I was a reluctant convert to fair value accounting, because I like standardization in accounting that allows for comparisons across corporations.  Also, unlike the complaints that emanate from financial companies that argue that fair value is procyclical, my experience has been that financial companies mismark their assets high, no matter what.

But when I read this article in the New York Times, it hit me.  The reason that the banks complain about fair value accounting being procyclical, is that they are mismatching assets and liabilities.

Think about it.  The argument that the banks make is that they are solvent.  Unfavorable temporary asset price changes should not be reflected in the accounting.  But if liabilities are marked to market at the same time, the difference should be minimal if the cash flows of the assets and liabilities are matched, unless there is a credit problem with the assets.

The thing is, with most banks, they have a large amount of their financing through deposits, savings accounts, CDs, and repo funding, all of which is short-dated, relative to the length of their assets.  (For floaters, look at the maturity, not the reset period.)

Thus, it should be no surprise when a bank is mismatched short versus its assets that it would squawk during times of crisis, and complain about fair value accounting.  But the problem isn’t the fair value accounting; it is the cash flow mismatch.  Banks try to make extra money off of that mismatch in good times, only for it to become a deadly risk in times of bad credit and liquidity.

Let the banks do what the insurers do, and come close to matching assets and liabilities.  If they do that, the financial system will become a lot more stable, and financial crises will be much less common.

And at that point, it won’t matter what accounting system is used, so long as those using book value impair assets fairly.  Still, I would prefer fair value.  Investors deserve the best information, even if it complicates life for corporate managements.

I am rarely a fan of commercial lines insurers. Over the past ten years, it has been the lowest returning sub-industry in insurance. There are several reasons for this: first, asbestos has been an open-ended drag on the industry’s surplus. Second, many commercial lines companies underwrote coverages where those insured understood the risk better than the companies. Examples of this include directors and officers, errors and omissions, surety, environmental, and political risk. Third, the devolving legal landscape has often left commercial lines insurers at a disadvantage in the courtroom. Policies get interpreted as providing coverage in ways not contemplated at the contract’s inception. Fourth, wars over market share depress premium levels.

Commercial coverages are typically larger in size, and do not share in the law of large numbers to the same degree that life and personal lines do. Underwriting results have a greater degree of variability because of this. The greater degree of profit and loss potential attracts less cautious insurance executives, underwriters, and investors. This can lead to tremendous results in the stock market if you buy the commercial lines stocks just as the underwriting cycle shifts from phase 2 to phase 3, such as in 2000. It can be equally bad if you buy them as the underwriting cycle shifts from phase 4 to phase 1, such as in 1998-1999.

Reserving for commercial lines insurers is similar to that for personal lines insurers, but the main difference comes from the uncertainty of claims reporting in long-tailed coverages. With auto and home coverages, most claims are filed and settled within a few months. Almost no claims extend over two years. Now considerable environmental damage coverage: claims could be filed decades after occurrence, settlement could take years, and the size of the claim could be significantly larger than anticipated. This makes reserve setting for commercial lines insurers more of an art than a science.

Secular shifts in society can utterly change the probability and severity of claims. As an example, consider directors and officers [D&O] coverage before and after 2000. Many of the events in the corporate scandals investigated in the last few years came from events in the 1990s. Insurers writing D&O coverage in the 1990s had to raise their reserves for accident years the 1990s but the financial result was felt between 2001 and 2003.

Many industry analysts, including the rating agencies, still believe that reserves are insufficient by roughly $50 billion, and that this black hole is spread among the commercial lines insurers and reinsurers of the world. The soft market accident years of 1997-2001 are blamed for this insufficiency. The question that wins the big money for this space goes to the clever analyst that can figure out to whom the black hole belongs.

The $50 billion insufficiency is probably why the stocks of the commercial lines insurers have gone nowhere over the past six years, even in the face of a very hard insurance market over the past three to four years. Commercial lines insurers are in phase 4 of the underwriting cycle, with modest valuations at present. Until the insufficiency is dealt with, or proven false, it is our belief that commercial lines stock will remain rangebound.

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Bringing it to the Present

Well, in 2004, I was wrong here.  Leaving aside AIG, and its losses, and understated reserves, the commercial lines sector did quite well.  Yes, it is very difficult to value commercial lines insurers, because the reserving is less than scientific.  But the difficulties alleged by the rating agencies failed to appear, unless they were somehow sloshed into the hurricane disasters of 2004-5, or like eating an elephant — one bite at a time.

Earnings quality of commercial insurers is always lower than that of personal lines insurers, so the group should trade at a discount to personal lines, as it does now.  And all that said, personal lines insurers did outperform the commercial insurers, even excluding AIG.

Full disclosure: long CB (they are not cheap for insurance prices, but they don’t argue over paying claims)