Genworth: A story of capital and crisis

A risky insurance product with a potential exposure of over $300bn with only $1.8bn in equity hardly sounds like a recipe for success, but uncertainty and fear in the sharemarket can create opportunity.

Genworth's sole product is lenders' mortgage insurance (LMI), which mortgage borrowers are typically required to purchase if their loans exceed a loan-to-value ratio of 80%. But it's not for their benefit; LMI protects the mortgage lender (usually a bank) in the event the borrower can't repay their loan.

So if the lender repossesses and sells the property, and it's insufficient to cover the costs of sale, the loan and any accrued interest, then the insurance will make up the difference.

Premium business

It is no doubt a risky business, but it has some attractive features. Premiums are collected upfront as cash but the corresponding claims may not need to be paid out for many years. In the meantime, Genworth can earn investment income on this ‘float'.

Genworth also has reasonable pricing power because banks are their customers with little tendency to change providers regularly.

Risks tend to decline over time as mortgages are paid back and – generally speaking – house prices increase. This provides a buffer in the event of a potential claim.

As a result, there are generous profits to be made when the going is good, with few defaults and rising house prices – something we've largely experienced for around 25 years in Australia. But a reversal in these factors could wipe out years of profits in short order.

What crisis?

A housing crisis and a big uptick in defaults appear unlikely anytime soon. Mortgage-related metrics including arrears data are all healthy, and interest rates are near historic lows – even if increases are expected. Even so, concerns about what might happen in a housing crash has pushed Genworth's share price down to only about 70% of its net tangible asset value.

At the same time, new business volumes have been declining due to a combination of contract losses and banks originating fewer high-LVR loans. The result is that risks are decreasing, freeing up capital, and making it more likely that something close to the net tangible asset value will ultimately be recovered.

Excess capital

As with any insurer, Genworth is required to hold minimum levels of capital to absorb unexpected losses. The required amount is subject to a few variables including LVRs, the total amount of loans, the age of loans and the estimated likelihood of defaults and losses.

For a house valued at $1m, for example, with a $0.9m loan (an LVR of 90%), Genworth might need to hold around $18,000 in equity. But as that mortgage is paid down over time, the potential risk to Genworth declines, and it needs to hold less capital.

After three years, for example the level of capital needed to support the policy may drop to around $6,500. That's nearly $12,000 less than when the policy was originated.

Shareholder returns

If the total capital requirements of new policies are less than the decline in the existing portfolio, then Genworth will have capital exceeding its regulatory requirements. 

Genworth has largely experienced reducing capital needs since listing in 2014. Management has acted sensibly by paying dividends and buying back shares totaling over $2 per share. The latter initiative is ongoing at a material discount to net tangible assets per share.

Even so, Genworth's capital levels are materially ahead of regulatory requirements (and peers') at 1.8 times. Increased returns to shareholders seem likely.

If it were to cease writing new policies, Genworth's tangible assets per share could still increase over the next few years (bar a housing crisis) due to almost $1.2bn of unearned premium – cash that it has collected but not yet recognised as revenue.

Mind the downside

So, GMA appears to have some attractive investment features. But what about that elephant in the room? What might happen if we experience a full-blown housing crisis?

Assessing the impacts of such an event is fraught with uncertainty. Assumptions need to be made about the depth of house price falls, levels of default, the time to sell a house and the level of interest rates. No one knows these for sure, including Genworth.

We can look at past events to guide us. Using default and house price decline metrics in the UK, USA, and Spain during the financial crisis suggest that Genworth could withstand such scenarios (taking account of its reinsurance protection).

The Australian market's stronger mortgage underwriting standards (such as fewer subprime loans), and more robust regulatory scrutiny suggest less severe downside scenarios. And of course, Genworth's regulatory capital is intended to help it withstand severe downturns.

Risky business

We've run through several stress scenarios but in the end, it requires a leap of faith.

If the discount to net tangible assets is wide enough, then you wouldn't lose much even in the event of a downturn.

If there's no housing downturn, you have the opportunity of increased cash returns while net assets per share increases.

But all this is quite theoretical and (very) complex. The range of outcomes is vast. Genworth has traded consistently below its tangible asset value since listing, and there is plenty of short-selling interest.

We prefer simpler opportunities. Genworth could be interesting for investors with a high tolerance for risk, particularly if they don't already have a large exposure to housing.

We'd be more interested if new business volumes declined further, putting the business into more of a run-off phase. That would free up capital at a faster rate, paving the way for increased returns to shareholders. We'll keep an eye on Genworth but we'd need a wider margin of safety before recommending it.