Tuesday General Electric (GE) announced it would take a fourth quarter after-tax charge of $6.2 billion related to its insurance business. The company just completed a comprehensive review of its reserve testing and will also make statutory reserve contributions of approximately $15 billion over the next seven years:

“As we disclosed during the company’s second - and third-quarter earnings calls and further discussed during our November 13, 2017, investor presentation, earlier this year GE Capital initiated a comprehensive review of our insurance reserves with the assistance of leading outside experts,” said John Flannery, chairman and CEO of GE. “This was a rigorous process involving complex factors and estimates relating primarily to long - term care policies written by primary insurance companies and reinsured by NALH.” Flannery added, “The required contributions to the statutory reserve will be made by GE Capital, which has sufficient liquidity to do so.

We have been taking ongoing actions to make GE Capital smaller and more focused while maintaining its key capabilities to support financing for GE Industrial products. These actions will also help restore GE Capital ratios to appropriate levels. At a time when we are moving forward as a company, a charge of this magnitude from a legacy insurance portfolio in run-off for more than a decade is deeply disappointing.”

GE is off over 7% since the announcement. This comes after financial markets continue to set record highs on a weekly basis.

The Situation

The lion's share of the reserve increases are driven by GE Capital's run-off portfolio, North American Life & Health ("NALH"), which is related to long-term care ("LTC"). Per the company's January 16, 2018 insurance update GE's LTC business was written between 1989 and 2006. LTC wrote business for and pays claims for nursing homes, assisted living and home health. LTC is a long-tailed business and assumptions used to justify underwriting or pricing the product 15 - 20 years ago may not be valid today. The block of business has been impacted by an aging population, insureds living longer than expected and more policy holder reaching claim status.

The current record low interest rate environment likely hurt the investment returns on LTC's investment portfolio. Lower investment returns than expected combined with a heightened claims paying experience does not bode well for the segment. GE sold its insurance operations over 10 years ago, but was left with the legacy LTC business which has now come back to haunt the company.

Impact On Cash Flow/Dividends

The reserve increases will create payments of $3 billion in 2018 and about $2 billion annually over the next six years. That will likely crimp cash flow at a time when GE's cash flows have dried up. In Q3 2017 GE generated cash flows from operations of $465 million - this pales in comparison to the $7.6 billion of cash flows in the year-earlier period. GE also received $5.1 billion of dividends from GE Capital in Q3 2016. That upstream was cut off last quarter amid a review of the company's insurance reserves.

GE recently cut its dividend in half after admitting dividend payouts had exceeded the company's cash flow in past years. Management intimated future dividend payouts could be determined by the company's review of its insurance operations. Now that LTC is expected to create a drag on cash flow for several years what happens to GE's dividend? Will the dividend be cut further or will the company maintain its current payout? To continue to attract value investors GE's dividend paying ability is important. However, it could be prudent to cut the dividend further to help the company sustain itself long-term. This could be a major question mark going forward.

The company's debt was recently downgraded from "A+" to "AA-" by Fitch. GE has $136 billion of debt of which $28 billion is short-term. In order to keep the rating agencies at bay management might have to prove it can increase cash flow. It can ill-afford more ratings downgrades or higher interest costs on its debt load. In addition to problems in its insurance portfolio and risks of higher rates,  GE's core business is not that strong. Power Systems was 29% of total Q3 2017 Industrial revenue, yet only 17% of the segment's profits. Management is expected to cut costs by laying off 12,000 employees at Power. Nonetheless, its core business is being disrupted by renewable energy and that disruption could intensify going forward.