Unum's Long-term Care Exposure Creates Uncertainty

Unum (UNM) is a leading provider of disability, group life, and related insurance products. These businesses serve primarily employers' health plans, resulting in long-term relationships that have delivered predictable results; Unum's premiums and earnings have grown at a mid-single digit clip most years, and the company has paid steady dividends since 2004.

However, there's more to Unum's story. The company's "Closed Block" division, which accounted for less than 10% of earnings last year, consists mostly of long-term care policies Unum sold decades ago. The firm stopped offering these policies in 2012 but remains on the hook for their future benefit claims.

Long-term care insurance essentially pays for assisted living and nursing home stays when the insured can no longer take care of themselves due to various limitations. Benefits can be paid for a period of several years or an entire lifetime.

Compared to most other insurers, Unum's exposure to long-term care is relatively high when looking at its reserves. Reserves represent claims that insurers estimate they will eventually pay to their policyholders.

At the end of 2019, Unum had recorded $12.1 billion of long-term care reserves on its balance sheet, representing about 30% of its overall policy reserves.

For comparison, MetLife (MET), Prudential (PRU), and CNA Financial (CNA) recorded long-term care reserves representing only 6%, 3%, and 15% of their total reserves, respectively. Genworth Financial's (GNW) reserve exposure to long-term care is 65%, and it has a B junk credit rating from S&P.

Sizing up the total liability of long-term care policies is difficult, which makes an insurer's relatively high exposure to this part of the market a bit uncomfortable.

The present value of future benefits depends on a number of sensitive assumptions around discount rates, how long benefits will be paid for a claim, life expectancies, claim incidence rates, and more.

Expected liabilities for long-term care policies have ballooned in recent years thanks to stubbornly low interest rates and lower mortality rates, according to S&P. 

If an insurer becomes significantly under-reserved because its policies turn out to be much more expensive than it initially assumed, then it risks racking up a large loss or even going bankrupt in some extreme cases.

Unum last reviewed its long-term care reserve in 2018, recording a $750 million charge since it was found to be under-reserved. However, long-term interest rates, which reduce Unum's investment income and increase the present value of future liabilities, have continued falling since then.

Unum previously disclosed that a 0.25 basis point fluctuation in the discount rate would impact its reserve margin by about $500 million, all else equal. Some analysts believe the company's reserves are understated by at least $5 billion.

That's a scary number compared to the size of Unum's business, which generates about $1 billion of profit annually. Regulators also require insurers to maintain a minimum amount of risk-based capital to support their business operations.

Unum's risk-based capital ratio, which divides its "capital and surplus" (similar to equity) by the minimum capital amount required by regulators, has declined from 405% in 2016 to 365% in 2019.

That's still a healthy level (regulators would likely intervene if the ratio dipped below 200%), but the firm's capital and surplus balance of about $3.6 billion could shrink quickly if a multibillion-dollar reserve charge is required by its long-term care business in the future.

Simply put, Unum's elevated exposure to legacy long-term care policies creates a cloud of uncertainty around the company's valuation and long-term financial outlook.

As a result, we are downgrading Unum's Dividend Safety Score to Borderline Safe.

If Unum eventually takes a substantial charge for its long-term care business, forcing it to set aside more capital, then its dividend has potential to come under pressure.

After all, in this industry regulators must approve any dividends that exceed the greater of 10% of a firm's prior year capital and surplus or net income, and both measures would plunge. (Unum's dividend totals about $230 million compared to a capital and surplus balance of $3.6 billion and net income around $1 billion.)

Overall, insurance is a complex industry due to the numerous assumptions required to price policies, gauge risk, and estimate future benefit claims. Long-term care is an especially dicey area of the market.

Unum's dividend may not face any imminent pressure, and it's possible that its long-term care business is more solid than some analysts believe. However, as conservative investors, we prefer to invest in simpler businesses that have more in their control and aren't exposed to potentially game-changing future liabilities.