Potential takeover target, page-47

www.tamim.com.au/markets--commentary/canaries-in-the-financial-mine

During the recent ASX reporting season, a few results have stood out to us as having warning signs of future stress. Two companies that we are keeping an eye on are Genworth Mortgage Insurance and Challenger, both of which offered soft results. Genworth is an insurer of high Loan to Value (LVR) mortgages. In recent times, the banking regulator APRA has reversed the long term trends with regards to capital rules and has started to apply more regulation on the banks. One of the effects of this increased regulation is that significantly less high LVR loans are being written. Less high LVR loans means less business for Genworth and sure enough they saw their Gross Written Premium fall 3.4% and their Net Earned Premium fall 18.2% over the last year. At the same time, their loss ratio climbed on the back of rising defaults in Western Australia. A slowing top line with increased claims is a terrible combination for an insurer.

Challenger has been a real success story in recent times and has transformed into the largest seller of annuities in the Australian market. Annuities guarantee the underlying investor a fixed payment every year. In order to provide the payment, Challenger takes the capital and invests it in a variety of assets. It is Challenger that takes the underlying risk on those investments. When asset markets perform well, Challenger books the additional profit but when asset prices reverse, Challenger wears the losses. The company reports both statutory and underlying net profit after tax. The underlying strips out the impact of movements in the investment book therefore we suggest investors focus on the statutory. In the last half, investment returns in their infrastructure as well as their equity book reduced profit and given recent movements in bond yields and credit spreads, we would expect at this early stage that the losses in the 2nd half will be more substantial.