December 2010 – Page 2 – The Aleph Blog

Book Review: What Investors Really Want

Posted on 18 December 2010 by David Merkel

Meir Statman wants to tell us about the human condition.? We make bad economic decisions regarding investments.? That comes mostly from having multiple desires regarding investing that are inconsistent.? What are our problems?

We look for free lunches.
We think he past is prologue.
We get hopeful.
We want to look like a winner for friends.
We follow the herd.
We are reckless with money not easily earned.
We save too little.
We want an option on riches, and a guarantee against poverty.
We are loss averse.
We are tax averse.
We want to be accepted into exclusive investments.
We want our investments to reflect our values.
We want fairness.
We want our progeny to thrive.
We don’t know what we are doing, can someone teach us?

The spirit of the book says to me that most people don’t have the vaguest idea on what to do with investments.? They invest for many reasons, many of which are not economic.

This is a reason why pension plans should strip the investment authority away from participants, and put it in the hands of trustees.? Face it, only 20% of people at most know how to invest.? Amateurs have a hard time? distinguishing between the long-run and the short-run.

My take is that one has to unemotional, Vulcan-like, in investing, in order to be successful.? Our feelings, whether of fear or greed, deceive us.? We must resist and suppress our feelings in order to be good investors.? And as for me, it took me 5-10 years to get there.? By the time I was done, I created a system that tied my hands when I would be tempted to make a rash decision.

Quibbles

Page 84 demonstrates how short-sighted people pay up for flexibility, paying credit card rates for extra cash. On pages 96-97, he managed to convince me by bad arguments that the old system of segregating capital and income is correct.? Truth, a market-base spend in rule would float with the 10-year Treasury yield, with adjustment for how optimistic we are about the stock market.? Unless the income taken from an endowment floats with the market, it is not possible to be fair across eras.

The book describes our problems in economic decision-making, but provides no cure.? The last chapter tries to make up for it, by suggesting that an intelligent mix of paternalism and libertarianism would be the best solution.

Yes, that would be the best solution, but the devil is in the details, and the author spells out few of them.

Who would benefit from this book:

Anyone wanting to understand why he makes bad economic decisions would benefit from this book.? That would include most of us, and me.? As you read it, think of how you would change your behavior for your good.? Personally, I have designed my buying and selling methods in the stock market to avoid these troubles, but it means I have to have no emotions in the market, and that is tough to do.

If you want to, you can buy it here: What Investors Really Want.

Full disclosure: This book was sent to me, because I asked for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Flavors of Insurance, Part XII (Summary — The End)

Posted on 17 December 2010 by David Merkel

The insurance industry is a diverse place, with many places to make and lose money. In order to remain on the winning side, I? recommend four basic principles, which were mentioned above:

1.????? Stick with conservative managements. You make money in insurance by not losing it.? Conservative underwriting and reserving allow managements to make economically rational decisions, rather than fruitless market share wars, or giving into sell side analysts with a fixation on top-line growth.

2.????? Focus on companies with sustainable competitive advantages. Insurance is a competitive business; companies that do not have an edge against their competition will likely earn subpar returns.

3.????? Consider companies that can (and do) earn a high ROE over a full underwriting cycle. Anyone can earn money when the market is hard, but who protects your investment when the market for insurance is soft?? Intelligent insurance managements adjust their competitive posture to the market environment.

4.????? Finally, buy them cheap, and sell them dear. Within the above three principles, focus on companies that are out of favor, and sell companies when their prices outstrip their fundamentals. This last principle is the most obvious, which is why it operates inside the contours of the first three principles.

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Bringing it to the Present

I still think these four principles are valid.? They aren’t flashy, and they take some thought, but they focus the analysis in an industry that is difficult to understand.

I try to focus on companies that are good operators; they manage their base of insurance businesses well, rather than those that are clever investors, because the ability to be clever investors over the long run is much harder than being a well-run insurer.

With that, I bring my “Flavors of Insurance” series to an end.? I hope you enjoyed it.? I always wanted to publish it, and if I hadn’t tripped across a very bad copy of it, and had my son Timothy correct the OCR version, this never would have seen the light of day.? So what I wrote 6-7 years ago can benefit a wide audience.? And remember, aside from the “Bringing it to the Present” parts, the original was written in one excruciating, draining day– a labor of love that was frustrated, but now realized.

Special Birthdays for Nerds (like me)

Posted on 16 December 201020 June 2017 by David Merkel

I called my bank today to try to straighten out something.? In the process, they asked my birthday for verification purposes.? I said, ?Twelve, Five, Sixty.? My birthday is special.? It multiplies.?

After a longish pause, the guy on the other end said, ?Huh, it does multiply.? Cool, I wonder how common that is.?? I replied, ?Good question.? I have known that my birthday multiplied since I was seven, but I never thought of that question until you asked it, and I must say that I don?t know.?

Well, now I do know.? Part of the question here stems from two digit date fields ? mm/dd/yy, in the American system. 12 X 5 = 60.? How common is that?

Over a 400 year period, there are 146,097 days.? (365.25 * 4) – 3 days.? No leap years in 1700, 1800, and 1900, but yes, leap year in 2000.

Month	Possible Days
1	31
2	28
3	31
4	24
5	19
6	16
7	14
8	12
9	11
10	9
11	9
12	8

In this situation, over 100 years, there are 212 days where the month and day multiply to be the year.?? That?s 848 over a 400 year period.? February 29^th would work in XX58, but that is never a leap year.

Then I said, why limit it to multiplication, why not consider addition, subtraction and division?? With addition, any combination of month and year will produce a year, so over a 100 year period, there should be 365 additive special birthdays.? February 29^th would work in XX31, but that is never a leap year.? So, 1460 over 400 years.

Subtraction is more scarce for special birthdays.? The potential number of special birthdays in any month is the month number itself.? All of the special days would pack into the beginning of a century, for us ending at 12/1/2011.? 78 per century, or 312 over 400 years.

Finally there is division, which is the rarest.? The number of days in a given month is equal to the number of factors for a month.? In order that would be 1, 2, 2, 3, 3, 2, 4, 2, 4, 3, 4, 2, 6.? That makes 35 over a century, or 140 over 400 years.

So how many mathematically special birthdays are there in total?? Wait, we have to net out double counting.? Without boring you with the math, double counting happens with multiplication and division when the day is one. 02/01/2002 is special for division and multiplication.? Addition and multiplication match for 02/02/2004.? Over 400 years, there are 52 days of overlap in total.

This brings us to the final table:

	Addition	Multiplication	Subtraction	Division	Total
Denominator	146,097	146,097	146,097	146,097	146,097
Special days	1,460	848	312	140	2,708
Percentage	1.00%	0.58%	0.21%	0.10%	1.85%
One in	100	172	468	1,044	54

So, by my definition, one in 54 have mathematically special birthdays.? I?m sure there are other ways to view this, and I look forward to comments from those that will broaden my mind, and/or correct my errors.

Flavors of Insurance, Part XI (Banks and the Insurance Business)

Posted on 16 December 201016 December 2010 by David Merkel

My bias in understanding banks in the insurance business is that banking and insurance are fundamentally different businesses, but there are areas of overlap where the participation of banks sense. In Europe, indiscriminate mingling of the two businesses has usually led to losses. Why?

Though banking and insurance are both described to be financial services, they are different in the terms of financing done, arid service provided. Here are some of the key differences:

Product complexity: Insurance liabilities are typically more complex than bank liabilities; there are more factors that can affect the overall cost of the promises that an insurer makes to a policyholder, than a bank makes to a depositor.
As a result, the liabilities underwritten by an insurance company are usually riskier than those underwritten by a bank.
Because of the relative riskiness of the asset and liability structures, including the greater length of guarantees made, insurance companies generally run at a higher ratio of book equity to assets.
With the longer liability structures, and a highly competitive environment, the investment policy of most insurance companies is more aggressive than that of most banks. Interest rate risk is not generally a problem; most companies attempt to squeeze out interest rate risk by approximately matching assets and liabilities. Most of the risk comes from investing in equities, lower grade corporate debt, and equity risk from the writing annuities. (As the market rises and falls, so do fees received.)
Liabilities are more expensive to originate and service at insurance companies.
There is a high amount of idiosyncratic expense associated with running an insurance company. When a bank buys an insurance company, there are usually few expense savings.
Though there are diversification advantages from a holding company owning both banks and insurers, this advantage often outweighed by the different skills needed to manage the different entities well.

The European experience with banks and insurance companies under the same roof has been mixed. One success has been banks coming to dominate distribution of life insurance products. Banks distribute more than 50% of all life insurance policies in most countries in developed continental Europe. The tendency for banks to sell insurance is strongest in countries where banks are dominant financial institutions aside from insurance.

But there have been failures as well. Most of the failures have been due to a lack of understanding of how different banking and insurance really are. Others have been due to taking too much risk, particularly in unfamiliar countries. Here are some examples:

CSFB buying Winterthur did not grasp how sensitive the performance of Winterthur was to the performance of the equity markets. When the equity markets fell, CSFB had to pump in $2.4 billion of capital.
Allianz did not grasp the poor asset quality of Dresdner, particularly in the midst of a bad market for investment banking
Zurich Financial Services was overly aggressive in the expansion plans in the US, leading them to overpay for marginal asset management companies like Kemper and Scudder.
Aegon, ING, and Prudential plc all suffered by building up leverage through 2000, particularly in their US life insurance subsidiaries, and then got whacked by the combination of the bear markets in equity and credit.

To summarizing the European experience positively, if a bank has strong customer relationships, it can earn additional margins through distribution of insurance products. Negatively, conservatism pays in entering new lines of business and new countries.

The US experience with banking and insurance together has been more limited, due to laws such as McCarran-Ferguson and The Bank Holding Company Act. McCarran-Ferguson, passed in 1945, entrenched the exclusive authority of the states to regulate insurance. The Bank Holding Company Act of 1956, amended in 1970, restricted the insurance activities of bank holding companies.

Until HR 10 was passed in 1999, the Federal Reserve gradually relaxed regulations on bank involvement in insurance companies so long as earnings from insurance activities remained below a threshold. In April of 1998; the merger announced between Citicorp and Travelers forced the need for structural legal change, leading to the passage of HR 10, otherwise known Gramm-Leach-Bliley. HR 10 allowed for the formation of financial holding companies that could engage in banking, investment banking, and insurance, with regulation of mixed entities to be done functionally down at the operating companies, in much the same way it would be done for standalone entities.

When HR 10 was passed, there was a lot of expectation in the insurance industry that the new law would have no large effect. Some observers suggested that life and personal property/casualty insurers might be bought by banks because of investment and product marketing synergies. But most thought that banks would not buy insurance companies, and insurance companies would not buy banks. This expectation has largely been met. Aside from Citicorp, only Bank One has acquired an insurance underwriter of significant size.

Even with Citigroup (ne? Citicorp) the acquisition of Travelers was re-thought. In 2002, Citigroup spun the property/casualty operations off as Travelers Property Casualty, which had a short-lived existence as a standalone company before merging with The St. Paul. Citigroup kept the Travelers life and investment operations (and the logo).

Bank One acquired the US life insurance operations of Zurich Financial Services. This allows Bank One, soon to be a part of JP Morgan Chase, to underwrite life insurance. They presently use it to sell term insurance and annuities.

So, why didn’t banks attempt to enter the life and personal property casualty lines, in general? The quick answer was that they didn’t need to; many already had the benefits that come from distribution of insurance products, without the additional risk of underwriting, the additional hassle of state regulation, and the complexities of managing two disparate businesses. Additionally, the sale of insurance products has tended to be a high ROE business, whereas underwriting, given the stiff capital and reserving requirements, tends to be a low ROE business.

Banks sell 23% of all annuities sold. At present, most of the insurance business that banks do is the sale of annuities. Here is a breakdown of insurance sales done by banks in the US (from LIMRA, as reported in the National Underwriter):

Product	Percentage of Sales
Annuities	68%
Benefits and other commercial lines	16%
Personal Property-Casualty	7%
Credit	5%
Individual Life and Health	4%

Aside from annuity sales, the other major area of insurance activity for banks is the brokerage of employee benefits and commercial insurance. Banks have been aggressive buyers of local insurance brokers; one-third of all sales of local insurance brokerages since 1995 have been sold to banks.

There is logic to banks engaging in insurance brokerage. It deepens commercial relationships within a bank’s footprint, and can even lead to opportunities to expand the geographic scope of a bank as it buys insurance brokerages outside its footprint. Insurance brokerage relationships can lead to new banking clients, and vice-versa.

There are two banks among the top ten insurance brokers in the US: Wells Fargo is fifth, and BB&T is sixth, behind the big insurance brokerage specialists Marsh and McClennan, Aon, Arthur J Gallagher, and Brown and Brown. There are cultural differences between banking and insurance brokerage. A large commitment to insurance brokerage by a bank implies that the brokerage arm will behave like the big insurance brokerage firms that they compete with. Banks with a small commitment to insurance brokerage tend resemble the small brokers that the bank acquired. And in general, insurance brokerage tends to be a more aggressive sales- and customer service-driven culture.

We are not yet at the end of the involvement of banks in the insurance business. Intelligent bankers will use insurance as yet another way to deepen the relationships that they have with commercial, and to a lesser extent, retail clients. In general, we do not expect many banks to take on underwriting risk.

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Bringing it to the Present

All of this is still true today, and banks don’t know what to do with insurance, aside from a few of them selling annuities, like CDs, and being insurance brokers through their business banking relationships.

The last major bit of the Travelers acquisition was unwound as well, as MetLife bought the Life & Annuity business of Travelers for an attractive price.

One correction: in general, we now know that insurers do asset-liability management far better than the banks, and that the banks were considerably overlevered compared to the stable insurers.

I still think the best summary here is: banks can be good marketers of insurance.? They are a logical distribution channel for many lines.? But they don’t do a good job managing insurers.

Insurers may be better at managing their own pup banks, like Allstate and MetLife, but the length of the time of success is too short to be definitive.? Be skeptical of large efforts to blend banking and insurance; it usually doesn’t work.

Full Disclosure: Long ALL

Redacted Version of the December 2010 FOMC Statement

Posted on 15 December 2010 by David Merkel

Comments

They highlight that they have a ?statutory? mandate, and a ?dual? mandate.? They are trying to say that they are required by Congress to do these things, and that it is a tough job.? The flip side is that they admit the Congress has the right to tell them what to do, which Ron Paul may make clear as the Chair of the House?s subcommittee on Monetary Policy.
The question is this: will the mechanisms of credit transmit inflation to goods and services?? So far, it has not.? Lowering the policy rate does little to incent borrowing when enough people and financial institutions are worried about their solvency.
Beyond that, if they succeed, how will it be received on Main Street, especially if price inflation is not accompanied by increases in employment, or is accompanied by higher interest rates or lower stock prices?? Stagflation is not popular.
That said the economy is not that strong.? In my opinion, policy should be tightened, but only because I think quantitative easing actually depresses an economy.? It does the opposite of stimulate; it helps make the banks lazy, and just lend to the government.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
They have no idea why their policy is not working, and they don?t know what to do about it.? Monetary policy works with long and variable lags, so they won?t say that their policy isn?t working.? It?s just slow in taking effect.

Flavors of Insurance, Part X (Conglomerates)

Posted on 15 December 2010 by David Merkel

One major trend that has existed in the insurance industry over the past several decades is increased specialization. This is true globally, but is most true in the US. In general, being good at one area of the insurance business does not confer significant advantages in other areas. This is true in underwriting, which is a specialized talent in each area of insurance. It is also true in market. Cross-selling opportunities across lines of business are not great enough to justify the effort. There are small consolidation advantages in shared corporate staff, and it may be cheaper to finance a large organization than two smaller ones, but those are slim advantages to conglomerate over. In general, we do not expect an increase in the number of major conglomerates; rather, the trend is toward increasing specialization, with increasing scale within a company’s area of specialization.

The most successful conglomerates have tended to be holding companies that allow individual operating companies to act with little coordination. They require results from the subsidiaries, and intervene when the holding company does not get results. The holding company directs the allocation of capital to the businesses that offer the best prospective returns. In one sense, some insurance conglomerates invert the insurance model; they are essentially investment companies, with insurance liabilities issued to provide funds to invest in favored projects. With ordinary insurers liability issuance leads the process.

The excellent performance of the conglomerates group is unique to two companies that are large and do it particularly well: AIG and Berkshire Hathaway. As these companies get larger, it will be increasingly difficult for them to achieve above average performance. It will also be more difficult to do as well without their unique current leaders.

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Bringing it to the Present

Well, when I wrote about this in 2004, I had not yet focused on the growth of debt inside AIG.? The firm I was with owned AIG, and sold into the flood of buying that occured when AIG was added to the Dow.

But I can adjust my views.? Before the time Greenberg was being shown the door, I was bearish on AIG because I thought that leverage was too high, far greater than the rating agencies should allow, which explained why AIG credit traded more like a single-A credit.? I also reflected on my prior days at AIG with more insight than when I was younger, and wondered if it might not be possible that the accounting at AIG was very liberal.? While working there, I was involved with uncovering five reserving errors, each of which should have led to a hiccup in earnings, and in one case, a severe loss.? But the earnings kept going up.

When I have written things like this, I have never gotten flak from people inside AIG; rather, I get e-mails from people inside AIG that have had similar experiences.? Part of the problem was the culture of fear.? When telling the truth is initially derided with force, even if it is eventually accepted if you are strong enough, you will get few people taking the risk to tell the truth.

But without Greenberg, AIG was doomed in the short run.? No one else could manage it, even if it was crooked in some ways.? The truth withheld re-emerged, and those in charge got whupped for the sins of Greenberg.

But what of insurance conglomerates generally?? I don’t recommend them, because synergies are few, and focus is necessary for most effective insurance companies.

Flavors of Insurance, Part IX (Title)

Posted on 14 December 2010 by David Merkel

The title insurance industry is small. How small is it? If you added together the market capitalizations of all title companies, it would be smaller than half the market capitalization of the largest life company. It would be less than 5% of the size of AIG.

Most people view title insurance as a necessary evil, or even a pseudo-tax, when they purchase or refinance a home. The main reason for that is that few people ever experience a fraudulent conveyance of a title to a property. Loss ratios are mid-single digits in percentages. There is no underwriting cycle in title insurance because claims are not a big enough part of the business.

Most of the economic challenge of running a title insurer comes from expense control. Distribution expenses are big; they range around half of premiums. Profit margins are typically a mid-single digit percentage of premiums as well. General and administrative expenses absorb the rest of the premiums.

Title insurers exist to protect purchasers of homes and their lenders from fraud in the conveyance of the title to the property. Title insurance is different, because it protects against events that have happened prior to the inception of the policy. Title insurance allows the gears of buying and selling homes to grind smoothly in the US. If our local governments did a better job of tracking property transactions, perhaps title insurers would not exist, as is true in most of Europe.

Because a large number of title policies are originated because of refinancing, and refinancing comes in waves, expense management is a priority for title insurers. Today, most title insurers employ temporary workforces that they grow substantially during refinancing waves. It is more costly to have temporary employees, but it makes responding to large changes in demand possible.

That interest rates have fallen so much has driven many of the title insurers to seek avenues of diversification, because opportunities to originate policies because of refinancing will likely not be as big in the next ten years as it was in the last ten. Most of the diversification is taking place in real estate related industries, thus leveraging off of existing competencies and relationships. Other efforts have been into other financial businesses including asset management, trust services, and credit verification services. The jury is still out on whether these diversification efforts will pay off; still to this point, no major company in the space has less than 75% of profits coming from lines of business other than title insurance.

For a business that sounds so marginal, why have the stocks done so well over the past ten years? A combination of three factors made it so: first, valuation levels were low back in 1994, as refinancing slowed down marked when rates began to rise. Second, there are barriers to entry; creating a new title insurer would involve creating or purchasing new databases of property records, which would be prohibitively costly. Third, falling interest rates since 1994 created three major refinancing waves that allowed for the issuance of many additional policies. Because interest rates are low now, and valuations considerably higher than where they were in 1994, we are less optimistic on high returns for the sub-industry for the immediate future. It is also possible that new title products, such as lien protection products, may eat into gross margins. That hasn’t happened so far, but it is another thing to watch.

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Bringing it to the Present

The big four became the big three.? LandAmerica died, which was the company I thought was the most reckless (note my comments at RealMoney).? The two large companies, FAF and FNF went through transformations, selling off their arms that did everything except title, unlocking a lot of value in the process.

Lien protection products ended being a big zero.? Perhaps that could have been a way for the GSEs to justify their existence, but no.

And yet, title insurers took some real losses from the financial crisis.? Not surprising, given the open-ended nature of title claims, and the degree of potential for fraud when real estate is sagging dramatically.

Just as residential real estate will take a while to settle, so will it be the same for title insurers.

Flavors of Insurance, Part VIII (Financial)

Posted on 12 December 2010 by David Merkel

Financial guarantee insurers insure creditworthiness in a number of related, but different areas. They insure home mortgages for lenders who accept low down payments. They insure the debt of municipalities, who often find it cheaper to sell insured debt. In structured finance they guarantee the senior-most debt branches of residential mortgage [RMBS], commercial mortgage [CMBS], and asset-backed securities [ABS]. In the corporate credit arena, they guarantee the senior-most debt branches of collateralized debt obligations, and occasionally, single issuer project finance.

There are generally two types of companies in this sub-industry, with a slight overlap of business between them. One group guarantees low down payment mortgages for lenders. The other group engages in the rest of the businesses listed above. Financial guaranty and mortgage insurance are regulated separately from other types of property and casualty insurance. For the most part, companies that engage in these lines of business are specialists, though their continued high profitability is attracting new entrants.

Financial guaranty insurers have a primary function of credit enhancement for the corporate, municipal and consumer credit. In this function, securitization both competes with and facilitates their business. RMBS, CMBS and ABS can be structured as insured deals, or as deals where the senior bonds are protected by subordinated bonds sold to institutional investors at yields appropriate to compensate them for the risk. Even so, insured bonds trade with greater liquidity than uninsured bonds. The financial guaranty insurers are vital to the smooth functioning of structured finance.

The mortgage insurers have faced problems in the recent past. Loss experience on subprime borrowers has been disappointing. There have been bulk loan transactions that have also had poorer loss experience than ordinary transactions that flow one-by-one from lenders. Mortgage insurers are adjusting their pricing to reflect the differing loss costs.

In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.

There are yet other threats that mortgage insurers face. Fannie and Freddie could get their charters adjusted to allow them to accept uninsured mortgages with lower down payments. Large lenders could decide that they don’t need insurance for loans that they keep on balance sheet. Second mortgages compete with mortgage insurance. Inflated appraisals inflate the true amount at risk to the mortgage insurers. Finally, refinancing makes it difficult for the insurers to retain business on their books.

Aiding the mortgage insurers is the continued price appreciation of housing, which lowers the incidence and severity of claims. Homes are critical to most people who own them; it usually is the last thing that people will miss a payment on. Finally, there are significant barriers to entry for new competitors in the mortgage insurance business.

With the financial guaranty insurers, the issues are different. The amount of leverage is huge; the face amount of debt insured at a AAA financial guaranty insurer can be more than one hundred times greater than their surplus. Financial guaranty insurers underwrite to a zero loss tolerance. In other words, every transaction is expected to produce no losses; anything less than that would make the ratings agencies downgrade them severely.

Balance sheet complexity is large in terms of the many contingencies insured. Remember our phrase “too smart for your own good risk?” That may apply here. The rating agencies consistently affirm that these insurers are AAA, but we will argue that the rating agencies are co-dependent with them. The financial guaranty insurers indirectly generate a lot of revenue for the rating agencies. If an insurer begins to slip, initially it would pay the ratings agencies to delay the recognition of that, and work with them to lower leverage; the damage to the ratings agencies and financial guarantee insurers from a downgrade of a financial guarantee insurer to less than AAA would be huge. It would throw into question many of the fundamental underpinnings of the structured securities markets. It would also lead to turbulence in the AAA-only portion of the fixed income markets, which are quite large, but can’t deal with any degree of uncertainty.

Against this, the financial guarantee insurers have the following big advantage: they only guarantee the timely payment of principal and interest of obligations. If it is to their advantage to pay off the obligation immediately, they will do so. If it is to their advantage to string out the payments, they can do that as well. In a time of financial stress, the financial guaranty insurers can pay off claims slowly, and reduce the writing of new business, which would allow them to delever rapidly.

The twin engines of the rise of structured finance and low down payments on mortgages amid a rapidly growing housing market have fueled the performance of this sub-industry. The stocks in this industry have performed well. Valuations today are not outlandish, but they are kept low by the concerns that we have listed above.

In general, we believe that the future will be more risky for this sub-industry than the past. Both engines of growth will be slower in the future. In addition, the mortgage insurers have to contend with borrowers that are reliant on the low interest rates on ARMs in order to continue making payments on their homes. Consumer credit is overextended, and that will affect the loss experience on RMBS and ABS.

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Bringing it to the Present

I wish I had screamed louder.? Yes, I told the party line story back in 2004, but I tried to highlight the risks involved.

When I went to work for Hovde, I had a hierarchy of trust for reserving:

Life
Personal lines / Health
Commercial Lines
Reinsurance
Title
Financial

Financial insurers and mortgage insurers have proven less than sound.? They are just another example of what happens when leverage collapses.

As a bond manager, I never trusted the rating agencies on structured finance.? I wanted my AAA bonds to be AAA without support.

The financial insurers were too critical to the system.? We needed them to work.? That should have been the signal that something was wrong.? When something has to work, we are in big trouble, that is a sign that things are out of balance.

As it is now things are broken, and we are in an intermediate state where we are waiting for guarantors to be created.? The system needs third parties to take risks for pay.

Flavors of Insurance, Part VII (Health)

Posted on 11 December 2010 by David Merkel

Health insurers have changed over the past thirty years. Thirty years ago, health insurers were strictly indemnity-based, and there were many of them. Many multiline insurers had health insurance subsidiaries. The creation of HMOs and Preferred Provider Organizations [PPOs] were innovations that helped lead to a consolidation in the sector. Today few health insurance providers are part of multiline insurers. Health insurers are specialists.

Another trend among health insurance is the slow but steady demutualization of Blue Cross/Blue Shield affiliates. The greatest expression of this is found in the merger of Anthem and Wellpoint, where the combined entity covers thirteen states, and makes it the second largest health insurance provider in the US.

Health insurance only became a profitable venture on an underwriting basis recently. If you added up underwriting profits and losses from health insurance through the 1990s, the profitability was breakeven. Since then, expense control on medical providers and at health insurers helped bring the group to sustained profitability. Part of that might be attributable to larger health insurance companies gaining additional bargaining power. The increase in market share of the major health insurers has helped to raise barriers to entry in the space. It is difficult to replicate the advantages of the largest health insurers in terms of buying power, or in terms of the ability to service national accounts.

People in the United States want the best of two incompatible worlds with health care. They want it to be inexpensive to users, and yet be available “on demand” with services of the highest-tech nature. Individuals and firms want it to be socialistic if their own costs are heavy, and “free market” if they are small. Add onto this the demand of perfection of results, enforced by tort attorneys, which drives up costs. Doctors practice defensive medicine in order to avoid malpractice claims, which is costly.

Because of their buying power, government-related purchasers of health care also tend to be price-sensitive purchasers of health care, leading health care providers to shift costs to private purchasers that are price-insensitive in the short run. Health insurers are middlemen in this situation, attempting to deal with the conflicting goals of controlling costs, while providing an amount of services that keeps users of the system happy.

Because of the foregoing, costs have been rising at rates in excess of the inflation rate in the general economy. There is consistent political pressure against the profits of health insurers, but it has not affected profit margins over the past three years. The health insurers have been able to pass through their cost increases so far, but the possibility of government actions makes future results less predictable.

The stock performance of the health insurers was fairly flat through the end of the nineties. In the 2000s, return improved dramatically, due to the advantages of scale and expense control. The advantage of scale is not going away, but the above average profits of the last four years may prove difficult to maintain, as the government will find it difficult to not increase regulation in response to complaints over high health insurance premiums in the face of what are viewed as high profits.

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Bringing it to the Present

After fighting off federal regulation 2004-2008, health insurers did a deal with the devil, deciding that it would be better to be health utilities than dead.? At this point, I do not know how things will go:

Will ObamaCare be ripped out two+ years from now?
Will ObamaCare be defunded?
Will ObamaCare persist?
And if there are changes, what will replace the current system?

The one thing presently in favor of the health insurers is the graying of the Baby Boomers.? There will be increased need, but how will it be filled?

On Book Reviews

Posted on 11 December 2010 by David Merkel

When I started Aleph Blog, I had no idea that I would do so many book reviews.? When I wrote for RealMoney, my wife noted that I stopped reading books.? “Don’t have time,” was my reply.? It’s not that I have more time now, but that I am using my time better.? I always have a book with me, and when I get a break, I read.? My wife tells me she could never read a book that way.? I tell her that I must do it that way, or the books will not get read.

One surprise to me is that the publishers are so free with their books.? When I ask for a book, I get it 80% of the time.? And I get books that I would never have thought of asking for.? PR flacks contact me and ask if I am willing to do something special for their author.? The answer is usually “no,” but for special books I will do more.

The books that I ask for usually get better reviews than the ones that come gratis.? There is a degree of self-selection here; I choose books that I am likely to like.

I receive books.? They presently fall into these categories:

Read, but not reviewed (7 at present)
Reading (1 book at a time)
Hot books (3 at present)
Waiting (10 books)

I read the books that seem the most promising.? Since I never promise to review a book, occasionally a book will get dropped from the review queue after a scan.? My objective is to highlight good books for readers, and warn on popular books that should be avoided.

But let me point out a bias of mine.? I think it is hard to write good books on asset allocation, technical analysis, or quantitative investing.? Why?? The books overpromise and underdeliver.? There are no easy solutions when all you need to know is the math, because the computers at hedge funds mop up those inefficiencies easily.

I would like to write a piece on how to write a good investment book, but I shy away from writing it, because I have never written a book, and who am I to dictate to those who made the effort to write a book.

But all that said, I have been asked by readers to rank my book reviews.? Well, here it is.? Please understand that the rankings are often close, and I don’t put a lot of weight into them.? I did my best, but if there is no link to buy the book at Amazon, it is because I think no one should buy it.? Note to Michael Covel: to that degree, you are on my buy list.

So here is my list of book reviews, sorted by category and rank:

Review	Amazon Stars	Category	Rank in Category	Amazon Widget
Book Review: Financial Shenanigans	5	Accounting	1	Financial Shenanigans
Book Review: Quality of Earnings	5	Accounting	2	Quality of Earnings
Book Review: Early Warning and Quick Response	4	Accounting	3	Early Warning and Quick Response
Book Review: Dynamic Asset Allocation	3	Asset Allocation	1	Dynamic Asset Allocation
Book Review: 7Twelve	2	Asset Allocation	2
Book Review: The Flexible Investment Playbook	1	Asset Allocation	3
Book Review: Co-opetition	5	Business	1	Co-Opetition
Book Review: Warren Buffett on Business	4	Business	2	Warren Buffett on Business
Book Review: All the Devils are Here	5	Crisis	1	All the Devils Are Here
Book Review: Street Fighters	5	Crisis	2	Street Fighters
Book Review: Complicit	5	Crisis	3	Complicit
Book Review: Confidence Game	5	Crisis	4	Confidence Game
Book Review: Slapped by the Invisible Hand	4	Crisis	5	Slapped by the Invisible Hand
Book Review: 13 Bankers	4	Crisis	6	13 Bankers
Book Review: Financial Shock	3	Crisis	7	Financial Shock
Book Review: When Giants Fall	2	Crisis	8
Book Review: The Volatility Machine	5	Economics	1	The Volatility Machine
Book Review: Priceless	5	Economics	2	Priceless
Book Review: Fault Lines	5	Economics	3	Fault Lines
Book Review: Where Keynes Went Wrong	5	Economics	4	Where Keynes Went Wrong
Book Review: Monetary Regimes and Inflation	4	Economics	5	Monetary Regimes and Inflation
Book Review: Making Sense of the Dollar	4	Economics	6	Making Sense of the Dollar
Book Review: Secrets of the Moneylab	3	Economics	7	Secrets of the Moneylab
Book Review: The Economics of Food	3	Economics	8	The Economics of Food
Book Review: Manias, Panics, and Crashes	5	History	1	Manias, Panics, and Crashes
Book Review: Devil Take the Hindmost	5	History	1	Devil Take the Hindmost
Book Review: This Time Is Different	5	History	2	This Time Is Different
Book Review: 100 Minds That Made The Market	5	History	3	100 Minds That Made the Market
Book Review: The Trouble With Prosperity	5	History	4	The Trouble With Prosperity
Book Review: The Wall Street Waltz	5	History	5	The Wall Street Waltz
Book Review: Mr. Market Miscalculates	5	History	6	Mr. Market Miscalculates
Book Review: Reminiscences of a Stock Operator (Annotated Edition)	5	History	7	Reminiscences of a Stock Operator Annotated Edition
Book Review: The Myth of the Rational Market	5	History	8	The Myth of the Rational Market
Book Review: Wealth, War & Wisdom	5	History	9	Wealth, War and Wisdom
Book Review: Once in Golconda	4	History	10	Once in Golconda
Book Review: The Last of the Imperious Rich	4	History	11	The Last of the Imperious Rich
Book Review: Fallen Giant	4	History	12	Fallen Giant
Book Review: A History of Interest Rates	4	History	13	A History of Interest Rates
Book Review: The Intelligent Investor	5	Investing	1	The Intelligent Investor
Book Review: The Aggressive Conservative Investor	5	Investing	2	The Aggressive Conservative Investor
Book Review: Dear Mr. Buffett	5	Investing	3	Dear Mr. Buffett
Book Review: The Only Guide to Alternative Investments You?ll Ever Need	5	Investing	4	The Only Guide to Alternative Investments You’ll Ever Need
Book Review: Margin of Safety	5	Investing	5
Book Review: Buffett Beyond Value	4	Investing	6	Buffett Beyond Value
Book Review: The Only Three Questions That Count	4	Investing	7	The Only Three Questions That Count
Book Review: Super Stocks	4	Investing	8	Super Stocks
Book Review: The Dick Davis Dividend	4	Investing	9	The Dick Davis Dividend
Book Review: Diary of a Hedge Fund Manager	4	Investing	10	Diary of a Hedge Fund Manager
Book Review: The Elements of Investing	4	Investing	11	The Elements of Investing
Book Review: Outperform	4	Investing	12	Outperform
Book Review: Market Indicators	4	Investing	13	Market Indicators
Book Review: Why are we so Clueless about the Stock Market?	4	Investing	14	Why Are We So Clueless about the Stock Market?
Book Review: TradeStream Your Way to Profits	3	Investing	15	TradeStream Your Way to Profits
Book Review: 7 Commandments of Stock Investing	3	Investing	16	7 Commandments of Stock Investing
Book Review: Higher Returns from Safe Investments	2	Investing	17
Book Review: Buying at the Point of Maximum Pessimism	1	Investing	18
Book Review: Soros on Soros	5	Macro Investing	1	Soros on Soros
Book Review: The Alchemy of Finance	5	Macro Investing	2	The Alchemy of Finance
Book Review: The Great Reflation	5	Macro Investing	3	The Great Reflation
Book Review: The Predictioneer?s Game	5	Miscellaneous	1	The Predictioneer’s Game
Book Review: Navigating the Financial Blogosphere	4	Miscellaneous	2	Navigating the Financial Blogosphere
Book Review: Book of isms	4	Miscellaneous	3	The Economist Book of isms
Book Review: While America Aged	5	Pensions	1	While America Aged
Book Review: Pension Dumping	5	Pensions	2	Pension Dumping
Book Review: Easy Money	5	Personal Finance	1	Easy Money
Book Review: That Thing Rich People Do	5	Personal Finance	2	That Thing Rich People Do
Book Review: The Bogleheads? Guide to Retirement Planning	4	Personal Finance	3	The Bogleheads’ Guide to Retirement Planning
Book Review: The Insured Portfolio	4	Personal Finance	4	The Insured Portfolio
Book Review: How to Be the Family CFO	1	Personal Finance	5
Book Review: Finding Alpha	5	Quantitative Investing	1	Finding Alpha
Book Review: Investing By The Numbers	5	Quantitative Investing	2	Investing by the Numbers
Book Review: Triumph of the Optimists	4	Quantitative Investing	3	Triumph of the Optimists
Book Review: Quantitative Strategies for Achieving Alpha	4	Quantitative Investing	4	Quantitative Strategies for Achieving Alpha
Book Review: The Complete Guide To Option Pricing Formulas, and Derivatives	4	Quantitative Investing	5	The Complete Guide to Option Pricing Formulas
Book Review: Models on Models	4	Quantitative Investing	6	Derivatives Models on Models
Book Review: Two Books on Options by Anthony Saliba	4	Quantitative Investing	7	Option Spread Strategies? Option Strategies for Directionless Markets
Book Review: The Guru Investor	3	Quantitative Investing	8	The Guru Investor
Book Review: Beating the Market, 3 Months at a Time	3	Quantitative Investing	9	Beating the Market, 3 Months at a Time
Book Review: The Fundamental Index	3	Quantitative Investing	10	The Fundamental Index
Book Review: Nerds on Wall Street	3	Quantitative Investing	11	Nerds on Wall Street
Book Review: Expectations Investing	2	Quantitative Investing	12	Expectations Investing
Book Review: What Works on Wall Street	2	Quantitative Investing	13	What Works on Wall Street
Book Review: Quantitative Equity Investing	2	Quantitative Investing	14
Book Review: The New Science of Asset Allocation	2	Quantitative Investing	15
Book Review: The Quant Investor?s Almanac 2011	1	Quantitative Investing	16
Book Review: Fortune?s Formula	5	Risk Control	1	Fortune’s Formula
Book Review: Risk and the Smart Investor	5	Risk Control	2	Risk and the Smart Investor
Book Review: No One Would Listen	5	Risk Control	3	No One Would Listen
Book Review: MarketPsych	4	Risk Control	4	MarketPsych
Book Review: Who Can You Trust With Your Money?	4	Risk Control	5	Who Can you Trust with Your Money?
Book Review: The Flaw of Averages	3	Risk Control	6	The Flaw of Averages
Book Review: The Club No One Wanted To Join	3	Risk Control	7	The Club No One Wanted To Join
Book Review: Think Twice	2	Risk Control	8	Think Twice
Software Review: Dragon NaturallySpeaking, Version 11	5	Software	1	Dragon NaturallySpeaking Home, Version 11
Book Review: The Heretics of Finance	4	Technical Analysis	1	The Heretics of Finance
Book Review: Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell	3	Technical Analysis	2	Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell
Book Review: Trend Following	2	Technical Analysis	3	Trend Following
Book Review: The Ten Roads to Riches	4	Wealth	1	The Ten Roads to Riches
Book Review: Rich Like Them	4	Wealth	2	Rich Like Them

If you want to read a review, click on the left link.? If you want to buy, click on the right link.

Full disclosure: If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Full disclosure: This book was sent to me, because I asked for it.