Genworth Financial Cites Inadequate Controls

Reporting requirements may sometimes seem to be set in stone, but they do in fact change from time to time. Usually, when a regulator changes a requirement, it also imposes a deadline for the implementation of the change.

The companies are normally given an early warning and are expected to change their reporting by a certain date. Recently, in May 2013, the COSO Commission announced a change to the internal control reporting guidelines with an implementation deadline of December 15, 2014. That is to say, companies that have a 12/31 fiscal year end are supposed to file their latest annual reports under the new guidelines.

According to the Wall Street Journal, more than 300 such companies used the old COSO Framework guidelines in their latest 2014 annual reports. (This number is likely not final – we are still early in the filing season and many companies are yet to report.) The article hints at a possible link between the use of the 1992 Framework and an elevated risk of other significant reporting deficiencies, such as material weaknesses in internal controls.

Although we still do not have much in the way of statistics, let’s look at one company as an example. Genworth Financial (GNW) filed its annual report with the SEC on March 2, meeting the filing deadline for large accelerated filers.

Genworth was one of the companies that used the 1992 Framework in its annual ICFR assessment. Yet, the Item 9A (Controls and Procedures) section was far from standard. The mortgage insurance company identified a material weakness in its Internal Controls over Financial Reporting and disclosed a $44 million error in the calculation of long term claims reserves:

Inadequate Controls Over Implementation of Changes to One of Our Methodologies

We did not have adequate controls designed and in place to ensure that we correctly implemented changes made to one of the methodologies as part of our comprehensive long-term care insurance claim reserves review completed in the third quarter of 2014. Specifically, the design of our control relating to the review of the implementation of claim reserve assumption and methodology changes (the “review control”) was not modified in light of the complex nature and volume of changes required to our claim reserves system in order to implement all the assumption and methodology changes we made as part of the third quarter review. As a result, we failed to identify a $44 million after-tax calculation error. This amount was corrected in the fourth quarter of 2014 prior to issuing our consolidated financial statements. The control deficiency related to the claim reserve changes made in the third quarter, and did not result in a material misstatement in the consolidated financial statements; however, we have concluded a material weakness exists in the controls over the implementation of our long-term care insurance claim reserves assumption and methodology changes because such a misstatement could have occurred.

The error was corrected as an out-of-period adjustment in the fourth quarter of 2014, implying that it was immaterial to both current and past financials. Yet, the Street reacted by sending GNW stock down almost 6% on at least three times average volume. The stock did regain some ground on Tuesday, March 3. Overall, GNW lost about half of its market cap in the past 12 month.

The GNW stock performance seems to match red flags in financial reporting that accumulated to a dangerous level in the past few years. Since 2011, and until the most recent annual report, Genworth disclosed three out-of-period adjustments, a revision restatement and very significant changes in estimates related to revised claims reserves, the most recent of which – a charge of $629 million – was alluded to in the disclosure copied above. An SEC comment letter, made public in December 2013, could help to shed some light on  the significant challenges involved in estimating long-term claim reserves.

Interestingly, the cumulative impact of the revision restatement, first disclosed in an 8-K filed in April 2013, was almost identical to the impact of the errors disclosed in the most recent annual report:

The company has a practice of refunding the post-delinquent premiums in our U.S. mortgage insurance business to the insured party if the delinquent loan goes to claim. The company’s historical accounting practice was to account for these premium refunds as a reduction in premiums upon payment. In the first quarter of 2013, the company determined that it should have been recording a liability for premiums received on the delinquent loans where its practice was to refund post-delinquent premiums. This error was not material to the company’s consolidated financial condition, results of operations or cash flows as presented in its previously filed annual and quarterly financial statements; however, the adjustment to correct the cumulative effect of this error would have been material if recorded in the first quarter of 2013. The company restated the financial information to correct this error for all periods presented herein. The cumulative decrease to retained earnings was $46 million as of January 1, 2012.

But the impact of the restatements is dwarfed in comparison to the $849 million goodwill impairment charge taken through 2014 (mostly in the third and fourth quarters):

Goodwill impairment.

Charges for impairment of goodwill are as a result of declines in the fair value of the reporting units. The goodwill impairment charges in 2014 were $354 million in our long-term care insurance business and $495 million in our life insurance business.

So do such massive goodwill impairment (that reduced the value of goodwill of these two businesses to zero) and other charges indicate that we have reached the bottom of the barrel? Or are there more charges to come? We would not be surprised to see GNW receive additional SEC comments in the next few months that might help to clarify the picture.

In evaluation of investment risks, an adherence to the reporting requirements or lack thereof may be an indicator of more systemic issues in the business. In particular, the internal controls are yet another piece of the puzzle the investors have to consider when assessing their potential risks.