I get a lot of interesting letters — here is another one:
First, let me say how much I appreciate your blog. I started my career in sellside research covering life insurers (after interning in insurance M&A). Your posts on insurance investing were invaluable in developing my understanding of the industry. My superiors did not have time to teach me the basics – I would have had a hard time getting started without your blog.
I’m now in equity research at a large mutual fund company, also covering insurers (and asset managers). However, I do not have an actuarial background. So I am very interested in why you think financial & mortgage insurers don’t have an actuarially sound business models.
And as a former life insurance analyst, I am curious what aspect of life insurance reserving you view as liberal – I’m guessing secondary guarantees on VAs?
Finally, to digress, do you have any views on medical malpractice insurance? I’ve been looking at PRA, and find it pretty compelling at first glance: massive excess capital, consistently conservative and profitable underwriting, and a relatively reasonable valuation. 90% of policies are claims made. There are headwinds: Obamacare, the reserve releases from mid-2000s accident years rolling off, and a diversifying business model (although PRA has historically proven competent at M&A). My only concerns are management continuing to underwrite at too low a level (currently writing at 0.32x NPW / Equity; regulators would be fine with up to 1.0x), and potentially squandering that capital.
In the interest of full disclosure, I own no insurance stocks personally for compliance reasons.
Thanks for writing. Let’s start with mortgage and financial insurance. It’s not that there isn’t a good way to calculate the risk (in most cases), it is that they do not choose to use those models. The regulators do not subscribe to contingent claims theory. They do not look at default as an option, even if it is not efficiently exercised. They should use those models, and assume efficient execution of default risk.
Even if they use approximations, the recent crisis should have forced reserves higher for mortgage credit, and other credit exposures.
Credit and mortgage insurers are bull market stocks. When I was a bond manager, I sold away my few financial insurer bonds from MBIA and Ambac, and avoided the mortgage insurers. The possibility of default was far higher than he market believed.
With respect to Life Insurers, it is secondary guarantees of all sorts, especially with variable products. Options that have a long duration are hard to price. Options that have a long duration, and involve significant contingencies where insureds may make choice hurting the insurer are impossible to price.
On Medmal, I have always liked PRA, but it has never been cheap enough for me to buy it. Always thought they were the best of the pure plays. They have survived many other companies by their clever management. I would not begrudge them their conservatism, Medmal is volatile, and it pays to be conservative in volatile businesses.