Many of you have shared thoughtful responses to our statements from last week. Given your follow-up questions, I wanted to lay out our perspective in a bit greater detail, especially on two issues: GE long-term care (LTC) insurance and Baker Hughes, a GE company (BHGE).
GE LTC insurance: First and foremost, we believe that our current reserves are well-supported for our portfolio characteristics. Our future liabilities depend on variables that will play out over decades, not years, and are dictated by rigorous testing processes, sound actuarial analysis, and the application of regulatory and accounting rules.
- It’s important to recognize that there are several characteristics of industry long-term care blocks of business, including coverage and cash benefit options. In addition, GE is a reinsurer that has a variety of contractual relationships and is not responsible for 100% of every claim on every life. And recall how reserves work: the 2017 $15 billion increase to statutory reserves, to be recognized through 2024, was established to cover future claims in addition to claims already incurred.
- The correct analysis of insurance reserves comes from an extensive annual process where key assumptions informed by claim experience are updated and reviewed in conjunction with independent actuarial partners, auditors and regulators. This process includes a GAAP and a statutory test. We expect to complete our annual loss recognition testing in accordance with U.S. GAAP in 3Q’19 and complete our annual statutory cash flow testing in 1Q’20. Remember that it is the statutory cash flow testing, not GAAP accounting, that determines the funding requirements for all insurance companies.
- We’ve recently taken new steps to explain our risk modelling and accounting around our LTC obligations to our investors, including our March Insurance Teach-in (see presentation and transcript) and enhanced disclosures in our 2018 Form 10-K (starting on page 61) and 2019 10-Q’s.
BHGE: As a majority shareholder of BHGE, we are required to report BHGE on a consolidated basis under U.S. GAAP. Public companies like BHGE are also required to issue their own financials under U.S. securities law, even if they are owned by someone else. Finally, as we’ve disclosed, once GE is no longer the controlling owner of BHGE, our sale will trigger a non-cash charge. This estimated loss was updated in our most recent 10-Q to ~$7.4 billion as of July 26, 2019. This will not impact GE’s cash needs and liquidity, and the sale of our remaining stake will also generate additional cash that can be used for deleveraging.
I’ve included a more detailed breakdown of each of these topics below. This is not intended to be comprehensive. These are two significant areas that we want to make sure are understood, and I hope that pointing out some of the specifics behind our company statements will be helpful for your own analysis.
Finally, some of questions I’ve been receiving go straight to the heart of GE’s culture, so let me be clear: we operate with absolute integrity and stand behind our financial reporting. We are focused on delivering on our strategic priorities and we remain committed to providing accurate, complete and timely financial information to you. Our team remains confident in our company’s long-term strengths; in addition to the executive and director stock purchases I mentioned last week, GE Gas Power CEO Scott Strazik also purchased another 34,836 shares on Thursday.
As always, I welcome your input and feedback. If you’d like additional information, the team and I are here to answer your questions. Thank you for your continued interest in GE.
VP Investor Communications
GE LTC INSURANCE
Q: Is GE under-reserved compared to peers?
A: No. We believe that our current reserves are well-supported for our portfolio characteristics, and we undertake rigorous reserve adequacy testing every year.
- We’ve been up front and transparent about the long-term liabilities around our run-off insurance operations, and there are a lot of viewpoints in the market regarding the risks and financial obligations across the entire LTC industry.
- The correct analysis of insurance reserves comes from our extensive annual process where key assumptions informed by claim experience are updated and reviewed in conjunction with independent actuarial partners, auditors, and regulators.
- There are important characteristics in GE’s LTC block that impact our reserve amounts that need to be considered:
- Assumed risk: As a reinsurer we are not responsible for 100% of every risk. Our contracts are with a variety of originating companies and cover a variety of risk percentages and contractual elements that impact both our reserves per life and premiums per life.
- Policy composition: As noted in public filings, ~35% of the comparator’s block has a cash benefit option, which meaningfully increases premiums & reserves. At least 99% of GE’s policies do not have cash benefit options.
- Premium increases: As we’ve disclosed, we collaborate closely with originating companies on premium increases. To date we have achieved up to ~35% cumulative rate increases for ERAC, which is up from ~30% last year.
- Policy risk: GE’s policies do contain risk, which we have disclosed many times before, as do the policies of other carriers. We are confident that the adverse differences are significantly overstated.
Q: Does GE have an inappropriate mismatch between its GAAP and statutory accounting, especially considering the coming GAAP rule changes in 2021-22?
A: No. The accounting rule change promulgated by FASB is not meant to align GAAP with statutory accounting.
- Statutory accounting – which is set forth by the National Association of Insurance Commissioners as well as state laws, regulation and general administrative rules – differs in certain respects from GAAP and is intended to be more conservative than GAAP. Among other changes, the new standard is meant to create a more uniform measure of insurance liabilities across companies reporting under U.S. GAAP. To our knowledge, no company has adopted the new standard early.
- We have stated in disclosures beginning with our 3Q’18 10-Q (page 48) that, following issuance of the new standard by the FASB in August 2018, we anticipate that the adoption of the new standard will materially affect our financial statements.
- We have also provided sensitivities so that investors can estimate the cost under different interest rate scenarios (see page 10 of our Insurance teach-in presentation and page 66 of our 2018 Form 10-K).
- We will also be able to eliminate certain balances upon adoption of the new accounting standard, such as $4.8 billion related to net unrealized gains and losses on our available-for-sale investment securities (as included in the “Other adjustments” column of Note 12, Insurance Liabilities and Annuity Benefits, to GE’s consolidated financial statements included in our 2Q’19 10-Q). If market interest rates were to decline further, this balance would be expected to increase, and vice-versa. This will at least partially offset any GAAP equity charge that may be required upon adoption.
Q: Do changes to market interest rates translate directly to changes in discount rates?
A: No. Interest rates are only one component in determining discount rates.
- It’s important not to confuse a change in market interest rates with a change in the discount rate. The discount rate is a complex calculation that involves the yield on our current asset portfolio, which does not vary meaningfully with short-term market movements. It is a mix of expected long-term reinvestment rates across a large variety of asset classes and a large range of asset durations.
- In our Insurance Teach-In presentation (page 10), we said that a 25-bps change in the discount rate would result in a $1 billion GAAP charge. In our 2Q’19 10-Q (page 16), we said that market interest rates have declined by ~75 bps, which will impact a component of our discount rate only, and holding all other assumptions constant, would have increased our future policy benefit reserves on a GAAP basis by less than $1.0 billion (pre-tax). But because interest rates are just a component of discount rates, a 75-bps decline in interest rates does not equate to a 75-bps change in the discount rate.
Q: Will you need to make a cash contribution of $29 billion?
A: No. Our future liabilities depend on variables that will play out over decades, not years, and are dictated by rigorous testing processes, sound actuarial analysis, and the application of regulatory and accounting rules.
- This annual process includes a GAAP and a statutory test.
- GAAP: As we said at 2Q’19 earnings, we expect to complete our annual loss recognition testing in accordance with U.S. GAAP in 3Q’19.
- Statutory: We will complete our annual statutory cash flow testing in 1Q’20. Remember that it is the statutory cash flow testing, not GAAP accounting, that determines the funding requirements for all insurance companies.
- Both tests are reviewed in conjunction with independent actuarial partners, auditors, and regulators.
Q: Why does GE consolidate BHGE?
A: Under US GAAP, a company is required to consolidate any entity that it has control over and to deconsolidate it when it no longer has control.
- To date, GE has maintained control over BHGE via majority voting rights (currently ~50.2%) and control of the board. Therefore, under ASC 810-10-15-10(a), GE is required to consolidate BHGE in its SEC filings.
Q: Why hasn’t GE deconsolidated BHGE sooner?
A: GAAP rules require this to happen when we lose control of BHGE (ASC 810-10-40-4). This simply has not happened yet.
- We expect to take a loss when this does happen, which we have shared in our financial filings since our 3Q’18 10-Q (page 81). This estimated loss was updated in our 2Q’19 10-Q (page 4) to ~$7.4 billion as of July 26, 2019.
- Recall that in Note 15 of our 2018 Form 10-K, we disclosed that we recognized a $1.7 billion after-tax loss within the Other Capital component of shareowners’ equity in conjunction with the reduction in our economic interest in BHGE from 62.5% to 50.4% in November 2018.
Q: Why do both GE and BHGE consolidate BHGE’s results?
A: U.S. securities laws require that public companies like BHGE issue their own financials, even if they are owned by someone else.
- As disclosed in public filings, there are two legal entities at play here that share similar names: BHGE LLC and BHGE Inc.
- BHGE LLC is a limited liability company owned by GE and BHGE Inc. It is accounted for as a variable interest entity, and BHGE Inc. is the primary beneficiary (ASC 810-10-25-38).
- BHGE Inc. is the publicly traded NYSE-listed company that GE controls through majority voting rights and board control. It is accounted for as a voting interest entity (ASC 810-10-15-10).
- Under GAAP, GE and BHGE Inc. must consolidate what they each control, and in doing so consolidate their subsidiaries as well. BHGE Inc. is the primary beneficiary of BHGE LLC and thus controls and consolidates BHGE LLC. GE controls and consolidates BHGE Inc. and all its consolidated subsidiaries, including BHGE LLC.
- Consider: Two investors own an interest in a single entity, and neither of the investors consolidates the other. GAAP would preclude both from consolidating the entity. Only one can.
- However, if the investor that is not the primary beneficiary consolidates the other that is the primary beneficiary, then both are required to reflect the single entity under GAAP. This is our situation with BHGE Inc.
Q: Does consolidating BHGE skew investor perception of GE’s cash flows?
A: No. GE has provided investors a non-GAAP measure that reports free cash flows excluding BHGE (“BHGE on a dividend basis”).
- See Adjusted GE Industrial Free Cash Flows on page 76 of our 2018 Form 10-K.
Q: Will the loss from your eventual BHGE deconsolidation violate your debt covenants?
A: No. Any loss flowing from deconsolidation of BHGE will not violate any of our debt covenants.
- Our primary credit agreement and the indentures governing most of our debt instruments are publicly available in the exhibits starting on page 167 of our 2018 Form 10-K.
Q: Will the loss from your eventual BHGE deconsolidation impact your ability to execute your deleveraging plan?
A: No. This will not impact our ability to make meaningful progress toward our deleveraging goal of <2.5x by the end of 2020.
- The sale of our remaining stake will generate additional cash that can be used for deleveraging.
- And while the separation/deconsolidation of BHGE will trigger a non-cash charge that will impact industrial equity, the net debt/EBITDA (non-GAAP) metric already excludes BHGE.
 Reduced from ~50.4% following the initial secondary offering last November due to normal-course employee equity issuances.
 In showing this, we are not calling into question the adequacy of the reserves of the comparator or the appropriateness of their accounting.