Genworth (GNW) Slumps as S&P Cuts to BBB-

October 11, 2012 1:50 PM EDT
Genworth Financial Inc. (NYSE: GNW) shares have erased gains on the session following a credit rating downgrade by S&P this afternoon. Shares are now up just 0.2 percent Thursday.

The S&P note is below:

Standard & Poor's Ratings Services said today that it has lowered its counterparty credit rating on Genworth Financial Inc. (GNW) to 'BBB-/A-3' from 'BBB/A-2'. At the same time, we lowered the insurer financial strength rating and counterparty credit rating on Genworth Life Insurance Co. (GLIC) and core U.S. life operations to 'A-/A-2' from 'A/A-1'. We also downgraded Genworth Financial Mortgage Insurance Ltd. to 'BBB-' because it relies on a holding-company guarantee.

"We continue to view GNW as investment grade due to its increased liquidity at the holding company, significant improvement in its U.S. mortgage insurance platform year to date, the Australian mortgage insurer's return to profitability in the second quarter, and the positive momentum in unassigned surplus at the U.S. life operations," said Standard & Poor's credit analyst Jeremy Rosenbaum. "However, we are lowering the counterparty credit rating by one notch to reflect the low earnings level for the organization (below expectations for the 'BBB' category) and the difficulty it will face expanding margins globally in the weak economy."

GNW let its two five-year credit facilities expire this year, and although we don't think a full renewal was necessary given a shift in its mix of businesses, the move highlights a straining of its financial flexibility in the capital markets. Finally, GNW's indenture contains a clause (section 6.01(g)) whereby the outstanding principal would become due and payable immediately if a "significant subsidiary" is adjudicated bankrupt or insolvent, or placed under court-ordered regulatory receivership. Genworth Mortgage Insurance Corp. is considered a "significant subsidiary." Although we think the likelihood of this clause being triggered is remote, we believe that it hampers GNW's financial flexibility in the marketplace and increases its financing costs above peer companies'.

The U.S. life operations are being downgraded one notch because of the business's sensitivity to interest rates (fixed annuities and long-term care [LTC]), and its underperforming legacy term and LTC blocks that will take time to stabilize and improve. In addition, financial flexibility continues to be affected by the ongoing stress at the holding company and the expectation for the life operations to support holding company interest expenses. The company's two main competitive advantages are in the commoditized term product and interest sensitive LTC. Legacy blocks that impede margin expansion continue to hurt both product lines. While management improves its position (as exemplified by its life block transaction completed in first-quarter 2012 [RiverLake III]), its ability to significantly and quickly alter the in-force
book is limited. The margin compression on the remaining legacy term block due to failed auctions in its RiverLake structures is a hindrance. While regulatory approvals of announced premium rate increases on the legacy LTC block are expected starting in 2013, it will take a few years for these increases to be fully recognized in premium revenue. Lapsation, morbidity, termination rates, and interest rates have all led to the deterioration of the block, necessitating the large premium increases that GNW recently announced.

The 'A-' U.S. life operations are supported by a strong business profile with leadership positions in both term life and LTC product lines. The streamlining of its product set following the sale of the Medicare supplement business and exit of the variable annuity line has allowed GLIC to better focus on its core competencies. Strong and improving capitalization at the U.S. life company also supports the 'A-' rating. We expect the U.S. life operations to become a regular dividend-paying entity to the parent company.

Finally, we believe that management has successfully hedged a significant part of its interest rate risk on its LTC block primarily through forward-starting swaps. As of second-quarter 2012, it has more than $2 billion in cash-flow hedge gains in accumulated other comprehensive income. Assuming interest rates stay level, these gains will be amortized into earnings over time.

The outlook on GNW is negative, reflecting the low fixed-charge coverage metrics, the uneven business performance, and the continued poor, albeit improved, performance at the U.S. mortgage insurer. Financing costs are more than peer companies' and likely factored into management's decision not to renew the credit facilities. We believe that the ongoing strategic review will address many of the factors that currently strain the company's financial flexibility. However, until management can execute its plans, we believe there are still downward rating scenarios given the volatility in operating performance since the start of the financial crisis. We would expect to review the outlook within six to 12 months as the strategic plans are executed and operating earnings trend above or below the 3x-5x coverage level expected for the ratings. In addition, we believe that to maintain the investment-grade rating, management needs to continue to hold a buffer in excess of 2x holding company interest expense.

"The outlook on the life companies is stable," Mr. Rosenbaum continued, "reflecting their strong capital and business positions. We are unlikely to change the ratings during the next 18-24 months. However, we could lower the ratings if the holding company relies too heavily on the U.S. life operations to service its debt, hindering capital formation and leading to sustained capital levels below the 'A' level. We could also lower the rating if the legacy LTC business further deteriorates and management actions are insufficient to stabilize the block. We could raise the ratings if the life companies can more quickly improve underperforming business lines and improve operating fundamentals in line with other companies that are rated 'A'."

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