 2008 book years, resulted in continued reductions in delinquency levels through the first nine months of 2013. As the aging of delinquencies continued to increase through 2011 and 2012, as well as through the first nine months of 2013, loan modification efforts have remained challenged. Moreover, both foreclosures and liquidations remained elevated through the same period, thereby resulting in ongoing elevated levels of loss reserves and claims. We believe that the ability to cure delinquent loans is dependent upon such things as employment levels, home values and mortgage interest rates. In addition, while we continue to execute on our loan modification strategy, which cures the underlying delinquencies and improves the ability of borrowers to service the mortgage loans going forward, we have seen the level of loan modification actions moderating during the two prior years and through the first half of 2013 compared with the levels we experienced during 2010. While we expect our level of loan modifications to continue declining going forward, a significant reduction in the level of our loan modification activity would have an adverse impact on the ability of borrowers to cure a delinquent loan and could impact our financial results.
Our loss mitigation activities, including those relating to workouts, loan modifications, pre-sales, rescissions, claims administration (including curtailment of claim amounts) and targeted settlements, net of reinstatements or adjustments, resulted in an estimated reduction of expected losses of $439 million and $509 million, respectively, including $263 million and $270 million, respectively, from workouts and loan modifications during the nine months ended September 30, 2013 and 2012.
Since 2010, benefits from loss mitigation activities have shifted from rescissions to loan modification activities and reviews of loan servicing and claims administration compliance from which we expect a majority of our loss mitigation benefits to arise going forward. While we expect to continue evaluating compliance of the insured or its loan servicer with respect to its servicing obligations under our master policy for loans insured thereunder and may curtail claim amounts payable based on our evaluations of such compliance, we cannot give assurance on the extent or level at which such claim curtailments will continue. Although loan servicers continue to pursue a wide range of approaches to execute appropriate loan modifications, government-sponsored programs such as Home Affordable Modification Program (“HAMP”) continue to result in fewer modifications as alternative programs have gained momentum. With lower benefits from government-sponsored programs and the impact from alternative programs to date, we have experienced higher levels of loss reserves and/or paid claims. Recently, the Obama Administration announced that it would extend HAMP through December 31, 2015, and expand borrower eligibility by adjusting certain underwriting requirements. In addition, incentives paid to the owner of a loan that qualifies for principal reduction under HAMP are being increased and, for the first time, will be offered to the GSEs. However, to date, the GSEs are not participating in this program. While the impact of the these program extensions to date has been positive, there can be no assurance that the increase in the number of loans that are modified under HAMP, including mortgage loans we insure currently, is sustainable over time or that any such modifications will succeed in avoiding foreclosure. Depending upon the mix
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of loss mitigation activity, market trends, employment levels in future periods and other general economic impacts which influence the U.S. residential housing market, we could see additional adverse loss reserve development going forward. We expect the primary source of new reserves and losses to come from new delinquencies.
We also participate in reinsurance programs in which we share portions of our premiums associated with flow insurance written on loans originated or purchased by lenders with captive insurance entities of these lenders in exchange for an agreed upon level of loss coverage above a specified attachment point. We have exhausted certain captive reinsurance tiers for our 2004 through 2008 book years based on loss development trends. While we continue to receive cash benefits from these captive arrangements at the time of claim payment, the level of benefit is expected to continue to decline going forward due to exhaustion of reinsurance as more reinsurers satisfy their contractual obligations such that remaining risk is borne by Genworth Mortgage Insurance Corporation (“GEMICO”), our primary U.S. mortgage insurance subsidiary. All of our excess of loss captive reinsurance arrangements are in runoff with no new books of business being added going forward. In addition, in April 2013, GEMICO and other mortgage insurance companies agreed to settle with the Consumer Finance Protection Bureau (the “CFPB”) to end the agency’s review of captive reinsurance arrangements in the mortgage insurance industry. As part of the settlement, GEMICO (and its affiliates, officers, employees and certain other related parties) are enjoined from entering into or revising certain reinsurance arrangements and violating any provisions of RESPA for a period of 10 years and GEMICO paid approximately $4 million.
As of September 30, 2013, GEMICO’s risk-to-capital ratio was below the maximum risk-to-capital ratio of 25:1 established under North Carolina law and enforced by the North Carolina Department of Insurance, which is GEMICO’s domestic insurance regulator. Fifteen other states maintain similar risk-to-capital requirements. As of September 30, 2013, GEMICO’s risk-to-capital ratio was approximately 23.2:1, compared with a risk-to-capital ratio of approximately 23.8:1 as of June 30, 2013, and 36.9:1 as of December 31, 2012. GEMICO’s ongoing risk-to-capital ratio will depend principally on the magnitude of future losses incurred by GEMICO, the effectiveness of ongoing loss mitigation activities, new business volume and profitability, as well as the amount of policy lapses and the amount of additional capital that is generated within the business or capital support (if any) that we provide. Our estimate of the amount and timing of future losses is inherently uncertain, requires significant judgment and may change significantly over time.
New insurance written in North Carolina (and in the 34 states which do not impose their own risk-to-capital requirements where we operate as long as North Carolina permits us to operate) represented approximately 48% and 49%, respectively, of our total new insurance written for the nine months ended September 30, 2013 and 2012. New insurance written in the other 10 states currently providing revocable waivers (or the equivalent) of their risk-to-capital requirements represented approximately 37% of total new insurance written for the nine months ended September 30, 2013 and 2012.
We expect to continue to manage GEMICO’s risk-to-capital ratio to be below the maximum regulatory requirement. At this time, GEMICO is writing business in all states, but two. In this regard, we continue writing new business through another insurance subsidiary, Genworth Residential Mortgage Assurance Corporation (“GRMAC”) in Florida pursuant to approvals issued by the GSEs in September 2012, which by their terms expire on December 31, 2013. Additionally, consistent with our long-standing business practice, one additional state continues to be written out of Genworth Residential Mortgage Insurance Corporation of North Carolina (“GRMIC-NC”).
In order to retain ongoing operational flexibility to continue writing new business if in the near-term GEMICO’s risk-to-capital ratio were to again rise above the maximum regulatory level of 25:1, to the extent permitted we intend to maintain GEMICO’s existing state regulatory waivers (and equivalents thereto) through their existing expiration dates. The terms of these waivers provide for either a December 31, 2013 or July 31, 2014 expiration, and as of September 30, 2013, no state providing a waiver has initiated any action to revoke or modify existing waivers. We also intend to maintain existing GSE approvals to write business through an affiliated insurance entity in states where waivers were not granted.
If we fail to meet applicable regulatory risk-to-capital requirements and are unable to obtain or maintain necessary waivers, GEMICO could be prevented from writing new business in those jurisdictions. If we were
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prevented from writing new business in those jurisdictions, our U.S. mortgage insurance operations could be placed in run-off, which means no new loans would be insured in those jurisdictions but loans previously insured would continue to be covered, with premiums continuing to be received and losses continuing to be paid on the existing portfolio of loans until GEMICO has either met applicable regulatory capital requirements or obtained applicable waivers to allow it to once again write new business. The U.S. mortgage insurance operations being placed in a run-off status in any jurisdiction would have a material adverse impact on our results of operations and financial condition.
Historically, we have actively managed the risk-to-capital ratios of our U.S. mortgage insurance business in various ways, including through reinsurance arrangements with our subsidiaries and by providing additional capital support to our U.S. mortgage insurance subsidiaries (including through the contribution of a portion of our common shares of Genworth MI Canada Inc. (“Genworth Canada”)). Most recently, we provided additional capital support and other benefits to our U.S. mortgage insurance business through our previously announced capital plan for the U.S. mortgage insurance business (the “Capital Plan”) that was completed on April 1, 2013. The Capital Plan consisted of the following actions: (i) transferring ownership of the European mortgage insurance subsidiaries to GEMICO, which was effective on January 31, 2013; (ii) enabling the future option, under certain adverse conditions, should they occur, to implement a “NewCo” type structure, for the continued writing of new business in all 50 states; and (iii) implementing an internal legal entity reorganization which created a new holding company structure that removed the U.S. mortgage insurance subsidiaries from the companies covered by the indenture governing Genworth Holdings’ senior notes. On April 1, 2013 (immediately prior to the reorganization), as part of the Capital Plan, Genworth Holdings also contributed $100 million to GEMICO. While this resulted in a risk-to-capital ratio that is currently below the maximum risk-to-capital requirement, and our long-term goal is to maintain a risk-to-capital ratio at or below 25:1, we cannot be sure that the U.S. mortgage insurance subsidiaries will maintain this ratio or that state insurance or other regulators may not require lower ratios. Moreover, our existing intercompany reinsurance arrangements are conducted through affiliated insurance subsidiaries, and therefore, remain subject to regulation by state insurance regulators who could decide to limit, or require the termination of, such arrangements.
Any decision to provide additional capital to support the U.S. mortgage insurance subsidiaries is subject to a number of business-related considerations and due diligence actions, including assessing future potential capital transactions, analyzing risk-related scenarios, understanding future U.S. policies relating to housing finance and studying regulatory and competitor activities. Depending on the state of the U.S. economy and housing market along with other factors, there is a range of potential additional capital needs that the U.S. mortgage insurance subsidiaries might require, including some that could be substantial.
If regulatory changes (including those under consideration by the GSEs and NAIC) or other business-related considerations indicate a contribution is required and appropriate, we could provide capital to GEMICO with an asset contribution or a cash contribution through a variety of means, including with available proceeds from the partial IPO of our Australia mortgage insurance business (if we execute that transaction) and proceeds from the issuance of new debt, equity or convertible, exchangeable or other hybrid securities at the New Genworth and/or Genworth Holdings levels and any other options that may be available to us. Based on GEMICO’s capital as of September 30, 2013, an additional $100 million capital infusion would result in a favorable impact to GEMICO’s risk-to-capital ratio of approximately three points. For a variety of reasons, there is no assurance that we will provide additional capital to support the U.S. mortgage insurance subsidiaries in the future beyond the amounts contributed under the Capital Plan or that we will not provide additional amounts, which could be material.
Generally, GRMAC’s ability to replace GEMICO as our principal writer of U.S. mortgage insurance (to the extent necessary) is dependent upon GRMAC continuing to satisfy its own regulatory requirements, which is principally a function of the amount of GRMAC’s statutory capital levels and the amount of new insurance it writes (which is in turn dependent upon the number of states in which GRMAC is writing new business). We cannot be sure that GRMAC will be able to continue to satisfy these requirements. In addition, GRMAC’s ability to replace GEMICO as our principal writer of U.S. mortgage insurance is also dependent upon approval from the
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GSEs to extend GRMAC’S status as an eligible insurer to continue to write to new business. Our future results of operations and financial condition could be adversely impacted if GEMICO exceeds its maximum risk-to-capital requirement, we do not contribute additional capital and its waivers are revoked or GRMAC is no longer eligible to write new business. GEMICO’s waivers, their equivalents and other approvals remain revocable at the discretion of the applicable regulator or GSE.
As previously disclosed, GEMICO’s Florida license was suspended pursuant to a voluntary consent order with the state dated July 9, 2012. On August 29, 2013, GEMICO requested that the Florida Office of Insurance Regulation (the “FOIR”) reinstate GEMICO’s license to do business in Florida based on its reduced risk-to-capital ratio. GEMICO remains engaged in ongoing discussions with the FOIR seeking reinstatement of its license prior to December 31, 2013. There can be no assurances that these discussions with the FOIR will be successful and GEMICO will have its license in the state of Florida reinstated by December 31, 2013. If GEMICO does not have its license reinstated by the FOIR by December 31, 2013, we plan to continue writing business in the state of Florida through GRMAC as long as it continues to satisfy its regulatory capital requirements and retains approval from the GSEs to write business in Florida, which expires on December 31, 2013. GEMICO is engaged in ongoing discussions with both GSEs regarding the extension of GRMAC’s approval to continue to write business in the state of Florida in the event that the FOIR does not reinstate GEMICO’s license to sell insurance prior to December 31, 2013. We can provide no assurances that these discussions will be successful and such extensions will be granted by the GSEs. Accordingly, if GEMICO fails to receive reinstatement of its license by the FOIR to sell insurance in the state of Florida, if GRMAC does not receive extension of its ability to write business in the state of Florida after December 31, 2013, and no other solutions are identified to allow us to write business in the state of Florida, our U.S. mortgage insurance business would be unable to write mortgage insurance prospectively in that state. We believe that we will have the ability to continue writing new business in the state of Florida beyond year end through one of these solutions. However, failure to accomplish one of these solutions could result in certain lenders choosing to not procure mortgage insurance from us because we would not have licenses to write business in all 50 states and this would have a material adverse impact on our results of operations and financial condition.
A possible future inability by GEMICO to meet regulatory capital requirements will not necessarily mean that GEMICO lacks sufficient resources to pay claims on its claim liabilities. While we believe GEMICO has sufficient claims-paying resources currently to meet its claim obligations on existing insurance in-force, we cannot be sure that this is the case. Furthermore, our estimates of claims-paying resources and claim obligations are based on various assumptions, which include the timing of the receipt of claims on loans in our delinquency inventory and future claims that we anticipate will ultimately be received, our anticipated loss mitigation activities, premiums, housing prices and unemployment rates. These assumptions are subject to inherent uncertainty and require judgment by management. Current conditions in the domestic economy make the assumptions about when anticipated claims will be received, housing values, and unemployment rates highly volatile, such that there is a wide range of reasonably possible outcomes.
Growth and performance of our lifestyle protection insurance business is dependent in part on economic conditions and other factors, including competitor actions, consumer lending and spending levels, unemployment trends, client account penetration and mortality and morbidity trends. Additionally, the types and mix of our products will vary based on regulatory and consumer acceptance of our products.
Consumer lending levels in Europe remain challenged particularly given concerns regarding various European economies and the effect of the European debt crisis. Unemployment rates increased slightly in the third quarter of 2013 with regional variation; however, in aggregate, European gross domestic product grew modestly in the third quarter of 2013 reversing the negative trend experienced in 2012 and into the first half of 2013. Net operating income of our lifestyle protection insurance business was lower in the third quarter of 2013 than the third quarter of 2012 as a result higher losses and lower premiums, partially offset by lower operating expenses. New claim registrations decreased 18% in 2013 from 2012 levels. We could experience higher losses if claim registrations
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increase, particularly with continued rising unemployment in Europe. Our declining premiums in 2013 compared to 2012 contributed to a loss ratio of 25% for the nine months ended September 30, 2013 compared to 22% for the nine months ended September 30, 2012. The loss ratio was also 25% in the third quarter of 2013.
In Southern Europe, stressed economies resulted in a decline in consumer lending where most of our insurance coverages attach as banks tightened lending criteria and consumer demand declined, while in Northern Europe consumer lending levels have stabilized. We have strengthened our focus in Europe on key strategic client relationships and are de-emphasizing our distribution with some other distributors where we are not expecting to achieve desired sales and profitability levels. This focus should enable us to better serve our strategic clients and promote improved profitability and a lower cost structure over time. Additionally, we continue to pursue expanding our geographical distribution into Latin America and China and have secured agreements with large insurance partners in both of these regions. We are currently working with these partners to establish product, distribution and servicing capabilities and anticipate bringing our products and services to the market in the near future.
Assuming the economies and lending environment in Europe are stable and do not improve in the near term, we expect our lifestyle protection insurance business to produce only slightly positive earnings in the fourth quarter of 2013 and in 2014. With our focus on enhanced distribution capabilities in Europe and growth in select new markets, we anticipate these efforts, coupled with sound risk and cost management disciplines, should, over time, improve profitability and help offset the impact of economic or employment pressures as well as lower levels of consumer lending in Europe. However, depending on the economic situation in Europe, we could experience additional declines in sales and operating results.
Distributor conduct associated with the sale of payment protection insurance products is currently under regulatory scrutiny in Ireland and Italy. The outcome of these reviews is unknown at this time, but impacts on how the product is distributed could have a negative impact on our sales.
Results of our Runoff segment are affected by investment performance, interest rate levels, net interest spreads, equity market conditions, mortality and policyholder surrenders and scheduled maturities. In addition, the results of our Runoff segment can significantly impact our operating performance, regulatory capital requirements, distributable earnings and liquidity.
In January 2011, we discontinued sales of our individual and group variable annuities; however, we continue to service our existing block of business and accept additional deposits on existing contracts. Throughout 2012 and into 2013, equity market volatility has caused fluctuations in the results of our variable annuity products and regulatory capital requirements. In the future, equity and interest rate market performance and volatility could result in additional gains or losses in our variable annuity products although associated hedging activities are expected to partially mitigate these impacts. Volatility in the results of our variable annuity products can result in favorable or unfavorable impacts on earnings and statutory capital. In addition to the use of hedging activities to help mitigate impacts related to equity market volatility and interest rate risks, in the future, we may pursue reinsurance opportunities to further mitigate volatility in results and manage capital.
The results of our institutional products are impacted by scheduled maturities, as well as liquidity levels. However, we believe our liquidity planning and our asset-liability management will mitigate this risk. During the nine months ended September 30, 2013, we paid benefits related to these products of $1.1 billion. While we do not actively sell institutional products, we may periodically issue funding agreements for asset-liability matching purposes.
We expect to manage our runoff products for at least the next several years. Several factors may impact the time period for these products to runoff including the specific policy types, economic conditions and management strategies.
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Financial Strength Ratings
Ratings with respect to financial strength are an important factor in establishing the competitive position of insurance companies. Ratings are important to maintaining public confidence in us and our ability to market our products. Rating organizations review the financial performance and condition of most insurers and provide opinions regarding financial strength, operating performance and ability to meet obligations to policyholders. Short-term financial strength ratings are an assessment of the credit quality of an issuer with respect to an instrument considered short-term in the relevant market, typically one year or less.
As of October 30, 2013, our principal life insurance subsidiaries were rated in terms of financial strength by S&P, Moody’s and A.M. Best Company, Inc. (“A.M. Best”) as follows:
Company
S&P rating
Moody’s rating
A.M. Best rating
Genworth Life Insurance Company
Genworth Life and Annuity Insurance Company
Genworth Life Insurance Company of New York
As of October 30, 2013, our principal mortgage insurance subsidiaries were rated in terms of financial strength by S&P, Moody’s and Dominion Bond Rating Service (“DBRS”) as follows:
DBRS rating
Genworth Mortgage Insurance Corporation
Genworth Residential Mortgage Insurance Corporation of NC
Genworth Financial Mortgage Insurance Pty. Limited (Australia)
Genworth Financial Mortgage Insurance Limited (Europe)
Genworth Financial Mortgage Insurance Company Canada
Genworth Seguros de Credito a la Vivienda S.A. de C.V. (1)
As of October 30, 2013, our principal lifestyle protection insurance subsidiaries were rated in terms of financial strength by S&P as follows:
Financial Assurance Company Limited
Financial Insurance Company Limited
The S&P, Moody’s, A.M. Best and DBRS ratings included are not designed to be, and do not serve as, measures of protection or valuation offered to investors. These financial strength ratings should not be relied on with respect to making an investment in our securities. At our request, S&P and Moody’s no longer provide short-term ratings for Genworth Life Insurance Company and Genworth Life and Annuity Insurance Company. In addition, at our request, S&P no longer provides a rating on Genworth Seguros de Credito a la Vivienda S.A. de C.V.
On May 7, 2013, S&P published new financial strength rating criteria for Global Life Insurers and the financial strength ratings of our core U.S. life insurance subsidiaries and holding company ratings were affirmed under this new criteria on June 24, 2013. S&P’s new criteria provides additional transparency in the ratings process by explicitly scoring numerous factors such as country and industry risk, competitive position, capital and earnings, financial flexibility, enterprise risk management, management and governance and liquidity.
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Following the affirmation of the U.S. life insurance financial strength ratings, Genworth’s other businesses including our Australian, Canadian and European mortgage insurance subsidiaries as well as our lifestyle protection insurance subsidiaries, which the ratings of which are based off of the core U.S. life insurance subsidiaries’ ratings, were also affirmed.
S&P maintained its negative rating outlook on our Australian mortgage insurance subsidiary as it views the planned partial IPO of Australia as necessary to support its current ratings. S&P anticipates that the partial IPO will be completed by June 2014. If the partial IPO is not successfully executed, S&P indicated that it would review and likely lower the ratings on our Australian mortgage insurance subsidiary by one notch, assuming all other rating factors remain unchanged.
S&P, Moody’s, A.M. Best and DBRS review their ratings periodically and we cannot assure you that we will maintain our current ratings in the future. Other agencies may also rate our company or our insurance subsidiaries on a solicited or an unsolicited basis. We do not provide information to agencies issuing unsolicited ratings and we cannot ensure that any agencies that rate our company or our insurance subsidiaries on an unsolicited basis will continue to do so.
Critical Accounting Estimates
As of September 30, 2013, other than as set forth below, there have been no material changes to critical accounting estimates set forth in our Current Report on Form 8-K filed on May 30, 2013, which reflected retrospective changes in accounting for costs associated with acquiring or renewing insurance contracts and changes in the treatment of future policy benefits for level premium term life insurance products.
Goodwill. Goodwill represents the excess of the amounts paid to acquire a business over the fair value of its net assets at the date of acquisition. Subsequent to acquisition, goodwill could become impaired if the fair value of a reporting unit as a whole were to decline below the value of its individually identifiable assets and liabilities. This may occur for various reasons, including changes in actual or expected income or cash flows of a reporting unit or generation of income by a reporting unit at a lower rate of return than similar businesses.
Under U.S. generally accepted accounting principles (“U.S. GAAP”), we test the carrying value of goodwill for impairment at least annually at the “reporting unit” level, which is either an operating segment or a business one level below the operating segment. Under certain circumstances, interim impairment tests may be required if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value.
The determination of fair value for our reporting units is primarily based on an income approach whereby we use discounted cash flows for each reporting unit. When available, and as appropriate, we use market approaches or other valuation techniques to corroborate discounted cash flow results. The discounted cash flow model used for each reporting unit is based on either operating income or statutory distributable income, depending on the reporting unit being valued.
For the operating income model, we determine fair value based on the present value of the most recent income projections for each reporting unit and calculate a terminal value utilizing a terminal growth rate. We primarily utilize the operating income model to determine fair value for all reporting units except for our life and long-term care insurance reporting units. In addition to the operating income model, we also consider the valuation of our Canadian mortgage insurance subsidiary’s publicly traded stock price in determining fair value for that reporting unit. The significant assumptions in the operating income model include: income projections, which are dependent on new business production, customer behavior, operating expenses and market conditions; discount rate; and terminal growth rate.
For the statutory distributable income model, we determine fair value based on the present value of projected statutory net income and changes in required capital to determine distributable income for the respective reporting unit. We utilize the statutory distributable income model to determine fair value for our life
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and long-term care insurance reporting units. The significant assumptions in the statutory distributable income model include: required capital levels; income projections, which are dependent on mortality or morbidity, new business production growth, new business projection period, policyholder behavior and other specific industry and market conditions; and discount rate.
The cash flows used to determine fair value are dependent on a number of significant assumptions based on our historical experience, our expectations of future performance and expected economic environment. We determine the best estimate of our income projections based on current market conditions as well as our expectation of future market conditions. Our estimates of projected income are subject to change given the inherent uncertainty in predicting future results. Additionally, the discount rate used to determine fair value is based on our judgment of the appropriate rate for each reporting unit based on the relative risk associated with the projected cash flows as well as our expectation of the discount rate that would be utilized by a hypothetical market participant.
We consider our market capitalization in assessing the reasonableness of the fair values estimated for our reporting units in connection with our goodwill impairment testing. In prior years, we impaired all goodwill associated with our U.S. mortgage insurance and our international protection businesses as well as our annuity and institutional products. Accordingly, these businesses are no longer subject to goodwill impairment testing but do have a significant impact on the valuation of our market capitalization in comparison to our book value. When reconciling to our market capitalization, we estimate the values for these businesses and also consider the negative value that would be associated with corporate debt, which would be subtracted from the fair value of our businesses to calculate the total value attributed to equity holders. We then compare the total value attributed to equity holders to our market capitalization.
During the third quarter of 2013, we completed our annual goodwill impairment analysis as of July 1, 2013. As a result of this analysis, we determined fair value was in excess of book value for all of our reporting units with goodwill, except for our long-term care insurance reporting unit discussed further below. While the remaining reporting units with goodwill had fair values in excess of their respective book values, we noted that our life insurance reporting unit had a fair value that was relatively close to book value and was at greater risk compared to our other reporting units of fair value being below book value in the future.
As part of our annual goodwill impairment testing, we noted that our long-term care insurance reporting unit’s fair value continues to be less than its book value. If fair value is lower than book value, the reporting unit’s fair value is allocated to assets and liabilities as if the reporting unit had been acquired in a business combination. If this “implied goodwill” exceeds the reporting unit’s goodwill balance, goodwill is deemed recoverable. Accordingly, we evaluated our long-term care insurance reporting unit’s goodwill balance of $354 million and determined that the amount of implied goodwill exceeded the amount of goodwill currently recorded by more than 100%. Accordingly, goodwill was recoverable and not impaired.
The key assumptions that impact our evaluation of goodwill for our long-term care insurance reporting unit under our goodwill impairment assessment primarily relate to the discount rate utilized to determine the present value of the projected cash flows and the valuation of new business. While the valuation of our in-force business for long-term care insurance is included in the fair value of the reporting unit, the in-force value does not contribute significant, incremental value to support goodwill. Based on a hypothetical acquisition under our goodwill impairment assessment, any difference in our current carrying value and the fair value of our in-force business would be associated with an intangible asset for the present value of future profits and would not create additional implied goodwill.
We utilized a discount rate for our long-term care insurance reporting unit of 14% based on our estimate of the weighted-average cost of capital that a hypothetical market participant would use in assessing the value of the business. The valuation of new business is determined by utilizing several inputs such as expected new business production for the next 10 years, both in terms of the quantity and number of years of new production assumed, as well as profitability of the new business, which is primarily dependent on policyholder assumptions, expected
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investment returns and targeted capital levels. The inclusion of 10 years of new business production is based on our experience of actuarial appraisals for life insurance companies where this is a common assumption. Significant changes in the expected new business production that would be used by a hypothetical market participant could result in a future impairment of goodwill.
In our annual goodwill assessment of our life insurance reporting unit, we used our best estimate of the future performance of the business and discounted these projections using a 10% discount rate. We determined the discount rate assumption used in our valuation based on our estimate of the weighted-average cost of capital that a hypothetical market participant would use in assessing the value of the business. Based on our annual goodwill impairment testing, our life insurance reporting unit’s fair value continued to exceed book value by approximately 15% with a goodwill balance of $495 million. The estimated fair value was relatively close to book value as of our annual assessment date and changes in market conditions, new business product mix, new business volume or regulatory environment could have a significant impact on our life insurance reporting unit’s fair value and could result in performing an interim goodwill impairment assessment or recognizing a future goodwill impairment. We will continue to closely monitor any changes that could impact our goodwill impairment testing results for our life insurance reporting unit.
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Consolidated Results of Operations
The following is a discussion of our consolidated results of operations and should be read in conjunction with “—Business trends and conditions.” For a discussion of our segment results, see “—Results of Operations and Selected Financial and Operating Performance Measures by Segment.”
Three Months Ended September 30, 2013 Compared to Three Months Ended September 30, 2012
The following table sets forth the consolidated results of operations for the periods indicated:
Premiums. Premiums consist primarily of premiums earned on insurance products for life, long-term care and accident and health insurance, single premium immediate annuities and structured settlements with life contingencies, lifestyle protection insurance and mortgage insurance.
Our International Mortgage Insurance segment decreased $13 million, including a decrease of $14 million attributable to changes in foreign exchange rates. Premiums in Canada decreased $9 million primarily driven by the seasoning of our larger 2007 and 2008 in-force blocks of business which are past their peak earning potential, partially offset by the elimination of the risk premium related to the government guarantee agreement in the current year. In Australia, premiums were flat, including a decrease of $11 million attributable to changes in foreign exchange rates. Excluding the effects of foreign exchange, premiums increased primarily as a result of a larger in-force portfolio and higher premiums from policy cancellations, partially offset by higher ceded reinsurance premiums in
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the current year. In Other Countries, premiums decreased $4 million primarily as a result of the seasoning of our in-force block of business and higher ceded reinsurance premiums in the current year.
Net investment income. Net investment income represents the income earned on our investments.
Net investment gains (losses). Net investment gains (losses) consist primarily of realized gains and losses from the sale or impairment of our investments and unrealized and realized gains and losses from our trading securities and derivative instruments. For further discussion of the change in net investment gains (losses), see the comparison for this line item under “—Investments and Derivative Instruments.”
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Insurance and investment product fees and other. Insurance and investment product fees and other consist primarily of fees assessed against policyholder and contractholder account values, surrender charges, cost of insurance assessed on universal and term universal life insurance policies, advisory and administration service fees assessed on investment contractholder account values, broker/dealer commission revenues and other fees.
Benefits and other changes in policy reserves. Benefits and other changes in policy reserves consist primarily of benefits paid and reserve activity related to current claims and future policy benefits on insurance and investment products for life, long-term care and accident and health insurance, structured settlements and single premium immediate annuities with life contingencies, lifestyle protection insurance and claim costs incurred related to mortgage insurance products.
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Interest credited. Interest credited represents interest credited on behalf of policyholder and contractholder general account balances.
Acquisition and operating expenses, net of deferrals. Acquisition and operating expenses, net of deferrals, represent costs and expenses related to the acquisition and ongoing maintenance of insurance and investment contracts, including commissions, policy issuance expenses and other underwriting and general operating costs. These costs and expenses are net of amounts that are capitalized and deferred, which are costs and expenses that are related directly to the successful acquisition of new or renewal insurance policies and investment contracts, such as first-year commissions in excess of ultimate renewal commissions and other policy issuance expenses.
Corporate and Other activities increased $2 million primarily attributable to $30 million of make-whole expenses paid related to the debt redemption in the third quarter of 2013 and higher net expenses after
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allocations to our operating segments in the current year. These increases were partially offset by a decrease of $40 million related to the sale of our reverse mortgage business on April 1, 2013.
Amortization of deferred acquisition costs and intangibles. Amortization of deferred acquisition costs and intangibles consists primarily of the amortization of acquisition costs that are capitalized, present value of future profits and capitalized software.
Goodwill impairment. The goodwill impairment charge in the third quarter of 2012 wrote off the entire goodwill balance for our lifestyle protection insurance business.
Interest expense. Interest expense represents interest related to our borrowings that are incurred at Genworth Holdings or subsidiaries and our non-recourse funding obligations and interest expense related to certain reinsurance arrangements being accounted for as deposits.
Provision for income taxes. The effective tax rate increased to 41.8% for the three months ended September 30, 2013 from 28.0% for the three months ended September 30, 2012. Included in the current year was additional tax expense of $20 million, including $18 million from a correction of prior periods, related to non-deductible stock compensation expense resulting from cancellations. The increase in the effective tax rate was also attributable to decreased tax benefits on lower taxed foreign income, tax favored investment benefits and a valuation allowance on a deferred tax asset on a specific separate tax return net operating loss that is no longer expected to be realized, partially offset by a non-deductible goodwill impairment in the prior year. The three months ended September 30, 2013 included a decrease of $2 million attributable to changes in foreign exchange rates.
Net income attributable to noncontrolling interests. Net income attributable to noncontrolling interests represents the portion of income in a subsidiary attributable to third parties.
Net income available to Genworth Financial, Inc.’s common stockholders. We had higher net income available to Genworth Financial, Inc.’s common stockholders in the current year primarily related to a goodwill impairment and a $6 million net loss related to a life block transaction in the prior year that did not recur. The increase was also attributable to favorable unlockings and reserve adjustments in our life insurance business, as well as lower losses in our U.S. mortgage insurance business from lower new delinquencies in the current year. These increases were partially offset by higher tax expense, unfavorable reserve adjustments in our long-term care insurance business in the current year, net investment losses in the current year compared to net investment gains in the prior year and overall lower net investment income. For a discussion of each of our segments and Corporate and Other activities, see the “—Results of Operations and Selected Financial and Operating Performance Measures by Segment.” Included in net income available to Genworth Financial, Inc.’s common stockholders for the three months ended September 30, 2013 was a decrease of $7 million, net of taxes, attributable to changes in foreign exchange rates.
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Nine Months Ended September 30, 2013 Compared to Nine Months Ended September 30, 2012
Net income available to Genworth Financial, Inc’s common stockholders
Our International Mortgage Insurance segment decreased $11 million, including a decrease of $16 million attributable to changes in foreign exchange rates. In Canada, premiums decreased
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$17 million principally from the seasoning of our larger 2007 and 2008 in-force blocks of business which are past their peak earning potential, partially offset by the elimination of the risk premium related to the government guarantee agreement in the current year. In Other Countries, premiums decreased $7 million primarily as a result of the seasoning of our in-force block of business and higher ceded reinsurance premiums in the current year. In Australia, premiums increased $13 million primarily as a result of a larger in-force portfolio and lower ceded reinsurance premiums, partially offset by lower premiums from policy cancellations in the current year.
Net investment gains (losses). For further discussion of the change in net investment gains (losses), see the comparison for this line item under “—Investments and Derivative Instruments.”
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Our U.S. Life Insurance segment increased $64 million primarily attributable to an increase of $70 million in our long-term care insurance business primarily from the aging and growth of our in-force block, $29 million of less favorable reserve adjustments primarily related to the continuation of a
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multi-stage system conversion and a $24 million correction that increased reserves to reflect a benefit for policyholders related to an accumulated benefit option in the current year. These increases were partially offset by reduced benefits of $48 million from in-force rate actions, a $17 million favorable adjustment for the refinement of the methodology for calculating incurred but not reported reserves to more fully reflect product specific incidence rates and increased claim terminations driven by higher mortality in the current year. In addition, reserves for prior year claims benefited $23 million during the current year mainly from an increase in claim terminations driven by higher mortality. Our life insurance business increased $45 million principally related to higher ceded reinsurance as we initially ceded $209 million of certain term life insurance reserves under a new reinsurance treaty as part of a life block transaction in the prior year. The increase was also attributable to growth of our term universal and universal life insurance in-force blocks. These increases were partially offset by a $70 million favorable unlocking in our term universal and universal life insurance products related to mortality and interest assumptions in the current year compared to a $31 million unfavorable unlocking related to interest assumptions in the prior year. The increase was also partially offset by a $28 million favorable reserve correction in our term universal life insurance product in the current year and mortality which was favorable to pricing and to the prior year. Our fixed annuities business decreased $51 million largely attributable to lower sales of our life-contingent products and favorable mortality in the current year.
Our International Mortgage Insurance segment decreased $13 million, including a decrease of $3 million attributable to changes in foreign exchange rates. Canada decreased $19 million mainly related to the elimination of exit fees related to the government guarantee fund, partially offset by higher stock-based compensation expense in the current year. Australia increased $4 million primarily
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from higher employee compensation and benefit expenses and higher operating expenses in the current year. Other Countries increased $2 million primarily from higher employee compensation and benefit expenses, including a $1 million restructuring charge in the current year.
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Provision for income taxes. The effective tax rate increased to 34.6% for the nine months ended September 30, 2013 from 23.8% for the nine months ended September 30, 2012. Included in the current year was additional tax expense of $20 million, including $13 million from a correction of prior years related to non-deductible stock compensation expense resulting from cancellations. The increase in the effective tax rate was also attributable to decreased tax benefits on lower taxed foreign income, tax favored investment benefits and a valuation allowance on a deferred tax asset on a specific separate tax return net operating loss that is no longer expected to be realized, partially offset by a non-deductible goodwill impairment in the prior year. The nine months ended September 30, 2013 included a decrease of $1 million attributable to changes in foreign exchange rates.
Net income available to Genworth Financial, Inc.’s common stockholders. We had higher net income available to Genworth Financial, Inc.’s common stockholders in the current year primarily related to significantly lower losses in our U.S. Mortgage Insurance segment in the current year and from a goodwill impairment in the prior year that did not recur. The prior year also included a reserve strengthening in our Australian mortgage insurance business that did not recur and $47 million of net losses related to life block transactions completed by our life insurance business. These increases were partially offset by $40 million of prior year favorable adjustments in our long-term care insurance business that did not recur and a $13 million restructuring charge in the current year related to the expense reduction plan announced on June 6, 2013 reflecting severance, outplacement and other associated costs. For a discussion of each of our segments and Corporate and Other activities, see the “—Results of Operations and Selected Financial and Operating Performance Measures by Segment.” Included in net income available to Genworth Financial, Inc.’s common stockholders for the nine months ended September 30, 2013 was a decrease of $9 million, net of taxes, attributable to changes in foreign exchange rates.
Reconciliation of net income to net operating income
We had net operating income for the three months ended September 30, 2013 of $119 million compared to $111 million for the three months ended September 30, 2012. We had net operating income for the nine months ended September 30, 2013 of $403 million compared to $195 million for the nine months ended September 30, 2012. We define net operating income (loss) as income (loss) from continuing operations excluding the after-tax effects of income attributable to noncontrolling interests, net investment gains (losses), goodwill impairments, gains (losses) on the sale of businesses and infrequent or unusual non-operating items. We exclude net investment gains (losses) and infrequent or unusual non-operating items because we do not consider them to be related to the operating performance of our segments and Corporate and Other activities. A component of our net investment gains (losses) is the result of impairments, the size and timing of which can vary significantly depending on market credit cycles. In addition, the size and timing of other investment gains (losses) can be subject to our discretion and are influenced by market opportunities, as well as asset-liability matching considerations. Goodwill impairments and gains (losses) on the sale of businesses are also excluded from net operating income (loss) because, in our opinion, they are not indicative of overall operating trends. Other non-operating items are also excluded from net operating income (loss) if, in our opinion, they are not indicative of overall operating trends. There were no infrequent or unusual items excluded from net operating income during the periods presented other than a $13 million after-tax expense recorded in the second quarter of 2013 related to restructuring costs. In June 2013, we announced an expense reduction plan as we continue to work on improving the operating performance of our businesses resulting in a pre-tax non-operating charge of $20 million reflecting severance, outplacement and other associated costs. This plan eliminated approximately 400 positions, including 150 open positions that will not be filled, and has, and will continue to, reduce related information technology and program spend.
While some of these items may be significant components of net income available to Genworth Financial, Inc.’s common stockholders in accordance with U.S. GAAP, we believe that net operating income, and measures that are derived from or incorporate net operating income, are appropriate measures that are useful to investors because they identify the income (loss) attributable to the ongoing operations of the business. Management also
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uses net operating income as a basis for determining awards and compensation for senior management and to evaluate performance on a basis comparable to that used by analysts. However, the items excluded from net operating income have occurred in the past and could, and in some cases will, recur in the future. Net operating income is not a substitute for net income available to Genworth Financial, Inc.’s common stockholders determined in accordance with U.S. GAAP. In addition, our definition of net operating income may differ from the definitions used by other companies.
The following table includes a reconciliation of net income to net operating income for the periods indicated:
Adjustments to net income available to Genworth Financial, Inc.’s common stockholders:
Net investment (gains) losses, net of taxes and other adjustments
(Income) loss from discontinued operations, net of taxes
Earnings per share
The following table provides basic and diluted net income available to Genworth Financial, Inc.’s common stockholders and net operating income per common share for the periods indicated:
Net operating income per common share:
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Diluted weighted-average shares outstanding reflect the effects of potentially dilutive securities including stock options, restricted stock units and other equity-based compensation.
Results of Operations and Selected Financial and Operating Performance Measures by Segment
Our chief operating decision maker evaluates segment performance and allocates resources on the basis of net operating income (loss). See note 9 in our “—Notes to Condensed Consolidated Financial Statements” for a reconciliation of net operating income (loss) of our segments and Corporate and Other activities to net income available to Genworth Financial, Inc.’s common stockholders.
Management’s discussion and analysis by segment contains selected operating performance measures including “sales” and “insurance in-force” or “risk in-force” which are commonly used in the insurance industry as measures of operating performance.
Management regularly monitors and reports sales metrics as a measure of volume of new and renewal business generated in a period. Sales refer to: (1) annualized first-year premiums for term life and long-term care insurance products; (2) annualized first-year deposits plus 5% of excess deposits for universal and term universal life insurance products; (3) 10% of premium deposits for linked-benefits products; (4) new and additional premiums/deposits for fixed annuities; (5) new insurance written for mortgage insurance; and (6) net written premiums for our lifestyle protection insurance business. Sales do not include renewal premiums on policies or contracts written during prior periods. We consider annualized first-year premiums/deposits, premium equivalents, new premiums/deposits, written premiums and new insurance written to be a measure of our operating performance because they represent a measure of new sales of insurance policies or contracts during a specified period, rather than a measure of our revenues or profitability during that period.
Management regularly monitors and reports insurance in-force and risk in-force. Insurance in-force for our life, international mortgage and U.S. mortgage insurance businesses is a measure of the aggregate face value of outstanding insurance policies as of the respective reporting date. For risk in-force in our international mortgage insurance business, we have computed an “effective” risk in-force amount, which recognizes that the loss on any particular loan will be reduced by the net proceeds received upon sale of the property. Effective risk in-force has been calculated by applying to insurance in-force a factor of 35% that represents our highest expected average per-claim payment for any one underwriting year over the life of our businesses in Canada and Australia. Risk in-force for our U.S. mortgage insurance business is our obligation that is limited under contractual terms to the amounts less than 100% of the mortgage loan value. We consider insurance in-force and risk in-force to be a measure of our operating performance because they represent a measure of the size of our business at a specific date which will generate revenues and profits in a future period, rather than a measure of our revenues or profitability during that period.
We also include information related to loss mitigation activities for our U.S. mortgage insurance business. We define loss mitigation activities as rescissions, cancellations, borrower loan modifications, repayment plans, lender- and borrower-titled pre-sales, claims administration and other loan workouts. Estimated savings related to rescissions are the reduction in carried loss reserves, net of premium refunds and reinstatement of prior rescissions. Estimated savings related to loan modifications and other cure related loss mitigation actions represent the reduction in carried loss reserves. Estimated savings related to claims mitigation activities represent amounts deducted or “curtailed” from claims due to acts or omissions by the insured or the servicer with respect to the servicing of an insured loan that is not in compliance with obligations under our master policy. For non-cure related actions, including pre-sales, the estimated savings represent the difference between the full claim obligation and the actual amount paid. Loans subject to our loss mitigation actions, the results of which have been included in our reported estimated loss mitigation savings, are subject to re-default and may result in a potential claim in future periods, as well as potential future loss mitigation savings depending on the resolution of the re-defaulted loan. We believe that this information helps to enhance the understanding of the operating performance of our U.S. mortgage insurance business as loss mitigation activities specifically impact current and future loss reserves and level of claim payments.
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These operating measures enable us to compare our operating performance across periods without regard to revenues or profitability related to policies or contracts sold in prior periods or from investments or other sources.
Management also regularly monitors and reports a loss ratio for our businesses. For our mortgage and lifestyle protection insurance businesses, the loss ratio is the ratio of incurred losses and loss adjustment expenses to net earned premiums. For our long-term care insurance business, the loss ratio is the ratio of benefits and other changes in reserves less tabular interest on reserves less loss adjustment expenses to net earned premiums. We consider the loss ratio to be a measure of underwriting performance in these businesses and helps to enhance the understanding of the operating performance of our businesses.
An assumed tax rate of 35% is utilized in certain adjustments to net operating income.
The following discussions of our segment results of operations should be read in conjunction with the “—Business trends and conditions.”
U.S. Life Insurance Division
Division results of operations
The following table sets forth the results of operations relating to our U.S. Life Insurance Division for the periods indicated. See below for a discussion by segment.
Net operating income:
U.S. Life Insurance segment
Total net operating income
Adjustments to net operating income:
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Segment results of operations
The following table sets forth the results of operations relating to our U.S. Life Insurance segment for the periods indicated:
Adjustment to income from continuing operations:
The following table sets forth net operating income for the businesses included in our U.S. Life Insurance segment for the periods indicated:
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Net investment gains (losses). For further discussion of the change in net investment gains (losses), see the comparison for this line item under “—Investments and Derivative Instruments.” In the current year, net investment losses were primarily related to our fixed annuities business driven by net losses from the sale of
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investment securities and impairments, partially offset by derivative gains. Net investment gains in the prior year were mainly related to our fixed annuities business driven by derivative gains and net gains from the sale of investment securities, partially offset by impairments.
Insurance and investment product fees and other. The decrease was primarily attributable to our life insurance business predominately from a $38 million gain from the repurchase of notes secured by our non-recourse funding obligations associated with a life block transaction in the prior year that did not recur. This decrease was partially offset by an $8 million favorable unlocking in our universal life insurance products related to interest assumptions in the current year and the write-off of $6 million in deferred borrowing costs from the repurchase and repayment of non-recourse funding obligations associated with a life block transaction in the prior year that did not recur.
Benefits and expenses
Interest credited. The decrease in interest credited was principally related to our fixed annuities business driven by lower crediting rates in a low interest rate environment in the current year.
Our life insurance business increased $39 million primarily from a $60 million unfavorable unlocking related to mortality and interest assumptions in our term universal and universal life insurance products in the current year compared to a $19 million favorable unlocking related to interest assumptions in the
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prior year. This increase was partially offset by higher amortization of $39 million reflecting loss recognition on certain term life insurance policies under a reinsurance treaty as part of a life block transaction in the prior year that did not recur.
Provision for income taxes. The effective tax rate increased to 43.4% for the three months ended September 30, 2013 from 33.1% for the three months ended September 30, 2012. The increase in the effective tax rate was primarily attributable to a valuation allowance on a deferred tax asset on a specific separate tax return net operating loss that is no longer expected to be realized and changes in uncertain tax positions in the prior year.
Adjustments to income from continuing operations:
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Insurance and investment product fees and other. The decrease was primarily attributable to our life insurance business related predominately to $120 million of gains on the repurchase of notes secured by our non-recourse funding obligations related to life block transactions in the prior year that did not recur. This decrease was partially offset by an increase in our term universal life insurance in-force block, an $8 million favorable unlocking in our universal life insurance products related to interest assumptions in the current year and an unfavorable valuation adjustment in the prior year that did not recur.
Our long-term care insurance business increased $70 million primarily from the aging and growth of our in-force block, $29 million of less favorable reserve adjustments primarily related to the continuation of a multi-stage system conversion and a $24 million correction that increased reserves to reflect a benefit for policyholders related to an accumulated benefit option in the current year. These increases were partially offset by reduced benefits of $48 million from in-force rate actions, a $17 million favorable adjustment for the refinement of the methodology for calculating incurred but not
130
reported reserves to more fully reflect product specific incidence rates and increased claim terminations driven by higher mortality in the current year. In addition, reserves for prior year claims benefited $23 million during the current year mainly from an increase in claim terminations driven by higher mortality.
Interest expense. Interest expense increased driven by our life insurance business largely related to a $20 million favorable adjustment in the prior year related to the Tax Matters Agreement with our former parent company that did not recur. This increase was partially offset by the write-off of $8 million in deferred borrowing costs from the repurchase and repayment of non-recourse funding obligations associated with a life block transaction in the prior year that did not recur.
Provision for income taxes. The effective tax rate increased to 39.6% for the nine months ended September 30, 2013 from 34.4% for the nine months ended September 30, 2012. The increase in the effective tax rate was primarily attributable to a valuation allowance on a deferred tax asset on a specific tax return net operating loss that is no longer expected to be realized and changes in uncertain tax positions in the prior year.
131
U.S. Life Insurance selected operating performance measures
The following tables set forth selected operating performance measures regarding our life insurance business as of or for the dates indicated:
Term and whole life insurance
Net earned premiums
Sales
Term universal life insurance
Net deposits
Universal life insurance
Sales:
Linked-benefits
Total life insurance
Net earned premiums and deposits
Term life insurance
Life insurance in-force, net of reinsurance
Life insurance in-force before reinsurance
Net earned premiums decreased for the three months ended September 30, 2013 primarily as a result of lapses of older policies and higher ceded reinsurance, partially offset by increased premiums of our new term life insurance product in the current year. Net earned premiums increased for the nine months ended September 30,
132
2013 primarily related to higher ceded reinsurance on certain term life insurance policies under a reinsurance treaty as part of a life block transaction in the prior year that did not recur, partially offset by our term life insurance products as lapses of older policies and higher ceded reinsurance outpaced increased premiums of our new term life insurance product in the current year. Sales of our term life insurance products increased because we began offering these products in the fourth quarter of 2012. Our life insurance in-force decreased from the runoff of our term life insurance products issued prior to resuming sales in the fourth quarter of 2012 and the runoff of our whole life insurance products.
Our life insurance in-force was flat as we discontinued sales of this product in the fourth quarter of 2012 which resulted in lower sales in the current year and flat net deposits for the three months ended September 30, 2013.
Net deposits and sales decreased from our modification and re-pricing of certain product offerings that we announced in the fourth quarter of 2012 in response to regulatory changes.
The following table sets forth selected operating performance measures regarding our individual and group long-term care insurance products for the periods indicated:
Net earned premiums:
Individual long-term care insurance
Group long-term care insurance
Annualized first-year premiums and deposits:
Loss ratio (1)
The loss ratio is the ratio of benefits and other changes in reserves less tabular interest on reserves less loss adjustment expenses to net earned premiums.
Net earned premiums increased for the three and nine months ended September 30, 2013 compared to the prior year mainly attributable to growth of our in-force block from new sales and in-force rate actions. The nine months ended September 30, 2013 also included $14 million of unfavorable adjustments.
133
Annualized first-year premiums and deposits decreased principally from changes in pricing and product options previously announced.
The loss ratio increased for the three months ended September 30, 2013 compared to the prior year largely attributable to $34 million of less favorable reserve adjustments primarily related to the continuation of a multi-stage system conversion, a $24 million correction that increased reserves to reflect a benefit for policyholders related to an accumulated benefit option and higher new pending claims, partially offset by cancellations of pending claims in the current year. These increases were mostly offset by $43 million of increased premiums and reduced benefits from in-force rate actions and a $17 million favorable adjustment for the refinement of the methodology for calculating incurred but not reported reserves to more fully reflect product specific incidence rates in the current year. In addition, reserves for prior year claims increased $17 million during the three months ended September 30, 2013 mainly from a decrease in claim terminations.
The loss ratio was flat for the nine months ended September 30, 2013 compared to the prior year as $70 million of increased premiums and reduced benefits from in-force rate actions, a $17 million favorable adjustment for the refinement of the methodology for calculating incurred but not reported reserves to more fully reflect product specific incidence rates and an increase in claim terminations driven by higher mortality in the current year were offset by $43 million of less favorable reserve and other adjustments and a $24 million correction that increased reserves to reflect a benefit for policyholders related to an accumulated benefit option in the current year. In addition, reserves for prior year claims benefited $23 million during the nine months ended September 30, 2013 mainly from an increase in claim terminations driven by higher mortality.
134
The following table sets forth selected operating performance measures regarding our fixed annuities as of or for the dates indicated:
Single Premium Deferred Annuities
Account value, beginning of period
Deposits
Surrenders, benefits and product charges
Net flows
Account value, end of period
Single Premium Immediate Annuities
Premiums and deposits
Effect of accumulated net unrealized investment gains (losses)
Structured Settlements
Account value, net of reinsurance, beginning of period
Account value, net of reinsurance, end of period
Total premiums from fixed annuities
Total deposits from fixed annuities
Account value of our single premium deferred annuities increased as deposits and interest credited outpaced surrenders. Sales have increased, particularly in the third quarter of 2013, driven by competitive pricing while maintaining targeted returns, and from a rise in interest rates in the current year.
Account value of our single premium immediate annuities decreased as benefits exceeded premiums and deposits and interest credited. Sales continued to be pressured under current market conditions and from the low interest rate environment in spite of the rise in interest rates in the current year.
135
We no longer solicit sales of structured settlements; however, we continue to service our existing block of business.
Global Mortgage Insurance Division
The following table sets forth the results of operations relating to our Global Mortgage Insurance Division for the periods indicated. See below for a discussion by segment.
Net operating income (loss):
International Mortgage Insurance segment
U.S. Mortgage Insurance segment
Net income available to Genworth Financial, Inc.'s common stockholders
136
The following table sets forth the results of operations relating to our International Mortgage Insurance segment for the periods indicated:
Income from continuing operation before income taxes
Adjustment to income from continuing operations available to Genworth Financial, Inc.’s common stockholders:
The following table sets forth net operating income (loss) for the businesses included in our International Mortgage Insurance segment for the periods indicated:
137
Net investment income. The decrease in net investment income was due to lower reinvestment yields in Canada and Australia, partially offset by higher average invested assets in Canada and Australia. The three months ended September 30, 2013 included a decrease of $6 million attributable to changes in foreign exchange rates.
Net investment gains (losses). For further discussion of the change in net investment gains (losses), see the comparison for this line item under “—Investments and Derivative Instruments.” The increase was primarily from higher net investment gains from the sale of securities in Canada in the current year.
138
Acquisition and operating expenses, net of deferrals. The decrease was primarily associated with our Canadian mortgage insurance business mainly from the elimination of exit fees related to the government guarantee fund, partially offset by higher stock-based compensation expense in the current year. The three months ended September 30, 2013 included a decrease of $2 million attributable to changes in foreign exchange rates.
Provision for income taxes. The effective tax rate increased to 25.8% for the three months ended September 30, 2013 from 20.9% for the three months ended September 30, 2012. The increase in the effective tax rate was primarily attributable to decreased tax benefits from lower taxed foreign income, partially offset by changes in uncertain tax positions in Australia. The three months ended September 30, 2013 included a decrease of $2 million attributable to changes in foreign exchange rates.
Adjustments to income from continuing operations available to Genworth Financial, Inc.’s common stockholders:
139
The following table sets forth net operating income for the businesses included in our International Mortgage Insurance segment for the periods indicated:
Net investment income. The decrease in net investment income was driven primarily by Australia and Canada from lower reinvestment yields, partially offset by higher average invested assets in the current year. The nine months ended September 30, 2013 included a decrease of $6 million attributable to changes in foreign exchange rates.
140
Provision for income taxes. The effective tax rate increased to 27.4% for the nine months ended September 30, 2013 from 24.4% for the nine months ended September 30, 2012. The increase in the effective tax rate was primarily attributable to decreased tax benefits from lower taxed foreign income, partially offset by changes in uncertain tax positions in Australia. The nine months ended September 30, 2013 included a decrease of $1 million attributable to changes in foreign exchange rates.
141
International Mortgage Insurance selected operating performance measures
The following tables set forth selected operating performance measures regarding our International Mortgage Insurance segment as of or for the dates indicated:
Primary insurance in-force:
Risk in-force:
Other Countries (1)
New insurance written:
Net premiums written:
Primary insurance in-force and risk in-force
Our businesses in Canada and Australia currently provide 100% coverage on the majority of the loans we insure in those markets. For the purpose of representing our risk in-force, we have computed an “effective” risk in-force amount, which recognizes that the loss on any particular loan will be reduced by the net proceeds received upon sale of the property. Effective risk in-force has been calculated by applying to insurance in-force a factor that represents our highest expected average per-claim payment for any one underwriting year over the life of our businesses in Canada and Australia. For the three and nine months ended September 30, 2013 and 2012, this factor was 35%.
In Canada, primary insurance in-force and risk in-force increased, including decreases of $14.0 billion and $4.9 billion, respectively, attributable to changes in foreign exchange rates, primarily as a result of flow new insurance written and bulk transactions in the current year.
142
In Australia, primary insurance in-force and risk in-force decreased, including decreases of $30.7 billion and $10.8 billion, respectively, attributable to changes in foreign exchange rates. Excluding the effects of foreign exchange, the increase in Australia was mainly attributable to flow new insurance written driven by improved housing affordability as interest rates remained low in the current year.
In Other Countries, primary insurance in-force increased, including an increase of $1.3 billion attributable to changes in foreign exchange rates, and risk in-force was flat, including an increase of $200 million attributable to changes in foreign exchange rates. Excluding the effects of foreign exchange, primary insurance in-force and risk in-force decreased in Other Countries mainly from ongoing loss mitigation activities in Europe.
New insurance written
For the three months ended September 30, 2013, new insurance written in Canada increased primarily as a result of higher bulk transactions in the current year. For the nine months ended September 30, 2013, new insurance written in Canada decreased primarily as a result of lower bulk transactions in the current year. Flow new insurance written in Canada also declined for the three and nine months ended September 30, 2013 mainly attributable to a smaller mortgage originations market, particularly for high loan-to-value refinance transactions as a result of the changes to mortgage insurance eligibility rules under the government guarantee which took effect in July 2012. The three and nine months ended September 30, 2013 included decreases of $200 million and $400 million, respectively, attributable to changes in foreign exchange rates in Canada.
For the three months ended September 30, 2013, new insurance written in Australia decreased driven by changes in foreign exchange rates. Excluding the effects of foreign exchange, new insurance written in Australia increased during the three months ended September 30, 2013 mainly attributable to improved housing affordability as interest rates have remained low in the current year, which also drove the increase during the nine months ended September 30, 2013. The three and nine months ended September 30, 2013 included decreases of $900 million and $1,000 million, respectively, attributable to changes in foreign exchange rates in Australia.
For the three and nine months ended September 30, 2013, new insurance written in Other Countries increased slightly but remained at low levels as the mortgage originations market in Europe continued to be pressured by high unemployment rates and a weak economic environment.
Net premiums written
Most of our international mortgage insurance policies provide for single premiums at the time that loan proceeds are advanced. We initially record the single premiums to unearned premium reserves and recognize the premiums earned over time in accordance with the expected pattern of risk emergence. As of September 30, 2013, our unearned premium reserves were $2,887 million, including a decrease of $200 million attributable to changes in foreign exchange rates, compared to $3,041 million as of September 30, 2012. Unearned premium reserves were slightly lower primarily as a result of changes in foreign exchange rates and the seasoning of our older in-force blocks of business were mostly offset by premiums from new business volume.
For the three months ended September 30, 2013, net premiums written in Australia decreased driven by changes in foreign exchange rates. Excluding the effects of foreign exchange for the three months ended September 30, 2013, net premiums written increased in Australia and net premiums written increased during the nine months ended September 30, 2013, in each case primarily from higher flow volume and higher flow premium rates. The three and nine months ended September 30, 2013 included decreases of $13 million and $14 million, respectively, attributable to changes in foreign exchange rates in Australia.
In Canada, net premiums written decreased during the three and nine months ended September 30, 2013 primarily from lower flow volume attributable to a smaller mortgage originations market and lower bulk transactions in the current year. The three and nine months ended September 30, 2013 included decreases of $4 million and $6 million, respectively, attributable to changes in foreign exchange rates in Canada.
143
Loss and expense ratios
The following table sets forth the loss and expense ratios for our International Mortgage Insurance segment for the dates indicated:
Loss ratio:
Expense ratio:
The loss ratio is the ratio of incurred losses and loss adjustment expenses to net earned premiums. The expense ratio is the ratio of general expenses to net premiums written. In our business, general expenses consist of acquisition and operating expenses, net of deferrals, and amortization of deferred acquisition costs and intangibles.
Loss ratio
For the three months ended September 30, 2013, the loss ratio in Australia decreased driven by lower new delinquencies and improved aging on our existing delinquencies in the current year. In addition, paid claims decreased in the current year as a result of a decrease in both the number of claims and the average claim payment. For the nine months ended September 30, 2013, the loss ratio in Australia decreased primarily attributable to a reserve strengthening in the prior year that did not recur and lower new delinquencies in the current year. In the first quarter of 2012, we strengthened reserves by $82 million due to higher than anticipated frequency and severity of claims paid from later stage delinquencies from prior years, particularly in coastal tourism areas of Queensland as a result of regional economic pressures as well as our 2007 and 2008 books of business which have a higher concentration of self-employed borrowers.
The loss ratio in Canada for the three months ended September 30, 2013 decreased primarily as a result of a shift in the mix of new delinquencies with fewer delinquencies from Alberta where the severity has been higher than other regions. The loss ratio in Canada for the nine months ended September 30, 2013 decreased primarily due to lower new delinquencies, net of cures, and lower paid claims due to a shift in regional mix, with fewer claims from Alberta. Higher benefits from loss mitigation activities also contributed to the decrease in the loss ratio in the current year.
In Other Countries, the loss ratio increased for the three and nine months ended September 30, 2013 as a result of higher delinquencies, particularly in Ireland, and lower earned premiums in the current year.
Expense ratio
For the three and nine months ended September 30, 2013, the marginal decrease in the overall expense ratio was primarily attributable to lower net premiums written. In Canada, the expense ratio decreased slightly as lower operating expenses that primarily resulted from the elimination of exit fees related to the government guarantee fund were not fully offset by the impact of lower net premiums written.
The expense ratio in Australia was flat for the three months ended September 30, 2013 as higher employee compensation and benefit expenses were offset by higher net premiums written in the current year. The expense ratio in Australia decreased for the nine months ended September 30, 2013 as the increase in net premiums written was higher than the increase in employee compensation and benefit expenses in the current year.
144
In Other Countries, the expense ratio increased for the three and nine months ended September 30, 2013 primarily from higher employee compensation and benefit expenses, including a $1 million restructuring charge in the second quarter of 2013, and lower net premiums written.
Delinquent loans
The following table sets forth the number of loans insured, the number of delinquent loans and the delinquency rate for our international mortgage insurance portfolio as of the dates indicated:
Canada:
Primary insured loans in-force
Percentage of delinquent loans (delinquency rate)
Flow loan in-force
Flow delinquent loans
Percentage of flow delinquent loans (delinquency rate)
Bulk loans in-force
Bulk delinquent loans
Percentage of bulk delinquent loans (delinquency rate)
Australia:
Other Countries:
Total:
Bulk delinquent loans (1)
145
In Canada, flow loans in-force increased primarily from ongoing new business and flow delinquent loans decreased primarily as a result of lower new delinquencies, net of cures. Bulk loans in-force decreased primarily from the expiration of several large bulk transactions in the current year.
In Australia, flow loans in-force increased as new policies written were partially offset by policy cancellations in the current year. Flow delinquent loans decreased as paid claims and cures more than offset new delinquencies.
In Other Countries, flow loans in-force loans decreased mainly attributable to ongoing loss mitigation activities in Europe. Flow delinquent loans compared to December 31, 2012 increased primarily from regional economic pressures, primarily in Ireland. Flow delinquent loans compared to September 30, 2012 decreased mainly from ongoing loss mitigation in Europe.
The following table sets forth the results of operations relating to our U.S. Mortgage Insurance segment for the periods indicated:
Loss from continuing operations before income taxes
Benefit for income taxes
Loss from continuing operations
Adjustment to loss from continuing operations:
Net operating loss
The decrease in net operating loss was mainly attributable to the decline in new delinquencies and improvements in net cures and aging on existing delinquencies in the current year.
146
Premiums decreased slightly with a modest decline in average price, partially offset by increased average insurance in-force and lower ceded reinsurance premiums related to our captive arrangements in the current year.
Net investment income decreased primarily from lower average invested assets in the current year.
Benefits and other changes in policy reserves decreased $51 million primarily driven by a decline in new delinquencies and improvements in net cures and aging on existing delinquencies in the current year. Overall delinquencies continued to decline from factors such as increased cure rates resulting from improvements in the overall housing market, fewer new delinquencies and ongoing loss mitigation efforts. Reserves for prior year delinquencies benefited $4 million during the current year from improvements in net cures.
Acquisition and operating expenses, net of deferrals, decreased primarily from lower operating expenses in the current year.
Benefit for income taxes. The effective tax rate decreased to 25.0% for the three months ended September 30, 2013 from 37.3% for the three months ended September 30, 2012. The decrease in the effective tax rate was primarily attributable to the effects of interim tax accounting standards on tax favored investment benefits in the current year.
Income (loss) from continuing operations before income taxes
Adjustment to income (loss) from continuing operations:
Net operating income (loss)
147
We had net operating income in the current year compared to a net operating loss in the prior year mainly attributable to the decline in new delinquencies and improvements in net cures and aging on existing delinquencies in the current year.
Premiums increased slightly driven by lower ceded reinsurance premiums related to our captive arrangements. This increase was largely offset by lower premiums assumed from an affiliate under an intercompany reinsurance agreement that was terminated effective July 1, 2012.
The decrease in net investment gains was primarily driven by higher gains on the sale of investment securities in the prior year.
Insurance and investment product fees and other income decreased primarily from a gain related to the termination of an external reinsurance arrangement in the prior year.
Benefits and other changes in policy reserves decreased due to lower net paid claims of $137 million and a change in reserves of $104 million. The decrease was primarily driven by a decline in new delinquencies and improvements in net cures and aging on existing delinquencies in the current year. Overall delinquencies continued to decline from factors such as increased cure rates resulting from improvements in the overall housing market, fewer new delinquencies and ongoing loss mitigation efforts. Reserves for prior year delinquencies benefited $60 million during the current year from improvements in net cures. The prior year included a net $9 million portfolio settlement with one of lender that did not recur.
Acquisition and operating expenses, net of deferrals, increased slightly primarily from a settlement of $4 million with the CFPB to end its review of industry captive reinsurance arrangements, partially offset by lower operating expenses in the current year.
Provision (benefit) for income taxes. The effective tax rate decreased to 27.9% for the nine months ended September 30, 2013 from 37.3% for the nine months ended September 30, 2012. The decrease in the effective tax rate was primarily attributable to the effect of tax favored investment benefits on pre-tax income in the current year compared to the effect of tax favored investment benefits on a pre-tax loss in the prior year.
U.S. Mortgage Insurance selected operating performance measures
The following tables set forth selected operating performance measures regarding our U.S. Mortgage Insurance segment as of or for the dates indicated:
Primary insurance in-force
Risk in-force
148
Primary insurance in-force decreased as the result of cancellation and lapse in bulk insurance in-force, which decreased from $8.3 billion as of September 30, 2012 to $4.6 billion as of September 30, 2013. This decrease was partially offset by the increase in flow insurance in-force, which increased from $102.8 billion as of September 30, 2012 to $104.4 billion as of September 30, 2013 as a result of new insurance written. In addition, risk in-force increased primarily as a result of higher flow new insurance written, partially offset by the decline in bulk risk in-force. Flow persistency was 80% and 82% for the nine months ended September 30, 2013 and September 30, 2012, respectively.
New insurance written increased for the three and nine months ended September 30, 2013 primarily driven by increased penetration in the mortgage insurance origination market.
Net premiums written for the three months ended September 30, 2013 increased due to lower ceded reinsurance premiums related to our captive arrangements in the current year. Net premiums written for the nine months ended September 30, 2013 increased due to lower ceded reinsurance premiums related to our captive arrangements in the current year, partially offset by lower premiums assumed from an affiliate under an intercompany reinsurance agreement that was terminated effective July 1, 2012.
The following table sets forth the loss and expense ratios for our U.S. Mortgage Insurance segment for the dates indicated:
The loss ratio for the three and nine months ended September 30, 2013 decreased primarily driven by a decline in new delinquencies and improvements in net cures and aging on existing delinquencies in the current year. Overall delinquencies continued to decline from factors such as increased cure rates resulting from improvements in the overall housing market, fewer new delinquencies and ongoing loss mitigation efforts. Reserves for prior year delinquencies benefited $4 million and $60 million, respectively, for the three and nine months ended September 30, 2013 from the cure rate improvement. The nine months ended September 30, 2012 included a net $9 million portfolio settlement with one of lenders that did not recur.
149
The expense ratio decreased for the three months ended September 30, 2013 with lower operating expenses and higher premiums written in the current year. The expense ratio was flat for the nine months ended September 30, 2013 as the settlement of $4 million with the CFPB to end its review of industry captive reinsurance arrangements was offset by lower operating expenses and higher net premiums written in the current year.
The following table sets forth the number of loans insured, the number of delinquent loans and the delinquency rate for our U.S. mortgage insurance portfolio as of the dates indicated:
Primary insurance:
Insured loans in-force
A minus and sub-prime loans in-force
A minus and sub-prime loans delinquent loans
Percentage of A minus and sub-prime delinquent loans (delinquency rate)
Pool insurance:
Delinquency and foreclosure levels that developed principally in our 2005 through 2008 book years have remained high as the United States continues to experience an economic recession and weakness in its residential real estate market, particularly in Florida, California, Arizona and Nevada. These trends also continue to be especially evident within these book years in our A minus, Alt-A, adjustable rate mortgages and certain 100% loan-to-value products. However, we have seen a continued decline in new delinquencies and lower foreclosure starts.
150
The following tables set forth flow delinquencies, direct case reserves and risk in-force by aged missed payment status in our U.S. mortgage insurance portfolio as of the dates indicated:
Payments in default:
3 payments or less
4 - 11 payments
12 payments or more
Primary insurance delinquency rates differ from region to region in the United States at any one time depending upon economic conditions and cyclical growth patterns. The tables below set forth our primary delinquency rates for the various regions of the United States and the 10 largest states by our risk in-force as of the dates indicated. Delinquency rates are shown by region based upon the location of the underlying property, rather than the location of the lender.
By Region:
Southeast (2)
South Central (3)
Northeast (4)
Pacific (5)
North Central (6)
Great Lakes (7)
New England (8)
Mid-Atlantic (9)
Plains (10)
151
By State:
California
Texas
New York
Florida
Illinois
New Jersey
Pennsylvania
Georgia
North Carolina
Ohio
The following table sets forth the dispersion of our total reserves and primary insurance in-force and risk in-force by year of policy origination and average annual mortgage interest rate as of September 30, 2013:
Policy Year
2002 and prior
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Total portfolio
152
Corporate and Other Division
The following table sets forth the results of operations relating to our Corporate and Other Division for the periods indicated. See below for a discussion by segment.
International Protection segment
Runoff segment
Corporate and Other activities
Total net operating loss
Adjustments to net operating loss:
Expenses from restructuring, net of taxes
Net loss available to Genworth Financial, Inc.’s common stockholders
153
The following table sets forth the results of operations relating to our International Protection segment for the periods indicated:
Net operating income decreased as a result of an increase in reserves driven by lower favorable claim reserve adjustments, investment income and premiums driven principally by continued reduced levels of consumer lending in Europe, partially offset by lower commissions and operating expenses in the current year. The three months ended September 30, 2013 included an increase of $2 million attributable to changes in foreign exchange rates.
Premiums decreased primarily due to lower premiums from our runoff clients and lower volume driven by continued reduced levels of consumer lending in Europe in the current year. The three months ended September 30, 2013 included an increase of $8 million attributable to changes in foreign exchange rates.
Net investment income decreased mainly due to lower average invested assets as a result of dividends paid to the holding company and lower reinvestment yields and from reinsurance arrangements accounted for under the deposit method as certain of these arrangements were in a lower gain position in the current year. The three months ended September 30, 2013 included an increase of $2 million attributable to changes in foreign exchange rates.
154
Benefits and other changes in policy reserves increased primarily driven by lower favorable claim reserve adjustments in the current year. The three months ended September 30, 2013 included an increase of $2 million attributable to changes in foreign exchange rates.
Acquisition and operating expenses, net of deferrals, decreased largely from lower profit commissions, lower paid commissions related to a decline in new business and lower operating expenses as a result of an ongoing cost-saving initiative in the current year. The three months ended September 30, 2013 included an increase of $4 million attributable to changes in foreign exchange rates.
Amortization of deferred acquisition costs and intangibles decreased primarily as a result of lower premium volume in the current year. The three months ended September 30, 2013 included an increase of $1 million attributable to changes in foreign exchange rates.
The goodwill impairment charge recorded during the third quarter of 2012 wrote off the entire goodwill balance for our lifestyle protection insurance business.
Interest expense decreased mainly due to reinsurance arrangements accounted for under the deposit method of accounting as certain of these arrangements were in a lower loss position in the current year. The three months ended September 30, 2013 included an increase of $1 million attributable to changes in foreign exchange rates.
Provision for income taxes. The effective tax rate increased to 42.9% for the three months ended September 30, 2013 from (1.3)% for the three months ended September 30, 2012 primarily attributable to a non-deductible goodwill impairment in the prior year, partially offset by changes in lower taxed foreign income.
155
Net operating income decreased as a result of lower premiums and net investment income, partially offset by lower operating expenses in the current year. The nine months ended September 30, 2013 included an increase of $2 million attributable to changes in foreign exchange rates.
Premiums decreased primarily due to lower premiums from our runoff clients and lower premium volume driven by continued reduced levels of consumer lending in Europe in the current year. The nine months ended September 30, 2013 included an increase of $11 million attributable to changes in foreign exchange rates.
Net investment income decreased principally attributable to lower average invested assets as a result of dividends paid to the holding company and lower reinvestment yields and from reinsurance arrangements accounted for under the deposit method as certain of these arrangements were in a lower gain position in the current year. The nine months ended September 30, 2013 included an increase of $2 million attributable to changes in foreign exchange rates.
156
Net investment gains increased mainly due to higher gains from the sale of investments from portfolio repositioning activities in the current year.
Benefits and other changes in policy reserves increased primarily driven by lower favorable claim reserve adjustments, partially offset by lower paid claims from a decrease in new claim registrations in the current year. The nine months ended September 30, 2013 included an increase of $3 million attributable to changes in foreign exchange rates.
Acquisition and operating expenses, net of deferrals, decreased largely from lower profit commissions, lower paid commissions related to a decline in new business and lower operating expenses as a result of an ongoing cost-saving initiative. These decreases were partially offset by a restructuring charge of $4 million in the current year. The nine months ended September 30, 2013 included an increase of $6 million attributable to changes in foreign exchange rates.
Amortization of deferred acquisition costs and intangibles decreased primarily as a result of lower premium volume in the current year. The nine months ended September 30, 2013 included an increase of $1 million attributable to changes in foreign exchange rates.
Interest expense decreased mainly due to reinsurance arrangements accounted for under the deposit method of accounting as certain of these arrangements were in a lower loss position in the current year. The nine months ended September 30, 2013 included an increase of $1 million attributable to changes in foreign exchange rates.
Provision for income taxes. The effective tax rate increased to 34.3% for the nine months ended September 30, 2013 from (4.6)% for the nine months ended September 30, 2012. This increase in the effective tax rate was primarily attributable to a non-deductible goodwill impairment in the prior year, partially offset by changes in lower taxed foreign income.
International Protection selected operating performance measures
The following table sets forth selected operating performance measures regarding our International Protection segment for the periods indicated:
Net Premiums Written:
Northern Europe
Southern Europe
Structured Deals
New Markets
Pre-deposit accounting basis
Deposit accounting adjustments
157
The loss ratio is the ratio of incurred losses and loss adjustment expenses to net earned premiums.
For the three months ended September 30, 2013, net premiums written increased due to improved consumer lending in certain regions and from sales growth in some countries in the current year. The three months ended September 30, 2013 included an increase of $7 million attributable to changes in foreign exchange rates.
For the nine months ended September 30, 2013, net premiums written declined primarily due to lower premiums from our runoff clients and from reduced levels of consumer lending as a result of deteriorating economic conditions in certain regions, partially offset by sales growth in some countries in the current year. The nine months ended September 30, 2013 included an increase of $10 million attributable to changes in foreign exchange rates.
For the three months ended September 30, 2013, the loss ratio increased mainly driven by higher losses from lower favorable claim reserve adjustments in the current year. For the nine months ended September 30, 2013, the loss ratio increased mainly driven by a decrease in premiums from our runoff clients and lower premium volume driven by reduced levels of consumer lending in Europe in the current year.
The following table sets forth the results of operations relating to our Runoff segment for the periods indicated:
158
Net operating income increased primarily related to our variable annuity products largely driven by a $6 million unfavorable unlocking in the prior year primarily related to our annual review of assumptions and favorable tax benefits in the current year.
We had net investment losses in the current year compared to net investment gains in the prior year. Net investment losses in the current year were principally from derivative losses and net losses from the sale of investment securities, partially offset by gains on embedded derivatives associated with our variable annuity products with GMWBs. Net investment gains in the prior year were largely related to gains on embedded derivatives associated with our variable annuity products with GMWBs, partially offset by derivative losses.
Interest credited decreased largely related to our institutional products as a result of lower interest paid on our floating rate policyholder liabilities due to a decrease in outstanding liabilities of $1.1 billion in the current year.
Amortization of deferred acquisition costs and intangibles decreased related to our variable annuity products mostly from a $7 million favorable unlocking related to our annual review of assumptions in the current year compared to a $10 million unfavorable unlocking in the prior year. The decrease was also attributable to lower net investment gains on embedded derivatives associated with our variable annuity products with GMWBs in the current year.
Provision (benefit) for income taxes. The effective tax rate decreased to (31.3)% for the three months ended September 30, 2013 from 21.4% for the three months ended September 30, 2012. The decrease in the effective tax rate was primarily attributable to the effect of pre-tax results on tax favored investment benefits, partially offset by a valuation allowance on foreign tax credit carryforwards in the current year.
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Net operating income increased primarily related to the recapture of a reinsurance agreement related to our corporate-owned life insurance products. The increase was also related to our variable annuity products from an unfavorable unlocking of $6 million in the prior year primarily related to our annual review of assumptions and favorable tax benefits in the current year.
We had net investment losses in the current year compared to net investment gains in the prior year. Net investment losses in the current year were principally from derivative losses and net losses from the sale of investment securities, partially offset by gains on embedded derivatives associated with our variable annuity products with GMWBs. Net investment gains in the prior year were largely related to gains on embedded derivatives associated with our variable annuity products with GMWBs and net gains from the sale of investment securities, partially offset by derivative losses and impairments.
Insurance and investment product fees and other increased mainly attributable to the recapture of a reinsurance agreement related to our corporate-owned life insurance products in the current year, partially offset by lower average account values from outflows of our variable annuity products in the current year.
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Amortization of deferred acquisition costs and intangibles decreased related to our variable annuity products largely from $9 million of favorable unlockings primarily related to our annual review of assumptions in the current year compared to $5 million of unfavorable unlockings in the prior year, partially offset by higher net investment gains on embedded derivatives associated with our variable annuity products with GMWBs in the current year.
Provision (benefit) for income taxes. The effective tax rate decreased to (13.3)% for the nine months ended September 30, 2013 from 30.7% for the nine months ended September 30, 2012. The decrease in the effective tax rate was primarily related to the effect of pre-tax results on tax favored investment benefits, partially offset by changes in uncertain tax positions.
Runoff selected operating performance measures
Variable annuity and variable life insurance products
The following table sets forth selected operating performance measures regarding our variable annuity and variable life insurance products as of or for the dates indicated:
Variable Annuities - Income Distribution Series (1)
Interest credited and investment performance
Traditional Variable Annuities
Variable Life Insurance
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Variable Annuities - Income Distribution Series
Account value related to our income distribution series products increased mainly attributable to favorable equity market performance during 2013 and interest credited outpacing surrenders. We no longer solicit sales of our variable annuities; however, we continue to service our existing block of business and accept additional deposits on existing contracts.
In our traditional variable annuities, the increase in account value was primarily the result of favorable equity market performance during the third quarter of 2013 outpacing surrenders. For the nine months ended September 30, 2013, surrenders outpaced favorable equity market performance and interest credited. We no longer solicit sales of our variable annuities; however, we continue to service our existing block of business and accept additional deposits on existing contracts.
We no longer solicit sales of variable life insurance; however, we continue to service our existing block of business.
Institutional products
The following table sets forth selected operating performance measures regarding our institutional products as of or for the dates indicated:
GICs, FABNs and Funding Agreements
Surrenders and benefits
Foreign currency translation
Account value related to our institutional products decreased mainly attributable to scheduled maturities of these products. Interest credited declined due to a decrease in average outstanding liabilities. Deposits during the three and nine months ended September 30, 2012 related to our participation in the Federal Home Loan Bank program. We consider the issuance of our institutional contracts on an opportunistic basis.
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Corporate and Other Activities
Results of operations
The following table sets forth the results of operations relating to Corporate and Other activities for the periods indicated:
We reported a higher net operating loss in the current year primarily attributable to additional expenses related to a debt redemption and lower tax benefits mainly from a correction of non-deductible stock compensation expense, as well as lower investment income in the current year.
Net investment income decreased primarily from the sale of our reverse mortgage business on April 1, 2013 and lower average invested assets in the current year.
We had higher net investment losses in the current year primarily attributable to losses from the sale of investment securities related to portfolio repositioning in the current year compared to gains in the prior year, partially offset by lower impairments and derivative losses.
Insurance and investment product fees and other decreased attributable to the sale of our reverse mortgage business on April 1, 2013.
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Acquisition and operating expenses, net of deferrals, increased primarily attributable to $30 million of make-whole expenses paid related to the debt redemption in the third quarter of 2013 and higher net expenses after allocations to our operating segments in the current year. These increases were partially offset by a decrease of $40 million as a result of the sale of our reverse mortgage business on April 1, 2013.
The decrease in the income tax benefit was mainly attributable to an adjustment in the current year of $20 million, including $18 million from a correction of prior periods, related to non-deductible stock compensation expense resulting from cancellations and additional tax expense required to offset tax benefits reported by the business segments.
We reported a higher net operating loss in the current year primarily attributable to additional expenses related to a debt redemption and lower tax benefits in the current year mainly from a correction of non-deductible stock compensation expense. Lower investment income and higher interest expense also contributed to the higher net operating loss in the current year.
Net investment income decreased primarily from the sale of our reverse mortgage business on April 1, 2013, as well as from lower average invested assets and lower gains of $3 million related to limited partnerships in the current year.
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Net investment losses decreased primarily related to derivative gains in the current year compared to derivative losses in the prior year. The current year also included lower impairments which were partially offset by higher net losses from the sale of investment securities related to portfolio repositioning in the current year.
Insurance and investment product fees and other decreased mainly attributable to our reverse mortgage business which was sold on April 1, 2013.
Acquisition and operating expenses, net of deferrals, increased primarily attributable to $30 million of make-whole expenses paid related to the debt redemption in the third quarter of 2013 and higher net expenses after allocations to our operating segments in the current year. These increases were partially offset by a decrease of $45 million as a result of the sale of our reverse mortgage business on April 1, 2013.
Interest expense increased largely attributable to a favorable adjustment of $20 million in the prior year that did not recur related to the Tax Matters Agreement with our former parent company and a debt issuance in March 2012. These increases were partially offset by the maturity of Genworth Holdings’ senior notes in June 2012 and the repurchase in the fourth quarter of 2012 of $100 million of Genworth Holdings’ senior notes that mature in June 2014.
The decrease in the income tax benefit was mainly attributable to an adjustment in the current year of $20 million, including $13 million from a correction of prior years, related to non-deductible stock compensation expense resulting from cancellations and additional tax expense required to offset tax benefits reported by the business segments.
Investments and Derivative Instruments
Investment results
The following tables set forth information about our investment income, excluding net investment gains (losses), for each component of our investment portfolio for the periods indicated:
Other invested assets (1)
Average invested assets and cash
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Yields are based on net investment income as reported under U.S. GAAP and are consistent with how the company measures its investment performance for management purposes. Yields are annualized, for interim periods, and are calculated as net investment income as a percentage of average quarterly asset carrying values except for fixed maturity and equity securities, derivatives and derivative counterparty collateral, which exclude unrealized fair value adjustments and securities lending activity, which is included in other invested assets and is calculated net of the corresponding securities lending liability.
For the three months ended September 30, 2013, annualized weighted-average investment yields were flat primarily attributable to higher average invested assets in longer duration products and $6 million of higher gains related to limited partnerships were offset by lower reinvestment yields.
For the nine months ended September 30, 2013, annualized weighted-average investment yields decreased primarily attributable to lower reinvestment yields and $16 million of lower gains related to limited partnerships, partially offset by higher average invested assets in longer duration products. Net investment income for the nine months ended September 30, 2013 also included $16 million of higher bond calls and prepayments.
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Derivative instruments
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Net investment losses related to derivatives of $63 million during the nine months ended September 30, 2013 were primarily associated with GMWB losses due to annual actuarial unlocking related to lapse and mortality assumption adjustments, decreases in the values of instruments used to protect statutory surplus from declines in equity markets and policyholder funds underperforming as compared to market indices. In addition, there were losses related to hedge ineffectiveness from our cash flow hedge programs for our long-term care insurance business due to an increase in long-term interest rates. These losses were partially offset by gains driven by tightening credit spreads on credit default swaps where we sold protection to improve diversification and portfolio yield, as well as gains related to a non-qualified derivative strategy to mitigate interest rate risk with our statutory capital positions. Net investment losses related to derivatives of $4 million during the nine months ended September 30, 2012 were primarily associated with embedded derivatives related to variable annuity products with GMWB riders and foreign currency risk. The GMWB losses were primarily due to the policyholder funds underperforming as compared to market indices and market losses resulting from volatility. Additionally, there were losses associated with derivatives used to hedge foreign currency risk associated with near-term expected dividend payments from certain subsidiaries and to mitigate foreign subsidiary macroeconomic risk.
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These losses were partially offset by gains from the narrowing of credit spreads associated with credit default swaps where we sold protection to improve diversification and portfolio yield.
Investment portfolio
The following table sets forth our cash, cash equivalents and invested assets as of the dates indicated:
Fixed maturity securities, available-for-sale:
Public
Private
Equity securities, available-for-sale
Total cash, cash equivalents and invested assets
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For a discussion of the change in cash, cash equivalents and invested assets, see the comparison for this line item under “—Consolidated Balance Sheets.” See note 4 in our “—Notes to Condensed Consolidated Financial Statements” for additional information related to our investment portfolio.
We hold fixed maturity, equity and trading securities, derivatives, embedded derivatives, securities held as collateral and certain other financial instruments, which are carried at fair value. Fair value is the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. As of September 30, 2013, approximately 10% of our investment holdings recorded at fair value was based on significant inputs that were not market observable and were classified as Level 3 measurements. See note 6 in our “—Notes to Condensed Consolidated Financial Statements” for additional information related to fair value.
Tax-exempt (1)
Government—non-U.S. (2)
U.S. corporate (2), (3)
Corporate—non-U.S. (2)
Residential mortgage-backed (4)
Other asset-backed (4)
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Total available-for-salesecurities
Fixed maturity securities decreased $3.1 billion principally from lower net unrealized gains attributable to the change in interest rates in the current year. Amortized cost increased slightly as purchases exceeded sales and maturities, partially offset by the weakening of foreign currencies, particularly in Australia and Canada, against the U.S. dollar in the current year.
The majority of our unrealized losses were related to securities held in our U.S. Life Insurance segment. Our U.S. Mortgage Insurance segment had gross unrealized losses of $40 million and $31 million as of September 30, 2013 and December 31, 2012, respectively.
Our exposure in peripheral European countries consists of fixed maturity securities and trading bonds in Greece, Portugal, Ireland, Italy and Spain. Investments in these countries are primarily made to support our international businesses and to diversify our U.S. corporate fixed maturity securities with European bonds
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denominated in U.S. dollars. The following table sets forth the fair value of our exposure to these peripheral European countries as of the periods indicated:
Ireland
Spain
Italy
Portugal
Greece
During the nine months ended September 30, 2013, we reduced our exposure to the peripheral European countries by $15 million to $607 million with unrealized gains of $11 million. Our exposure as of September 30, 2013 was diversified with direct exposure to local economies of $234 million, indirect exposure through debt issued by subsidiaries outside of the European periphery of $80 million and exposure to multinational companies where the majority of revenues come from outside of the country of domicile of $293 million.
The following tables set forth additional information regarding our commercial mortgage loans as of the dates indicated:
Loan Year
2004 and prior
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See note 4 in our “—Notes to Condensed Consolidated Financial Statements” for additional information related to restricted commercial mortgage loans related to securitization entities.
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The following table sets forth the carrying values of our other invested assets as of the dates indicated:
Limited partnerships
Short-term investments
Other investments
Our investments in derivatives and derivatives counterparty collateral decreased primarily attributable to changes in the long-term interest rate environment in the current year. There was also a decrease in trading securities due to sales and changes in the long-term interest rate environment in the current year.
The activity associated with derivative instruments can generally be measured by the change in notional value over the periods presented. However, for GMWB and fixed index annuity embedded derivatives, the change between periods is best illustrated by the number of policies. The following tables represent activity associated with derivative instruments as of the dates indicated:
Measurement
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The increase in the notional value of derivatives was primarily attributable to a $4.0 billion notional increase in qualified interest rate swaps related to our interest rate hedging strategy associated with our long-term care insurance products. The increase was partially offset by a $1.4 billion notional decrease in interest rate swaps and financial futures associated with our institutional products, a $0.7 billion notional decrease related to a non-qualified derivative strategy to mitigate interest rate risk with our statutory capital positions and a $0.6 billion notional decrease related to hedges of the GMWB liability on our variable annuity products.
The number of policies related to our GMWB embedded derivatives decreased as variable annuity products are no longer being offered. The number of policies related to our fixed index annuity embedded derivatives increased as a result of product sales.
Consolidated Balance Sheets
Total assets. Total assets decreased $5.2 billion from $113.3 billion as of December 31, 2012 to $108.1 billion as of September 30, 2013.
Total liabilities. Total liabilities decreased $3.2 billion from $95.5 billion as of December 31, 2012 to $92.3 billion as of September 30, 2013.
Total stockholders’ equity. Total stockholders’ equity decreased $2.0 billion from $17.8 billion as of December 31, 2012 to $15.8 billion as of September 30, 2013.
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Liquidity and Capital Resources
Liquidity and capital resources represent our overall financial strength and our ability to generate cash flows from our businesses, borrow funds at competitive rates and raise new capital to meet our operating and growth needs.
Genworth and subsidiaries
The following table sets forth our condensed consolidated cash flows for the nine months ended September 30:
Net decrease in cash before foreign exchange effect
Our principal sources of cash include sales of our products and services, income from our investment portfolio and proceeds from sales of investments. As an insurance business, we typically generate positive cash flows from operating activities, as premiums collected from our insurance products and income received from our investments exceed policy acquisition costs, benefits paid, redemptions and operating expenses. These positive cash flows are then invested to support the obligations of our insurance and investment products and required capital supporting these products. Our cash flows from operating activities are affected by the timing of premiums, fees and investment income received and benefits and expenses paid. We had higher net cash inflows from operating activities during the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012 primarily as a result of higher tax settlements in the prior year.
In analyzing our cash flow, we focus on the change in the amount of cash available and used in investing activities. We had lower net cash outflows from investing activities during the nine months ended September 30, 2013 compared to the nine months ended September 30, 2012 from higher proceeds from maturities and repayments of fixed maturity securities and net cash received from the sale of our wealth management business in the current year, partially offset by lower cash inflows from other invested assets in the current year compared to the prior year.
Changes in cash from financing activities primarily relate to the issuance of, and redemptions and benefit payments on, universal life insurance and investment contracts; the issuance and acquisition of debt and equity securities; the issuance and repayment or repurchase of borrowings and non-recourse funding obligations; and dividends to our stockholders and other capital transactions. We had higher net cash outflows from financing activities during the nine months ended September 30, 2013 primarily from higher redemptions of our investment contracts, partially offset by lower redemptions of non-recourse funding obligations in the current year compared to the prior year.
In the United States and Canada, we engage in certain securities lending transactions for the purpose of enhancing the yield on our investment securities portfolio. We maintain effective control over all loaned securities and, therefore, continue to report such securities as fixed maturity securities on our consolidated balance sheets. We are currently indemnified against counterparty credit risk by the intermediary.
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Under the securities lending program in the United States, the borrower is required to provide collateral, which can consist of cash or government securities, on a daily basis in amounts equal to or exceeding 102% of the applicable securities loaned. Currently, we only accept cash collateral from borrowers under the program. Cash collateral received by us on securities lending transactions is reflected in other invested assets with an offsetting liability recognized in other liabilities for the obligation to return the collateral. Any cash collateral received is reinvested by our custodian based upon the investment guidelines provided within our agreement. In the United States, the reinvested cash collateral is primarily invested in a money market fund approved by the National Association of Insurance Commissioners, U.S. and foreign government securities, U.S. government agency securities, asset-backed securities and corporate debt securities. As of September 30, 2013 and December 31, 2012, the fair value of securities loaned under our securities lending program in the United States was $161 million and $194 million, respectively. As of September 30, 2013 and December 31, 2012, the fair value of collateral held under our securities lending program in the United States was $154 million and $187 million, respectively, and the offsetting obligation to return collateral of $168 million and $203 million, respectively, was included in other liabilities in our consolidated balance sheets. We did not have any non-cash collateral provided by the borrower in our securities lending program in the United States as of September 30, 2013 and December 31, 2012.
Under our securities lending program in Canada, the borrower is required to provide collateral consisting of government securities on a daily basis in amounts equal to or exceeding 105% of the fair value of the applicable securities loaned. Securities received from counterparties as collateral are not recorded on our consolidated balance sheet given that the risk and rewards of ownership is not transferred from the counterparties to us in the course of such transactions. Additionally, there was no cash collateral as cash collateral is not permitted as an acceptable form of collateral under the program. In Canada, the lending institution must be included on the approved Securities Lending Borrowers List with the Canadian regulator and the intermediary must be rated at least “AA-” by S&P. As of September 30, 2013 and December 31, 2012, the fair value of securities loaned under our securities lending program in Canada was $270 million and $210 million, respectively.
We also have a repurchase program in which we sell an investment security at a specified price and agree to repurchase that security at another specified price at a later date. Repurchase agreements are treated as collateralized financing transactions and are carried at the amounts at which the securities will be subsequently reacquired, including accrued interest, as specified in the respective agreement. The market value of securities to be repurchased is monitored and collateral levels are adjusted where appropriate to protect the counterparty and us against credit exposure. Cash received is invested in fixed maturity securities. As of September 30, 2013 and December 31, 2012, the fair value of securities pledged under our repurchase program was $1,182 million and $1,616 million, respectively, and the repurchase obligation of $1,196 million and $1,534 million, respectively, was included in other liabilities in our consolidated balance sheets.
Genworth—holding company
New Genworth and Genworth Holdings each acts as a holding company for their respective subsidiaries and do not have any significant operations of their own. Dividends from their respective subsidiaries, payments to them under tax sharing and expense reimbursement arrangements with their subsidiaries and proceeds from borrowings or securities issuances are their principal sources of cash to meet their obligations. Insurance laws and regulations regulate the payment of dividends and other distributions to New Genworth and Genworth Holdings by their insurance subsidiaries. We expect dividends paid by the insurance subsidiaries will vary depending on strategic objectives, regulatory requirements and business performance.
The primary uses of funds at New Genworth and Genworth Holdings include payment of holding company general operating expenses (including taxes), payment of principal, interest and other expenses on current and any future borrowings, payments under current and any future guarantees (including guarantees of certain subsidiary obligations), payment of amounts owed to GE under the Tax Matters Agreement, payments to subsidiaries (and, in the case of Genworth Holdings, to New Genworth) under tax sharing agreements,
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contributions to subsidiaries, repurchases of debt and equity securities, potentially payments for acquisitions, payment of dividends on New Genworth common stock (to the extent declared by New Genworth’s Board of Directors) and, in the case of Genworth Holdings, loans, dividends or other distributions to New Genworth. We do not have any long-term debt maturities until June 2014, when $485 million of Genworth Holdings’ long-term notes mature. Net proceeds of approximately $360 million from the wealth management sale will be held at Genworth Holdings, and together with cash on hand, will be used to repay the 2014 debt at maturity or before. We may from time to time seek to repurchase or redeem outstanding notes (including the notes maturing in June 2014) for cash in open market purchases, tender offers, privately negotiated transactions or otherwise.
In November 2008, our Board of Directors decided to suspend the payment of common stock dividends indefinitely. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will be dependent on many factors including the receipt of dividends from our operating subsidiaries and Genworth Holdings, our financial condition and operating results, the capital requirements of our subsidiaries, legal requirements, regulatory constraints, our credit and financial strength ratings and such other factors as our Board of Directors deems relevant.
Genworth Holdings had $1,164 million and $843 million of cash and cash equivalents as of September 30, 2013 and December 31, 2012, respectively. Included in the balance as of September 30, 2013 was approximately $360 million from the net proceeds of the wealth management sale, which together with cash on hand, will be used to pay off the 2014 debt at maturity or before. Genworth Holdings also held $150 million in U.S. government securities as of September 30, 2013 and December 31, 2012, respectively.
During the nine months ended September 30, 2013, Genworth Holdings received dividends from its subsidiaries of $330 million. During the nine months ended September 30, 2013, Genworth Holdings made cash capital contributions to its subsidiaries of $22 million. On April 1, 2013, immediately prior to the distribution of the U.S. mortgage insurance subsidiaries to New Genworth in connection with the holding company reorganization, Genworth Holdings also contributed $100 million in cash to the U.S. mortgage insurance subsidiaries as part of the Capital Plan for those subsidiaries. Genworth Holdings also contributed the shares of its European mortgage insurance subsidiaries with an estimated value of $230 million to the U.S. mortgage insurance subsidiaries to increase the statutory capital in those companies. During the three months ended June 30, 2013, Genworth Holdings paid $14 million of dividends to New Genworth. During the three months ended June 30, 2013, New Genworth made cash capital contributions to its subsidiaries of $10 million.
As part of the Capital Plan for the U.S. mortgage insurance subsidiaries, Genworth Holdings agreed to provide $100 million to GEMICO in the future in the event that certain adverse events occur. In addition, Genworth Holdings also agreed to guarantee the receipt by GEMICO of up to $150 million of intercompany payments in the normal course from our subsidiaries by June 30, 2017. As of September 30, 2013, the amount outstanding under this guarantee was $108 million.
Regulated insurance subsidiaries
The liquidity requirements of our regulated insurance subsidiaries principally relate to the liabilities associated with their various insurance and investment products, operating costs and expenses, the payment of dividends to us, contributions to their subsidiaries, payment of principal and interest on their outstanding debt obligations and income taxes. Liabilities arising from insurance and investment products include the payment of benefits, as well as cash payments in connection with policy surrenders and withdrawals, policy loans and obligations to redeem funding agreements.
Our insurance subsidiaries have used cash flows from operations and investment activities to fund their liquidity requirements. Our insurance subsidiaries’ principal cash inflows from operating activities are derived from premiums, annuity deposits and insurance and investment product fees and other income, including commissions, cost of insurance, mortality, expense and surrender charges, contract underwriting fees, investment management fees and dividends and distributions from their subsidiaries. The principal cash inflows from
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investment activities result from repayments of principal, investment income and, as necessary, sales of invested assets.
Our insurance subsidiaries maintain investment strategies intended to provide adequate funds to pay benefits without forced sales of investments. Products having liabilities with longer durations, such as certain life insurance and long-term care insurance policies, are matched with investments having similar duration such as long-term fixed maturity securities and commercial mortgage loans. Shorter-term liabilities are matched with fixed maturity securities that have short- and medium-term fixed maturities. In addition, our insurance subsidiaries hold highly liquid, high quality short-term investment securities and other liquid investment grade fixed maturity securities to fund anticipated operating expenses, surrenders and withdrawals. As of September 30, 2013, our total cash, cash equivalents and invested assets were $73.1 billion. Our investments in privately placed fixed maturity securities, commercial mortgage loans, policy loans, limited partnership interests and select mortgage-backed and asset-backed securities are relatively illiquid. These asset classes represented approximately 31% of the carrying value of our total cash, cash equivalents and invested assets as of September 30, 2013.
On January 31, 2013, Genworth Holdings made a $21 million cash capital contribution to its European mortgage insurance subsidiaries. Genworth Holdings then subsequently contributed the shares of its European mortgage insurance subsidiaries with an estimated value of $230 million to the U.S. mortgage insurance subsidiaries to increase the statutory capital in those companies as part of the Capital Plan for the U.S. mortgage insurance subsidiaries. On April 1, 2013, immediately prior to the distribution of the U.S. mortgage insurance subsidiaries to New Genworth in connection with the holding company reorganization, Genworth Holdings contributed $100 million in cash to the U.S. mortgage insurance subsidiaries as part of the Capital Plan for those subsidiaries.
During the nine months ended September 30, 2013, Genworth Canada repurchased 3.9 million shares for $102 million through a Normal Course Issuer Bid (“NCIB”) authorized by its board for up to 4.9 million shares. We participated in the NCIB in order to maintain our overall ownership percentage at its current level and received $58 million. Purchases of Genworth Canada’s common shares may continue until the earlier of May 2, 2014 and the date on which Genworth Canada has purchased the maximum number of authorized shares under the NCIB.
Capital resources and financing activities
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In the second quarter of 2013, we terminated our $1.0 billion commercial paper program. There was no amount outstanding under the commercial paper program when terminated and none outstanding since February 2009.
If regulatory changes (including those under consideration by the GSEs and NAIC) or other business-related considerations indicate a contribution is required and appropriate, we could provide capital to GEMICO with an asset contribution or a cash contribution through a variety of means, including with available proceeds from the partial IPO of our Australia mortgage insurance business (if we execute that transaction) and proceeds from the issuance of new debt, equity or convertible, exchangeable or other hybrid securities at the New Genworth and/or Genworth Holdings levels and any other options that may be available to us.
We believe existing cash held at Genworth Holdings combined with dividends from subsidiaries, payments under tax sharing and expense reimbursement arrangements with subsidiaries and proceeds from borrowings or securities issuances will provide us with sufficient capital flexibility and liquidity to meet our future operating requirements. We actively monitor our liquidity position, liquidity generation options and the credit markets given changing market conditions. We previously managed liquidity at Genworth Holdings to maintain a minimum balance of two times expected annual debt interest payments plus an additional excess of $350 million, although the excess amount may be lower during the quarter due to the timing of cash inflows and outflows. With the addition of the revolving credit facility in September 2013, the target changed from two times expected annual debt interest payments to one and half times expected annual debt interest payments plus the additional excess of $350 million. We will evaluate the target level of the excess amount as circumstances warrant. We cannot predict with any certainty the impact to us from any future disruptions in the credit markets or further downgrades by one or more of the rating agencies of the financial strength ratings of our insurance company subsidiaries and/or the credit ratings of our holding companies. The availability of additional funding will depend on a variety of factors such as market conditions, regulatory considerations, the general availability of credit, the overall availability of credit to the financial services industry, the level of activity and availability of reinsurance, our credit ratings and credit capacity and the performance of and outlook for our business.
Contractual obligations and commercial commitments
We enter into obligations with third parties in the ordinary course of our operations. However, we do not believe that our cash flow requirements can be assessed based upon analysis of these obligations as the funding of these future cash obligations will be from future cash flows from premiums, deposits, fees and investment income that are not reflected herein. Future cash outflows, whether they are contractual obligations or not, also will vary based upon our future needs. Although some outflows are fixed, others depend on future events. Examples of fixed obligations include our obligations to pay principal and interest on fixed rate borrowings. Examples of obligations that will vary include obligations to pay interest on variable rate borrowings and insurance liabilities that depend on future interest rates and market performance. Many of our obligations are linked to cash-generating contracts. These obligations include payments to contractholders that assume those contractholders will continue to make deposits in accordance with the terms of their contracts. In addition, our operations involve significant expenditures that are not based upon “commitments.”
There have been no material additions or changes to our contractual obligations and commercial commitments as set forth in our Current Report on Form 8-K filed on May 30, 2013, except as discussed above under “—Capital resources and financing activities.”
Securitization Entities
There were no off-balance sheet securitization transactions during the nine months ended September 30, 2013 or 2012.
New Accounting Standards
For a discussion of recently adopted and not yet adopted accounting standards, see note 2 in our “—Notes to Condensed Consolidated Financial Statements.”
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Market risk is the risk of the loss of fair value resulting from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates and equity prices. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying financial instruments are traded. The following is a discussion of our market risk exposures and our risk management practices.
Credit markets generally showed signs of improvement across most asset classes in the first nine months of 2013. After a period of continued and measured spread tightening through May 2013, market volatility increased in June 2013 and into the third quarter of 2013. However, during the third quarter of 2013, credit spreads tightened in most asset classes. Despite the recent volatility, spreads for most fixed-income products remained at tighter levels than were prevalent at the end of 2012. Additionally, U.S. Treasury yields remained at historically low levels during the first nine months of 2013. See “—Business trends and conditions” and “—Investments and Derivative Instruments” in “Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion of recent market conditions.
In the third quarter of 2013, the U.S. dollar strengthened against currencies in Canada and Australia as compared to the third quarter of 2012. However, currencies in the United Kingdom and the Euro strengthened against the U.S. dollar in the third quarter of 2013 compared to the third quarter of 2012. In the third quarter of 2013, the U.S. dollar weakened against currencies in Canada, Australia and the United Kingdom, as well as the Euro, as compared to the second quarter of 2013. This has generally resulted in lower levels of reported revenues and net income, assets, liabilities and accumulated other comprehensive income (loss) in our U.S. dollar consolidated financial statements. See “Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion on the impact of changes in foreign currency exchange rates.
There were no other material changes in our market risks since December 31, 2012.
Evaluation of Disclosure Controls and Procedures
As of September 30, 2013, an evaluation was conducted under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on this evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2013.
Changes in Internal Control Over Financial Reporting During the Quarter Ended September 30, 2013
There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
We face the risk of litigation and regulatory investigations and actions in the ordinary course of operating our businesses, including the risk of class action lawsuits. Our pending legal and regulatory actions include proceedings specific to us and others generally applicable to business practices in the industries in which we operate. In our insurance operations, we are, have been, or may become subject to class actions and individual suits alleging, among other things, issues relating to sales or underwriting practices, increases to in-force long-term care insurance premiums, payment of contingent or other sales commissions, claims payments and procedures, product design, product disclosure, administration, additional premium charges for premiums paid on
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a periodic basis, denial or delay of benefits, charging excessive or impermissible fees on products, recommending unsuitable products to customers, our pricing structures and business practices in our mortgage insurance businesses, such as captive reinsurance arrangements with lenders and contract underwriting services, violations of RESPA or related state anti-inducement laws, and mortgage insurance policy rescissions and curtailments, and breaching fiduciary or other duties to customers, including but not limited to breach of customer information. Plaintiffs in class action and other lawsuits against us may seek very large or indeterminate amounts which may remain unknown for substantial periods of time. In our investment-related operations, we are subject to litigation involving commercial disputes with counterparties. We are also subject to litigation arising out of our general business activities such as our contractual and employment relationships. In addition, we are also subject to various regulatory inquiries, such as information requests, subpoenas, books and record examinations and market conduct and financial examinations from state, federal and international regulators and other authorities. A substantial legal liability or a significant regulatory action against us could have an adverse effect on our business, financial condition and results of operations. Moreover, even if we ultimately prevail in the litigation, regulatory action or investigation, we could suffer significant reputational harm, which could have an adverse effect on our business, financial condition or results of operations.
Except as disclosed below, there were no material developments during the three months ended September 30, 2013 in any of the legal proceedings identified in Part I, Item 3 of our 2012 Annual Report on Form 10-K, as updated in Part II, Item 1 of our Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2013 and June 30, 2013. In addition, there were no new material legal proceedings initiated during the three months ended September 30, 2013.
At this time, we cannot determine or predict the ultimate outcome of any of the pending legal and regulatory matters specifically identified above or the likelihood of potential future legal and regulatory matters against us. We also are not able to provide an estimate or range of possible losses related to these matters. Therefore, we cannot ensure that the current investigations and proceedings will not have a material adverse effect on our business, financial condition or results of operations. In addition, it is possible that related investigations and proceedings may be commenced in the future, and we could become subject to additional unrelated investigations and lawsuits. Increased regulatory scrutiny and any resulting investigations or proceedings could result in new legal precedents and industry-wide regulations or practices that could adversely affect our business, financial condition and results of operations.
The discussion of our business and operations should be read together with the risk factors contained in Part I, Item 1A of our 2012 Annual Report on Form 10-K, as updated in Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2013, which describe various risks and uncertainties to which we are or may become subject. These risks and uncertainties have the potential to affect our business, financial condition, results of operations, cash flows, strategies or prospects in a material and adverse manner. Except as disclosed below, there have been no material changes to the risk factors set forth in the above-referenced filings as of September 30, 2013.
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Adverse market or other conditions might further delay or impede the planned IPO of our mortgage insurance business in Australia.
On November 3, 2011, we announced our plan to sell up to 40% of our Australian mortgage insurance business through an IPO during 2012. On April 17, 2012, we announced a new timeframe for completing the planned IPO of early 2013 and in November 2012 updated this to the fourth quarter of 2013 or later. Execution of an IPO is subject to market conditions, valuation considerations, including business performance, and regulatory considerations, and we now believe it is more likely that there will be better execution opportunities in 2014 and, therefore, we will not execute the IPO in 2013. There can be no assurance that the IPO can be executed during 2014, on the desired terms, or at all.
The information in this Quarterly Report concerning the IPO securities is not an offer to sell, or a solicitation of an offer to buy, any securities. The IPO securities referred to in this Quarterly Report have not been and will not be registered under the U.S. Securities Act of 1933 and may not be offered or sold in the United States except pursuant to an exemption from, or in a transaction not subject to, the registration requirements of the U.S. Securities Act of 1933. If an offer of IPO securities which requires disclosure in Australia is made, a disclosure document for the offer will be prepared at that time. Any person who wishes to apply to acquire IPO securities will need to complete the application form that will be in or will accompany the disclosure document. In addition, the information in this Quarterly Report concerning the IPO securities is not intended for public distribution in Australia.
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Number
Description
184
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
/s/ Kelly L. Groh
Kelly L. Groh
Vice President and Controller
(Duly Authorized Officer and
Principal Accounting Officer)
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