by
Justin McCarthy | Apr 01, 2015
Published 19 February 2015
On 17 February, Genworth released an ASX announcement that Westpac had cancelled its contract for lenders mortgage insurance (LMI). Essentially, Westpac has found cheaper LMI (lenders mortgage insurance) offshore through a company called Arch Capital Group. With the Westpac business accounting for around 14% of total premiums written in FY14, it is a significant reduction in volume and future profits, although the impact is likely to be felt from 2016 onwards as existing Westpac LMI policies roll off.
Not surprisingly the shares were off significantly with a fall of 23% the following day, although around a quarter of this was likely related to the stock going ex-dividend 24.6c.
This is a major issue for growth and future profitability, which is of far greater concern to equity investors than debt investors. If the Westpac cancellation is a one off and not followed by any other significant contract losses, it could be argued that this is actually a positive for debt investors as the company maintains the same equity buffer but on a smaller pool of (less risky) insurance, improving the relative position of the subordinated notes (remembering all Westpac LMI through Genworth was for higher risk loans with loan to value (LVR) ratios of 90% or more, significantly higher than the average LVR on the Genworth book). With excess capital levels, the expensive subordinated notes (paying a very high floating margin of 475bps over BBSW) are increasingly likely to be called in June 2016.
However, the risk of further contract losses, particularly from the other large customers NAB and CBA, has the potential to put Genworth’s business model in question if they are not able to write sufficient business to cover costs and operate profitably. Insurers typically need scale to ensure profitability and the Westpac cancellation has raised the question as to whether the other banks will be able to find cheaper alternatives. This risk is considered remote but it would impact credit ratings and the risk on the subordinated notes should Genworth lose more major contracts.
Whilst our base case scenario is the Westpac cancellation is actually positive for the subordinated notes and that they will be called in June 2016, there is very little upside remaining in the notes which are currently trading at a margin of circa 200bps over BBSW or an expected yield to call of just 4.1%. (pricing accurate at time of writing). Investors may consider removing the uncertainty surrounding the other major contracts and exit positions now given the limited upside but significant, albeit remote, downside risk.
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