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| GNW > SEC Filings for GNW > Form 10-Q on 31-Jul-2009 | All Recent SEC Filings |
31-Jul-2009
Quarterly Report
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.
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 the following:
• Risks relating to our businesses, including adverse capital and credit market conditions, downturns and volatility in equity and credit markets, downgrades in our financial strength or credit ratings, the impact of the U.S. government's plan to purchase illiquid mortgage-backed and other securities, our ability to access the U.S. government's financial support programs, interest rate fluctuations, the valuation of fixed maturity, equity and trading securities, defaults, downgrades or impairments of our fixed maturity securities portfolio, goodwill impairments, the soundness of other financial institutions, our inability to access our credit facilities, declines in risk-based capital, insufficiency of reserves, legal constraints on dividend distributions by subsidiaries, intense competition, availability and adequacy of reinsurance, defaults by counterparties, 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 or compromise of the security of our computer systems and the occurrence of natural or man-made disasters or a pandemic;
• Risks relating to our Retirement and Protection segment, including changes in morbidity and mortality, accelerated amortization of deferred acquisition costs and present value of future profits, reputational risks as a result of rate increases on certain in-force long-term care insurance products, medical advances such as genetic mapping research, unexpected changes in persistency rates, increases in statutory reserve requirements and the failure of demand for long-term care insurance to increase as we expect;
• Risks relating to our International segment, including political and economic instability, foreign exchange rate fluctuations, unexpected changes in unemployment rates, unexpected increases in mortgage insurance default rates or severity of defaults, decreases in the volume of high loan-to-value international mortgage originations, increased competition with government-owned and government-sponsored enterprises offering mortgage insurance and changes in regulations;
• Risks relating to our U.S. Mortgage Insurance segment, including our review of strategic alternatives for the segment, increases in mortgage insurance default rates or severity of defaults, deterioration in economic conditions or a decline in home price appreciation, the effect of the conservatorship of Fannie Mae and Freddie Mac on mortgage originations, 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, increases in the use of alternatives to private mortgage insurance and reductions by lenders in the level of coverage they select, increases in the use of reinsurance with reinsurance companies affiliated with our mortgage lending customers, increased competition with government-owned and government-sponsored enterprises ("GSEs") offering mortgage insurance, changes in regulations, legal actions under the Real Estate Settlement Practices Act of 1974 ("RESPA") and potential liabilities in connection with our U.S. contract underwriting services;
• Risks relating to our common stock, including the suspension of dividends and stock price fluctuation.
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 security company dedicated to providing insurance, wealth management, investment and financial solutions to more than 15 million customers, with a presence in more than 25 countries. We have three operating segments: Retirement and Protection, International and U.S. Mortgage Insurance.
• Retirement and Protection. We offer a variety of protection, wealth management, retirement income and institutional products. Our primary protection products include: life, long-term care and Medicare supplement insurance. Additionally, we offer wellness and care coordination services for our long-term care policyholders. Our wealth management and retirement income products include: a variety of managed account programs, financial planning services and mutual funds, fixed and variable deferred and immediate individual annuities and group variable annuities offered through retirement plans. Most of our variable annuities include a guaranteed minimum death benefit ("GMDB"). Some of our group and individual variable annuity products include guaranteed minimum benefit features such as guaranteed minimum withdrawal benefits ("GMWB") and certain types of guaranteed annuitization benefits. Institutional products include: funding agreements, funding agreements backing notes ("FABNs") and guaranteed investment contracts ("GICs"). For the three months ended June 30, 2009, our Retirement and Protection segment's net income and net operating income were $81 million and $127 million, respectively. For the six months ended June 30, 2009, our Retirement and Protection segment's net loss was $304 million and net operating income was $190 million.
• International. We are a leading provider of mortgage insurance products in Canada, Australia, New Zealand, Mexico and multiple European countries. Our products predominately insure prime-based, individually underwritten residential mortgage loans, also known as flow mortgage insurance. On a limited basis, we also provide mortgage insurance on a structured, or bulk, basis that aids in the sale of mortgages to the capital markets and helps lenders manage capital and risk. Additionally, we offer services, analytical tools and technology that enable lenders to operate efficiently and manage risk. We also offer payment protection coverages in multiple European countries, Canada and Mexico. Our lifestyle protection insurance products help consumers meet specified payment obligations should they become unable to pay due to accident, illness, involuntary unemployment, disability or death. For the three months ended June 30, 2009, our International segment's net income and net operating income were $90 million and $87 million, respectively. For the six months ended June 30, 2009, our International segment's net income and net operating income were $181 million and $188 million, respectively.
• U.S. Mortgage Insurance. In the U.S., we offer mortgage insurance products predominantly insuring prime-based, individually underwritten residential mortgage loans, also known as flow mortgage insurance. We selectively provide mortgage insurance on a structured, or bulk, basis with essentially all of our bulk writings prime-based. Additionally, we offer services, analytical tools and technology that enable lenders to operate efficiently and manage risk. For the three months ended June 30, 2009, our U.S. Mortgage Insurance segment's net loss and net operating loss were both $134 million. For the six months ended June 30, 2009, our U.S. Mortgage Insurance segment's net loss and net operating loss were $282 million and $269 million, respectively.
We also have Corporate and Other activities which include debt financing expenses that are incurred at our holding company level, unallocated corporate income and expenses, eliminations of inter-segment transactions and the results of non-core businesses that are managed outside of our operating segments. For the three months ended June 30, 2009, Corporate and Other activities' net loss and net operating loss were $87 million and $71 million, respectively. For the six months ended June 30, 2009, Corporate and Other activities' net loss and net operating loss were $114 million and $86 million, respectively.
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. The following discussion of business trends and conditions should be read together with the trends discussed in our 2008 Annual Report on Form 10-K, which described additional business trends and conditions.
General conditions and trends affecting our businesses
Financial and economic environment. As a financial security company, the stability of both the financial markets and global economies in which we operate impacts our sales, revenue growth and trends in profitability of our businesses. Globally, we are experiencing slowing economies, rising unemployment, falling real estate values and reduced consumer spending, all of which contributed to a recessionary economic environment. Although these and other macroeconomic factors maintained their negative trend in the first half of 2009, there was a more modest deterioration in the U.S. housing markets in the first half of 2009 as compared to the second half of 2008.
We believe that the challenging market conditions combined with slowing global economies have influenced, and will continue to influence, investment and spending decisions as both consumers and businesses adjust their consumption, debt and risk profiles in response to these conditions. This is evident in the slow down of mortgage originations and consumer lending in the majority of our target markets. We have also experienced an elevated incidence of claims in our U.S. and international mortgage and lifestyle protection insurance businesses. In addition, we could experience an increase in lapses or surrenders of policies in our life and long-term care insurance businesses given our policyholders' cash needs. Other factors such as government spending, the volatility and strength of the capital markets and inflation also affect the business and economic environment. We have seen an adverse impact on sales, revenues and profitability trends of certain insurance and investment products in early 2009 related to these market conditions, as well as other factors discussed within each segment discussion herein. However, in certain markets, we have seen an increase in sales and assets under management which indicate certain trends may be reversing. We could see further adverse or more positive impacts on our results depending on the direction these trends take.
In response to these current market conditions, we have tightened underwriting guidelines to reduce mortgage insurance exposures globally. We have also increased pricing in targeted markets and products in our U.S., Australian and European mortgage insurance businesses, as well as in our lifestyle protection insurance business. We have also adjusted our asset-liability management strategy in an attempt to reduce risk during the current economic and financial market conditions. In addition, we have refined our product and distribution management strategies to best fit with our strengths, profitability targets and risk tolerance. These and other company actions seek to enhance our competitive position as well as our capital and liquidity flexibility as discussed under "-Liquidity and Capital Resources."
In October 2008, the Emergency Economic Stabilization Act of 2008 (the "EESA") was enacted in response to the financial crises affecting the banking system and financial markets and continuing concern for the financial stability of investment banks and other financial institutions. Under the EESA, the U.S. Department of the Treasury ("Treasury") has the authority to, among other things, purchase up to $700.0 billion of mortgage-backed and other securities from financial institutions, as well as invest directly into certain financial institutions, for the purpose of stabilizing the financial markets. In February 2009, President Obama signed into law an
additional economic recovery package that is designed to further stimulate the U.S. economy through a variety of measures, including new federal spending programs designed to spur new job creation and certain federal tax cuts. Since the end of the first quarter of 2009, the U.S. government, Federal Reserve and other legislative and regulatory bodies have taken or are continuing to consider a variety of other actions. These include various mortgage restructuring programs under consideration or implemented by the GSEs, lenders and the U.S. government. Outside of the U.S., various governments have taken actions to stimulate economies, stabilize financial systems and reduce interest rates. There can be no assurance as to what impact any of these actions will have on the economic and financial markets, including the high levels of volatility currently being experienced. Further weak global economic performance could materially and adversely affect our business, financial condition and results of operations.
Volatility in credit and investment markets. Credit market conditions showed signs of improvement in the second quarter of 2009. Bank capital stress test results in the U.S. and U.K. led to improved stability in the financial markets. Those results combined with more opportunistic economic data contributed to improved equity and credit market performance. Investor appetite for riskier assets began to return, resulting in a narrowing of credit spreads and improved liquidity across many asset classes. Despite the overall improvement, marketplace uncertainty continued to impact other asset classes such as sub-prime and Alt-A residential mortgage loans. The weak economic climate has begun to impact performance in prime residential mortgage loans and commercial real estate mortgages, which have seen delinquencies rise off a relatively low base.
As a result, the marketplace has experienced a decline in the performance of collateral underlying certain structured securities and losses related to limited partnership investments have increased, while corporate impairments have decreased significantly. These factors and other performance characteristics have contributed to net other-than-temporary impairments of $152 million and $33 million of losses related to limited partnership investments in the second quarter of 2009. Impairments recorded in the second quarter of 2009 were lower than the trends experienced in the second half of 2008 and the first quarter of 2009 as the current downturn appears to be at or near the bottom of the cycle. Although economic conditions may continue to negatively impact our investment valuation, the underlying collateral associated with assets that have not been impaired continues to perform.
We believe that the current credit environment provides us with opportunities to invest in select asset classes and sectors that may enhance our investment yields over time. See "-Investments and Derivative Instruments" for additional information on our investment portfolio.
Trends and conditions affecting our segments
Retirement and Protection
Life insurance. Results in our life insurance business are impacted by sales, mortality, persistency, investment yields and statutory reserve requirements. Additionally, sales of our products and persistency of our insurance in-force are dependent on competitive product features and pricing, distribution and customer service. As a result of our discipline to achieve targeted returns and our refined target market, we have experienced lower term life insurance sales. We anticipate that sales may decline as we focus on our strategic shift to the "main street" market characterized by face amounts of $1 million or below. However, during 2009, we have seen certain competitors increase prices in this market, particularly in policies with longer guarantee periods and no lapse guarantees, which could benefit our competitiveness and returns over time. We also experienced lower persistency in term life insurance policies going into their post-level rate period (10 and 15 years after policy issue) and expect this trend to continue for a period of time as certain blocks of business reach the post-level rate period.
Regulations XXX and AXXX require insurers to establish additional statutory reserves for term life insurance policies with long-term premium guarantees and certain universal life insurance policies with secondary guarantees, which increase the capital required to write these products. For term life and certain
universal life insurance, we have implemented capital management actions, including the use of letters of credit and other financing transactions, such as reinsurance, to reduce the capital impact of these regulations. These solutions have become more limited and expensive, which will impact our returns given increased financing costs. We are evaluating product modifications to minimize the excess reserves, thereby improving the competitiveness and reducing the financing costs associated with additional statutory reserve requirements.
Long-term care insurance. Results of our long-term care insurance business are influenced by morbidity, persistency, investment yields, new product sales, expenses and reinsurance. In recent years, industry-wide first-year annualized premiums of individual long-term care insurance have either declined or grown moderately. Although our sales in the current year have been adversely impacted primarily by the general economic conditions and lower sales through financial institutions, the decline has been partially mitigated by the strength of our career force, breadth of our distribution and progress across multiple growth initiatives with an emphasis on broadening our product offerings, including an additional group long-term care insurance product and linked benefit offerings. In 2008, the impact of lower termination rates, in particular lapse rates on older issued policies, some with expiring reinsurance coverage caused higher benefits and other changes in policy reserves, resulting in lower net operating income for older blocks of business. However, in the first half of 2009, termination rates increased on the new and old blocks of business resulting in lower benefits and other changes in policy reserves that contributed to higher net operating income. Previously, we filed for state regulatory approvals for premium rate increases of between 8% and 12% on most of our block of older issued long-term care insurance policies and are currently in the process of implementing these rate increases. The rate increase has been approved in 45 states and has contributed to higher revenue and net operating income. In response to these trends, we continue pursuing multiple growth initiatives, investing in case management improvements, maintaining tight expense management, actively exploring reinsurance and capital market solutions, executing effective investment strategies and, if appropriate, considering other actions to improve profitability of the overall block.
Wealth management. Results of our wealth management business are impacted by demand for asset management products and related support services, investment performance and equity market fluctuations. Growth in the asset management industry has slowed significantly in the recent market environment. In the second half of 2008 through early 2009, the decline and volatility in the equity markets negatively impacted our assets under management, net flows, the performance of certain mutual funds we offer and associated fee income. With the improvement in the equity markets in the second quarter of 2009, as well as the offering of new investment strategies, we had higher sales, positive net flows and higher assets under management. Depending upon the direction market conditions or equity markets take in the future, we would expect to see a correlated impact on performance in these areas.
Retirement income. Results for our retirement income business are affected by investment performance, interest rate levels, slope of the interest rate yield curve, net interest spreads, equity market fluctuations, mortality, policyholder lapses and new product sales. Our competitive position within many of our distribution channels and our ability to retain business depends on many factors, including product features, ratings and competitive strength. We provide various product features such as current and minimum crediting rates on spread-based products, surrender charge periods in our annuities, as well as guaranteed benefit features we offer in variable annuity products that provide a guaranteed death or living benefit to the consumer.
Over the past several years, we have seen a decline in defined benefit retirement plans in favor of defined contribution plans with more of the responsibility for retirement planning shifting to the individual. We believe this trend supports long-term demand for individual and group retirement income products that provide various forms of guaranteed benefits with the opportunity to realize upside market performance.
During the second half of 2008 and into 2009, we experienced lower variable annuity sales as a result of consumers seeking safety from recent market turbulence and uncertainty by shifting to cash, government securities and other products. We also experienced a decline in fixed annuity sales that began in December 2008 and extended into 2009. We have scaled back certain product features, targeted distributors and sales personnel
supporting certain product lines due to the adverse market conditions and future risk appetite, profitability and capital considerations. In addition, due to adverse market conditions, our operating results and recent ratings downgrades, certain firms elected to suspend sales of fixed and variable annuity products issued by one or more of our subsidiaries. The largest impact of these suspensions was on our fixed annuity offerings through large financial institutions. However, as a result of the recent market recovery and our financial performance, certain firms have lifted their suspension and are once again offering our products. Market pressures in late 2008 and early 2009 are also increasing our expected claim costs, the costs of our hedging programs and the level of capital we may need to support these products, which will fluctuate, depending on market conditions.
Despite the improved market performance in the second quarter of 2009, we believe there could be declines in equity markets and interest rates and ongoing equity market volatility that could impact the costs and effectiveness of our hedging programs and new sales. Additionally, the significant declines and increased volatility in the equity markets during different stages of the first half of 2009 negatively impacted our results through accelerated amortization of deferred acquisition costs and increased reserves. Equity market performance and volatility could result in additional losses in our variable annuity products and associated hedging program which would negatively impact our results of operations.
In response to the declines in equity markets, we will continue offering annuity products with living benefit features, such as those described above; however, certain product features will be scaled back to reduce risk and costs could be increased to the consumer. We do not believe that this will impact our competitive position as these benefits will still be attractive to the consumer within our target markets. We also see competitors taking similar actions.
Institutional. Results in our institutional business are affected by credit markets. Our ability to issue funding agreements, FABNs and GICs to institutional investors is primarily dependent upon the credit markets, market perception of credit and risk-based pricing and our credit rating and credit default swap levels. As a result of market turmoil and investors' need for higher yields, credit quality and/or greater liquidity, we do not anticipate writing new institutional business in the current market environment. Therefore, we expect liabilities associated with these products to decline as existing contracts mature. In addition, we have not experienced any significant levels of early termination requests in 2009.
International
International mortgage insurance. Results of our international mortgage insurance business are affected by changes in regulatory environments, employment and other economic and housing market trends, including interest rate trends, home price appreciation, mortgage origination volume, levels of mortgage delinquencies and movements in foreign currency exchange rates. Over the past 12 months, we have seen a slowdown in mortgage origination levels and an increase in unemployment in virtually all of our international markets. As a result of these economic trends and slowing mortgage origination volume, we anticipate continued lower levels of new insurance written and increased losses, which will adversely impact the growth of our revenues and our results of operations with variations seen by individual country. In the first half of 2009, we have observed increased housing stability, particularly in Canada and Australia, as lower mortgage rates and lower home prices have increased home sales activity. As a result, home prices, in aggregate, have modestly increased in these markets during the first half of 2009.
Canada and Australia comprise approximately 96% of our international mortgage insurance risk in-force with an estimated average effective loan-to-value ratio of 67% as of June 30, 2009. We expect that these established markets will continue to contribute the majority of total revenues and profits of this business. As global economies remain pressured, our entry and growth in developing international markets will be selective and we may withdraw from certain markets.
In Canada and Australia, our international mortgage insurance business has expanded with favorable operating results; however, we expect higher loss levels over time as recent books of insurance in-force season in
a period of higher unemployment and lower or declining levels of home price . . .
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