Genworth Financial: Fewer Adjustments, But Controls Still Ineffective

As we discussed in our previous blog, the remediation of control deficiencies can be a lengthy and costly process. The case of Genworth Financials (NYSE: GNW) is no exception. Its most recent quarterly report, filed on Wednesday, April 29, states that its controls and procedures are still not effective.

The weakness goes back to the 2014 annual report, in which the company disclosed control deficiencies related to the implementation of changes in its long-term care insurance claims reserves methodology. The deficiency rose to the level of material weakness and resulted in a failure to identify a $44 million calculation error.

As previously disclosed in our 2014 Annual Report on Form 10-K, we did not have adequate controls designed and in place to ensure that we correctly implemented changes made to one of our methodologies as part of our comprehensive long-term care insurance claim reserves review completed in the third quarter of 2014.

While still working on the remediation plan, Genworth did list some concrete steps it is planning to take, including an improved review process that would involve two separate teams, and additional testing of the reserves calculation. The company stated that control enhancements would take place as early as Q2 of 2015:

We are currently working to remediate this material weakness and have created a project team to lead the remediation efforts. To date, we have developed a detailed timeline and project plan for remediation and we have already separated our actuarial team responsibilities to provide that, beginning in the second quarter of 2015, one team develops and implements all significant assumption and methodology changes to our long-term care insurance claim reserves while another team determines the nature and scope of the review required as a result of the changes, and then executes the review process. In addition, we have begun re-designing the “review control” over the implementation of assumption and methodology changes to our claim reserves to include testing of our claim reserves calculation, on an individual claim basis, from the point at which the claim record is included in our policy administration system through the point at which our reserve is reported in our consolidated financial statements. These control enhancements are intended to ensure that assumption and methodology changes to our long-term care insurance claim reserves function as intended.

For the remediation to be complete, the company will still need to thoroughly test the changes in internal controls before determining whether the new procedures are effective, but these are positive steps.

What about some of the other points we discussed in our previous blog, namely the company’s numerous one-time adjustments? Let’s take a look at page 6 of the press release filed on April 28:

Long Term Care Insurance
Results in the quarter included net unfavorable items of $7 million after-tax reflecting a refinement to a reserve calculation on the acquired block of business, partially offset primarily by a correction related to reinsurance.

Based on the disclosure above, noting a “refinement” to the calculation and a separate “correction”, it appears that GNW is still facing some challenges in its reserve estimates – one of the most complex areas of accounting.

One interesting (but easy-to-miss) item is found on page 9 of the press release. In Q1 2015, GNW highlights a change in its definition of “Net Operating Income”, a non-GAAP metric that excludes certain infrequent, one-time, and non-operational items:

In the first quarter of 2015, the company modified its definition to explicitly state that restructuring costs, which were previously included in the infrequent and unusual category, are excluded from net operating income (loss). There were no restructuring costs in the periods presented.

From the sound of it, there is no substantial change here. Restructuring costs were previously categorized as infrequent and unusual, and therefore would already have been excluded from the non-GAAP metric. So why does Genworth go out of its way to explicitly state that restructuring charges are indeed excluded from net operating income, especially if there were no such charges in the quarter? Perhaps this reclassification indicates that restructuring charges are expected?

Interestingly, GNW stock was up sharply, gaining as much as 11% on more than 3 times average volume, following their announcement that they are looking for strategic alternatives, including potential sale of life and annuity business. It remains to be seen whether the changes in definitions were made in anticipation of charges related to a sale of the unit, or whether there are other pending, still-undisclosed restructuring costs.