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Jack's Magic
By JONATHAN R. LAING
JACK WELCH, GENERAL ELECTRIC'S DEMANDING former chief executive, delighted in setting the bar high. When he stepped down a few days before Sept. 11, 2001, he left his successor, Jeffrey Immelt, the challenge of matching a remarkable string of years of strong profit growth.
What was most remarkable about those years, however, wasn't apparent to anyone outside the company until recently. The bar might have been set artificially high.
During the last five years of the Welch era, ended in 2001, GE's reported earnings jumped from 72 cents a share to $1.37, a rise of 65 cents a share, or 90.2% -- spectacular for a behemoth like GE. But without a massive under-reserving at its reinsurance unit, the company would have shown a cumulative earnings gain of just four cents, or 5.6%.
Ex-boss Welch, top, left current CEO Immelt with a big mess to clean up.
The under-reserving is expected to be completely corrected early next year, clearing the way for the unit's sale to Swiss Re. By the time that occurs, General Electric (ticker: GE) will have pumped in $9.4 billion in pretax dollars since 2001 to raise the reserves to an adequate level. When taxes are taken into consideration, the tab will come to $6.1 billion, or about 61 cents a share. And 61 cents would have all but torched the 65 cents of earnings gains in Welch's last five years.
Welch, whom Fortune crowned Manager of the Century in 1999, declined to speak with Barron's for this article. But certainly, the under-reserving boosted GE's earnings -- and Welch's reputation -- during the gun lap of his career. Immelt, forced to boost the reserves by billions over the past few years, has paid a heavy price in lackluster earnings growth.
In the Welch era, the reinsurance unit was known as Employers Reinsurance; later, it was renamed GE Insurance Solutions. Swiss Re announced last month that it is buying the bulk of Insurance Solutions for $6.8 billion in cash and stock. In a conference call, Swiss Re officials described both the $6 billion in reserve hits that GE had taken since 2001 and the additional $3.4 billion GE had agreed to add to finalize the transaction.
Swiss Re's Jacques Aigrain said the needed additions were "more or less entirely related to pre-2001 years, in both what they have done during the last few years [the $6 billion] and what we are asking them to do [adding $3.4 billion]...During the late 'Nineties, they had indeed gone into relatively large amounts of underwriting in business lines, which have been unpleasantly developing. Those include the traditional mix of some workers' comp, the developments related to various financial institutions and pharmaceuticals type of activities, and a variety of other accident-related activities."
Reserving includes an important time dimension. When a policy is issued, most of the first year's premium goes into reserves, because, for companies that reinsure "long-tail" policies like ERC, most claims probably won't show up for years. Such insurers provide coverage for risks -- such as those stemming from workers' exposure to potentially harmful substances like asbestos -- that are long-term. On the income statements of these companies, annual reserve provisions are by far the largest expense items. As they accumulate on the balance sheet, they dwarf other liabilities. Calculating proper reserves is tough; estimates hinge on shifting factors, such as the frequency and force of hurricanes.
Under-reserving temporarily can pump up earnings. But, eventually, sometimes years later, the piper must be paid. Calculating adequate reserves, as Warren Buffett once put it, is a self-graded exam.
GE officials contend that much of ERC's under-reserving was a result of industry-wide overcapacity and resultant cutthroat competition that led to under-pricing. They say a surge in big damage awards by juries and changing legal and regulatory definitions of liability played hob with estimates of proper reserves. "What you see in hindsight is the inherent volatility in reinsurance, and that's why we're exiting the business," says GE spokesman Russell Wilkerson. "GE leaders made thousands of business decisions in the late 'Nineties, and focusing on one business in isolation doesn't reflect the fact that the overall outcome of those decisions has been extremely positive for investors."
Cover Story -- Part II
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