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“Is He Economically Rational?”

At AIG in the early ’90s on the life side, some of the actuaries had a phrase “economically rational.”  When a new person would come into some position of power that we had never dealt with before, we would ask others who knew him better, “Is he economically rational?”  (“He” applies to females as well as males.)

Now economically rational could mean two things:

  • He is economically rational for the company, and thinks like an owner.
  • He is economically rational for himself, and thinks like a worker.

When we/I used the phrase, we meant the former, not the latter.  It implies a very different standard of behavior than merely trying to get the best for yourself — you are trying to faithfully serve the company that employs you.

Insurance is the most complex industry in accounting terms.  In simple terms, that is because when a sale is made, you have little idea what the “cost of goods sold” is.  The cost varies in time and severity.  That complexity meant that there were a lot more games that could be played with the accounting, and the games could go on for a long time.

If you were out for the good of the company, you would aim for organic growth where it made sense, but close down lines of business where it did not make sense.  Now, when you are trying to close down another person’s line of business because it does not earn enough, you might run into some opposition.  And so I did, several times on flawed business that had been, and was being written by the domestic life companies.

It may seem lousy to shut businesses down, but when the underwriting is losing large amounts of money, it is a mercy to the company and its shareholders.

I have known many people in insurance that talk a good game, but in reality, they aren’t doing much.  They may play with the accounting to make things look good.  They may cram sales out the door in the short run, but the quality is bad.  They may boast of big sales in the past, but they don’t deliver when you hire them.  They claim to be a good claims manager, and they settle a lot of claims, but then you find that all the tough cases are stagnating in their bottom left hand drawer.

But the worst is when it reaches to a CFO or a CEO.  The Peter Principle propelled him into office, and the CFO manipulates the earnings, or the CEO takes actions to make it look like he is doing something, when it is not adding to value.  Worse is when the incentives are misaligned, and they sacrifice real profitability to meet incentive targets.

That’s why I believe that pay incentives should be based on growth in book value plus dividends over 3-5 years, with book value being “old style” book, not taking in market value elements.  It has to be long enough to take in a full economic cycle.

Now the phrase “economically rational” does have utility in this respect — the first definition would mean the same thing for everyone — acting like an owner.  The second definition is every man for himself.

I ran into the same situation at companies I served before and later.  Were financials being managed for the good of the owners, of the good of the leading managers?  Sometimes it was owners, sometimes it was managers, and sometimes it was greedy managers.  I remember being disillusioned when the guy who hired me for my first job had used me to tweak earnings higher (I didn’t get it until a years later).  He had left to start something new.  I never saw him again.

I liked my work most when we were acting like owners.  It forced us to be more creative, and take prudent risks.  On imprudent risks, I remember a boss praising me for not putting the company at risk on floating rate Guaranteed Investment Contracts, when I proved it was too risky.  When several of my competitors failed shortly thereafter, I was vindicated.  But being a good businessman, I called those who would want floating rate GICs but no one was willing to lower their yield demands for the contracts.  They weren’t economically rational, and we abandoned the market.

At another company, a chief actuary who would eventually be shown the door for malfeasance, said to me, “We are losing business to these five companies.  Why can’t the investment department make money like they do!?”

I did heavy due diligence.  It was a perfect question to ask me, because my skills on both sides of the balance sheet were significant.  I came back to him and said, “Four of the companies are taking risks far beyond what anyone else in the industry is taking.  In a bear market, they will die.  The last one has a weird holding company structure that allows them to lever up more.  If you want the ask [the parent company] for a similar deal.

Within one year, two of the competitors died, and my explanation of it put me on Jim Cramer’s radar; he even posted what I wrote. Within three years, another had died, and one merged into another entity.  After seven years, the last merged into another entity.  They all were gone.

So what is the value of all this?  I think of it as training to understand managements — see if they act like owners maximizing long-term profits, or as workers aiming to maximize their pay packets.  You will earn more with companies that think like owners.

Now after all of this, it’s not so much a question of rationality but ethics.  Who will do the right thing for the one he ultimately serves?  Working for those people is a joy, and is beneficial to those that own. Doing right does well for many.

 






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2 Responses to “Is He Economically Rational?”

  1. RedSt8r says:

    David:
    Your previous post asked, “Get the US Government Out of Lending & Insurance Businesses”. I submit that our political class, regulatory agencies and miscellaneaous bureaucrats are very much “thinking like workers”. It does explain why government won’t get out of any business. The individuals profit from it at the expense of the highly diffuse taxpayer owner.

  2. [...] David Merkel, “You will earn more with companies that think like owners.”  (Aleph Blog) [...]

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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