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%.
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 90's, 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 90's, 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."
Under-reserving was indeed an industry-wide phenomenon during this period. But the scale of ERC's deficiencies is epic. Was the unit blind-sided or was it straining to deliver the double-digit earnings growth Welch always expected? Was anything illegal done? That is unclear.
At the end of 2001, ERC had net property and casualty reserves of $12.3 billion. The $9.4 billion in eventual additions means there should have been 76% more there when Welch handed Immelt the executive-washroom keys. Compare ERC's reserve deficiency with that of its larger competitor Gen Re, owned by Buffett's Berkshire Hathaway since late 1998. Gen Re had its own underwriting woes in the late 90's. It's taken a total reserve charge of $1.9 billion since 2001, principally linked to "the 1997 through 2000 accident years," Buffett ruefully noted in Berkshire Hathaway's 2004 annual report. Yet $1.9 billion is a mere 14% addition to the $13.6 billion in total net reserves that Gen Re carried in late 1998, the last reporting year before Gen Re was acquired by Berkshire.
ERC has long been part of GE Capital, a financial unit whose businesses included everything from equipment leasing and insurance to consumer and commercial finance. Under Welch, GE Capital delivered double-digit earnings gains, year in and year out, regardless of what was going on in the financial markets. At its peak in the 90's, the unit was generating about 45% of GE's earnings.
To some observers, GE Capital was always something of a black box during its glory years. It sailed through the late 80's/early 90's collapse in commercial real estate with nary a scratch, despite having to foreclose on a number of properties. The story was much the same for its onetime huge leveraged-buyout loan portfolio. The collapse of Montgomery Ward in 2000 caused not a hiccup in GE Capital's earnings, even though it had loaned hundreds of millions of dollars to the retailer. And GE Capital, a major aircraft lessor, has flown unscathed through the airline industry's crisis. Nonrecurring capital gains from GE Capital's insurance and equity portfolios always seemed to make up for any tough quarter.
Analysts covering GE, mostly manufacturing geeks, didn't delve deeply into GE Capital, even though it was the top contributor to its parent's earnings, because it was outside their sphere of expertise.
To his credit, Immelt appears to have somewhat reined in the free-wheeling culture at GE Capital, which he's restructuring. Since becoming GE's leader, he has been dumping GE Capital's insurance operations, including bond insurer FIGIC, its Japanese life insurer and a U.S. auto insurer, and is sharply reducing its interest in Genworth, a mortgage-guarantee and life-insurance outfit. After selling Insurance Solutions, GE will be all but out of the risky reinsurance game. Immelt also has improved transparency at GE Capital by breaking it into several separately reporting units.
Immelt was dealt a weak hand when he took over. He had to contend with the global economic slump, heavy claims losses from 9/11, collapsing profitability in the plastics market, plummeting demand for power systems and a vicious aircraft-sale downcycle. Immelt has handled these problems while pouring cash into Insurance Solutions' reserves and restructuring GE Capital. Earnings in 2002, 2003 and 2004 rose only 2.9%, 7.1% and 6.6%, respectively numbers Welch would sneer at. Yet GE seems to be regaining its mojo.
This year, it probably made $1.72 a share, 6.8% above 2004's figure. But Immelt has forecast 12%-17% 2006 earnings growth from continuing operations, which would produce earnings of $1.92 to $2.02 a share. (The Street's consensus estimate is $1.98.) The '06 figures exclude Genworth and Insurance Solutions, as discontinued operations.
For Welch, the disclosure of the under-reserving is the latest blow in a retirement marked by a lucrative second career as a speaker, consultant and writer, along with some unflattering revelations.
First, there was a nasty divorce from his second wife, Jane Welch, incensed by his affair with Suzy Wetlaufer, then the Harvard Business Review's editor and now Mrs. Welch No. 3. Divorce papers disclosed the gold-plated contract Welch got from GE in the mid-'Nineties, which granted him lifetime perks, including free use of an $80,000-a-month New York apartment and a corporate Boeing 737, reimbursement for restaurant meals, access to GE seats at sporting events, and payment for country-club and security fees.
Welch quickly renounced the package, which seemed excessive for someone whose employment at GE already had vaulted him into Forbes' 2001 list of the 400 richest Americans, with an estimated net worth of $680 million, in part helped by the sterling performance of GE stock in his last years at the helm.
Welch is still a totemic figure in Corporate America. On Wall Street, he remains Jumpin' Jack Flash, as one analyst admiringly dubbed him, for his cheerleader verve, canny management insights and star power. But, like many stars, his celebrity seems to have depended as much on appearances as performance. Without the ERC smoke machine, GE's 1997-2001 numbers would have been far less lustrous.
Still, he's likely to remain a legend, though now in more senses of that word than before.