The Aleph Blog » Blog Archive » The Education of an Investment Risk Manager, Part VIII

The Education of an Investment Risk Manager, Part VIII

“So you’re the new investment risk manager?”

“Yes, I am,” I said.

CA: “Well, I am the Chief Actuary for [the client firm].  I need you to do a project for me.  We have five competitors that are eating our lunch.  I want you to figure out what they are doing, and why we can’t do that.”

Me: “I’ll need to get approval from my boss, but I don’t see why not.  A project like this is right up my alley.”

CA: “What do you mean, right up your alley?”

Me: “I’m a generalist.  I understand liabilities, but I also understand financing structures, and I can look at assets and after a few minutes know what the main risks are and how large they are.  I may not be the best at any of those skills, but when they are combined, it works well.”

CA: “When can you have it to me?”

Me: (pause) “Mmm… shouldn’t take me longer than a month.”

CA: “Great.  I look forward to your report.”

The time was late 1998, just prior to the collapse of LTCM.  Though not well understood at the time, this was the “death throes” of the “bad old days” in the life insurance industry for taking too much asset risk.  Yes, there had been bad times every time the junk bond market crashed, and troubles with commercial mortgages 1989-1992, but the industry had not learned its lessons yet.

The 5 companies he picked were incredibly aggressive companies.  One of them I knew from going to industry meetings came up with novel ways of earning extra money by taking more risk.  I thought the risks were significant, but they hadn’t lost yet.

So what did I do?  I went to EDGAR, and to the websites of the companies in question.  I downloaded the schedule Ds of the subsidiaries in question, as well as the other investing schedules.  I read through the annual statements and annual reports.  I had both my equity investor and bond investor “hats” on.  I went through the entirety of their asset portfolios at a cursory level, and got a firm understanding of how their business models worked.

Here were the main findings:

  • These companies were using double, and even triple-leveraging to achieve their returns.  Double-leveraging is a normal thing — a holding company owns an operating insurance subsidiary, and the holding company has a large slug of debt.  Triple leveraging occurs when a holding company owns an operating insurance subsidiary, which in turn owns a large operating insurance subsidiary.  This enables the companies to turn a small return on assets into a large return on equity, so long as things go well.
  • The companies in question were taking every manner of asset risks.  With some of them I said, “What risks aren’t you taking?”  Limited partnerships, odd subordinated asset-backed securities, high yield corporates, residential mortgage bonds with a high risk of prepayment, etc.

So, when I met with the Chief Actuary, I told hid him that the five were taking unconscionable risks, and that some of them would fail soon.  I explained the risks, and why we were not taking those risks.  He objected and said we weren’t willing to take risks.  As LTCM failed, and our portfolios did not get damaged, those accusations rang hollow.

But what happened to the five companies?

  • Two of them failed within a year — ARM Financial and General American failed because they had insufficient liquid assets to meet a run on their liquidity, amid tough asset markets.
  • Two of them merged into other companies under stress — Jefferson Pilot was one, and I can’t remember the other one.
  • Lincoln National still exists, and to me, is still an aggressive company.

Four of five gone — I think that justified my opinions well enough, but the Chief Actuary brought another project a year later asking us to show what we had done for them over the years.  This project took two months, but in the end it showed that we had earned 0.70%/yr over Single-A Treasuries over the prior six years, which is  a great return.  The unstated problem was they were selling annuities too cheaply.

That shut him up for a while, but after a merger, the drumbeat continued — you aren’t earning enough for us, and, in 2001-2, how dare you have capital losses.   Our capital losses were much smaller than most other firms, but our main client was abnormal.

To make it simple, we managed money for an incompetent insurance management team who could only sell product by paying more than most companies did.  No wonder they grew so fast.  If they had not been so focused on growth, we could have been more focused on avoiding losses.

What are the lessons here?

  • Rapid growth with financials is usually a bad sign.
  • Analyze liability structures for aggressiveness.  Look at total leverage to the holding company.  How much assets do they control off of what sliver of equity?
  • If companies predominantly buy risky assets, avoid them.
  • Avoid slick-talking management teams that don’t know what they are doing.  (This sounds obvious, but 3 out of 4 companies that I worked for fit this description.  It is not obvious to those that fund them.)

And sadly, that applied to the company that I managed the assets for — they destroyed economic value, and has twice been sold to other managers, none of whom are conservative.  Billions have been lost in the process.

It’s sad, but tons of money get lost through some financials because the accounting is opaque, and losses get realized in lumps, as “surprises” come upon them.

Be wary when investing in financial companies, and avoid novel asset risks, credit risk, and excess leverage.

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3 Responses to The Education of an Investment Risk Manager, Part VIII

  1. bbarberayr says:

    Thanks for the article David. it is very interesting to read how industries have evolved over time and how some thing change and others never do.

    The one thing I was curious about was how well the insurance rating companies like Fitch, etc. did in picking out these issues that you saw back at that time and whether they are doing a better job today. It seems like if you could figure out 5 companies in a month, it would have been something the rating agencies should have known too, but I’m not sure that was the case.

    Thanks for commenting if you remember these details, and have the time.

    • The rating agencies are fine with known issues and seasoned products (where there has been a genuine failure at least once). They are not good with forward looking items that would require insight into how the boom-bust cycle will impact a new issue or new product. Qualitatively, they may explain the issue well, but quantitatively they have a hard time factoring in how it fits into the rating, particularly if the much of the risk relies on systemic effects.

      Now the same is true to a higher degree with the regulators, who are supposed to be tasked with solvency. New products and features should be treated skeptically, rather than welcomed, particularly when the math is weak, and participant behavior is unknown. The regulators outsource some their work to the rating agencies, rather than limit the size of new assets and product features until they are better understood. (That’s what they did in older days, and there were fewer blow-ups.)

      • bbarberayr says:

        Thanks David. Makes Sense.

        In light of the recent financial crisis, I have to believe now that the regulators and ratings agencies will be much more diligent than in the past and faster to identify issues. But, as you said, it is the new and unexpected that causes the big problems.


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.

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