On Complexity in Financials, and Insurers Specifically

I’m not a fan of complexity in financial companies.  Complexity is a sign of trying to be” too clever by half,” as the British might say.  If an economic idea is good it can be executed simply.  Complex financial business stems from a desire to do accounting, regulatory, and other arbitrage.

Like my piece on AIG in 2009, I am doing low level research on an insurer using the statutory data.  Let me give an example of what I mean.

There is no economic reason to have internal reinsurance treaties aside from sharing losses on short duration coverages.  To have large internal reinsurance credits is a sign that you are passing your reserves to the subsidiaries in domiciles with weak rules.

Also, to have a complex organization chart means that you are taking advantage of weak reserving requirements, capital requirements, except to the extent that national requirements call for a separate subsidiary.

Things are also tough when you interlace the capital of your subsidiaries, whether through equity, preferred stock, trust preferreds, or debt.  And with insurance companies, surplus notes.

That’s one reason why investment banks trade at low valuations, and might be better to be broken up.  Complexity.  “If you are not buying a Sunkist orange, you don’t know what you are eating.”  Okay, that dates me, but if the financials of a company are not transparent, in this environment, they will trade at a discount.  That is what I have said to reporters who have called me.  Complexity deserves a discount.  Level 3 assets deserve a discount.

Also, under-reserving deserves a discount, when you see significant claims arise out of prior year business.

Good financial businesses are simple and have few complexities to make them look like they are trying to scam the accounting rules.  Please remember my folly with Scottish Re, where I was a bull, and when it  got into trouble, I did a deep analysis, and turned into a bear.  When the company announced superficial changes and the price almost doubled, we sold out, though we held ~5% of the stock in a very busy day.  Where did the stock go out at? Zero.  Do I feel bad for losing money? Yes.  Do I feel good for cutting losses? Yes, and even more so.  Risk control is important.

Scottish Re was Bermuda domiciled, and so we didn’t get as much data as with a US domiciled company, but I had enough in the SEC-required documents to see the morass that Scottish Re was in, and the lack of ability for cash to flow to the publicly-traded holding company.

Financials are tough to invest in and the simpler that they are, the better.  To the degree that you can see that margins are assured, they are safe, but that is tough to assure.

Financials require extra caution.  That is most of what I am trying to say.