[SOLVED] On January 30, 2018, General Electric (GE)

On January 30, 2018, General Electric (GE) announced that it was taking an after-tax charge of $6.2 billion in the December 31, 2017 financial statements and additional cash funding of $15 billion in statutory capital contributions to its insurance subsidiary. GE also acknowledged a Securities and Exchange Commission investigation into the process leading to the sudden multibillion-dollar charge and an additional review of revenue recognition and controls over its long-term contracts. In October of 2020 , the SEC notified GE that they may be facing a civil action for violations of securities laws surrounding their accounting for these insurance contracts. On December 9, 2020, GE agreed to a $200 million penalty to settle the matter with the SEC. While GE did not admit any wrongdoing, the SEC stated that GE misled investors and violated antifraud, accounting and other SEC regulations . When GE first announced the charge on January 16, 2018, which related to the remnants of its long-term care reinsurance portfolio, CEO John Flannery told analysts he had “underappreciated the risk in this book.” [A book of business, in the context of insurance, is a database or "book" that lists all of the insurance policies the insurance company has written.]
GE’s North America Life & Health subsidiary is a reinsurance portfolio the company held on to after mostly exiting the business between 2004 and 2006. A reinsurer buys the right to receive premiums from the primary insurers that deal directly with consumers in exchange for eventually shouldering any potential losses. Those primary insurers underwrite and administer the policies and process claims when they come in.
The majority of GE Capital’s remaining insurance business, 60 percent, is related to long-term care insurance. At the time, Flannery told analysts, GE believed that a gradual runoff of existing claims -- no new business has been added since 2006 -- would be more profitable than selling the whole business. Unfortunately, Flannery said, GE didn’t anticipate the low interest rate environment, low policy lapse rates, and higher claims cost that it is seeing now.
GE warned analysts as long ago as the second-quarter of 2017 that a review of its claims experience and reserves was under way, and any charge would happen in the fourth quarter. In its 2017 second quarter filing with the SEC, GE wrote: “We have recently experienced elevated claim experience for a portion of our long-term care insurance products, which may result in a deficiency in reserves plus future premiums compared to future benefit payments. Should such a deficiency exist, we would record a charge to earnings in the second half of 2017 upon completion of this review.” And in its third quarter 2017 filing with the SEC, GE warned about the potential charge again but with more details.
“We have recently experienced elevated claim experience for a portion of our long-term care insurance contracts and are conducting a comprehensive review of premium deficiency assumptions across all insurance contracts, including a reassessment of future claim projections for long-term care contracts that will be incorporated within our annual test of future policy benefit reserves for premium deficiencies in the fourth quarter of 2017. We would record a charge to earnings for any premium deficiencies in the fourth quarter of 2017 upon completion of this review.”
Accounting experts were expecting the review to result in some financial charge, but not on this scale. “The review of business always carries the risk of unexpected findings, yet the magnitude of the $6.2 billion charge is far more staggering than the $3 billion that the market anticipated,” research firm Audit Analytics wrote in a note to subscribers.
At its annual meeting last November, chief financial officer Jamie Miller told shareholders that GE was likely to take a charge of more than $3 billion.
Changes in insurance claim reserves typically are disclosed in advance as changes in accounting estimates related to long-term care reserves. Companies are only required to disclose adjustments that are material. In its note, Audit Analytics wrote it looked at 30 insurance companies and found 60 changes in accounting estimates filed with the SEC for adjustment to the long-term care loss reserves filed since 2004.
The last time GE disclosed any changes in reserves even partly attributable to the long-term care reinsurance portfolio, according to Audit Analytics, was in its 2004 annual report, the same year it spun off the Genworth Financial business -- another insurance company. GE wrote that liabilities, reserves, and annuity benefits were $4.5 billion higher than in 2003 and “attributable to growth in annuities, long-term care insurance, structured settlements, the effects of the weaker U.S. dollar, increases in loss reserves for policies written in prior years and 2004 U.S. hurricane-related losses.”
On the call when the charge was first announced, Chief Risk Officer Ryan Zanin told analysts that a large percentage of the policyholders in their book of business were sold the policies at a very early age and are only now reaching the prime claim paying period—ages 80 and up. Therefore, approximately 40% of inception-to-date claims have occurred in the last two years.
A GE spokeswoman told MarketWatch: “GE has tested the adequacy of its policy reserves for the runoff insurance business every year through premium deficiency testing.” In all prior years, Zanin said on the call with analysts, “these tests resulted in a positive margin, which, under GAAP, requires that original assumptions above the book remain locked.” JP Morgan analyst Stephen Tusa asked GE Chief Financial Officer Jamie Miller if the company was happy with its auditor. “If these guys reviewed this stuff every year for the last several years and this is kind of a result of that, doesn’t that kind of raise questions?” he asked. Flannery said that he was not planning an auditor change.
KPMG, the GE auditor for more than 100 years, is also the external auditor for Genworth Financial. A spokesman for KPMG emailed MarketWatch to say this:
“We are confident that our audits and reviews were appropriately performed in accordance with applicable professional standards, and we stand behind our work. Our client confidentiality obligations prohibit us from commenting further.”
Note: In June of 2020, GE announced they would be replacing KPMG as their auditors with Deloitte. Total Audit and Tax fees charged by KPMG to GE were $104.6 million in 2018 and $79.1 million in 2019 .
Questions:
1. Assume you are asked as part of an audit of GE’s insurance business to assess fraud risks, what would you include in your report and why?
2. At GE’s annual meeting in November 2017, CFO Jamie Miller told shareholders that GE was likely to take a charge of more than $3 billion. Just 14 months later GE announced a charge of $6.2 billion. Do you believe this indicates a failure on the part of KPMG to adequately evaluate the estimates of insurance claim reserves and risk assessment, or is it reflective of a change in economic circumstances that could not have been anticipated?
3. According to the Financial Executives Research Foundation, “enhancing the effectiveness of corporate disclosures is of paramount importance to companies, investors, creditors, regulators and the capital markets at large. This has compelled many companies to take a fresh look at how effectively they ‘tell their story.’”
2 Some worry that increased disclosures through different channels can be confusing and lead to “disclosure overload.” What role should materiality play in determining what kinds of information should be disclosed and how frequently? What are the dangers from an audit perspective of having clients increasingly add to its disclosures, especially when estimates are involved? Did GE do the “right thing” when it warned of a $3 billion charge only to wind up taking a $6.2 billion charge?

Question: On January 30, 2018, General Electric (GE)