I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc.  Here goes:

1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to.  How much implicit equity exposure do we get from our variable annuities?”  The idea was this: as the equity markets go up, so does our fee stream.  If the equity market goes up or down 1%, how much does the present value of fees change?  I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.

2) This post, Why are we the Lucky Ones? could have been a post in this series.  At a small broker-dealer, all sorts of charlatans bring their ideas for financing.  The correct answer is usually no, but that conflicts with hope.  Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.

3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.

4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm.  I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.

Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing.  Go variable by variable, on a long term basis, and ask:

  • At what level does this bring line profits to zero?
  • At what level does this bring company profits to zero?
  • At what level does this imperil the solvency of the company?

5) This story is a little weird.  One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC.  You are our representative.  They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts.  Your job is to make sure the fund is not created.”

His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs.  He didn’t want to get stuck with losses.  I told him the persuasion was not my forte, but I would do my best.  I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table.  Use it.”

A few days later, I was on the Metroliner down to DC.  I tried to understand both sides of the argument.   I even prayed about it.  Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund?  What might be the moral hazard implications?

At the meeting, I found one friend in the room from AIG.  We had worked together, and AIG didn’t like the idea either.  In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us.  Not promising.  We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.

By 3PM the moderator asked for any final comments before the vote.  I raised my hand and said something like, “You have to think of the law of unintended consequences here.  What will be the impact on competition here?  What if one us, a large company decides to be more aggressive as a result of this?  What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance?   The state guaranty funds would certainly like the industry to put even more skin into the game.”

The room went silent for a few seconds, and the vote was taken.

4-9 against creating the guaranty fund.

The moderator looked shocked.

The meeting adjourned and I went home.  The next day I told my boss we had won against hard odds.  He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me.  This is the thanks I get for trying something very hard?

6) In early 2000, I had an e-mail dialogue with Ken Fisher.  I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value.  Throw away the CFA syllabus, and all of the classics — look for what is not known.

So I sat down with my past trading and looked for what I did best.  What I found was that I did best buying strong companies in damaged industries.  That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.

In Closing

My career has been odd and varied, which has led to some of the differential insights that I write about here.  In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust?  Not many, and even I did not anticipate the intensity of the bust.  At least I didn’t own any banks, and only owned sound insurers.

Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc.  We can create our own crises by moving together in packs, going from bust to boom and back again.

It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important.  It is not what you earn, but what you keep that matters.

“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.

In late 2007, I was unemployed, but had a line on a job with a minority broker-dealer who would allow me to work from home, something that I needed for family reasons at that point.  The fellow who would eventually be my boss called me and said he had a client  that needed valuation help with some trust preferred CDOs that they owned.

Wait, let’s unpack that:

  • CDO — Collateralized Debt Obligation.  Take a bunch of debts, throw them into a trust, and then sell participations which vary with respect to credit risk.  Risky classes get high returns if there are few losses, and lose it all if there are many losses.
  • Trust preferred securities are a type of junior debt.  For more information look here.

I got to work, and within four days, I had a working model, which I mentioned here.  It was:

  • A knockoff of the KMV model, using equity market-oriented variables to price credit.
  • Uncorrelated reduced discrepancy point sets for the random number generator.
  • A regime-switching boom-bust cycle for credit
  • Differing default intensities for trust preferred securities vs. CMBS vs. senior unsecured notes.

It was a total scrounge job, begging, borrowing, and grabbing resources to create a significant model.  I was really proud of it.

But will the client like the answer?  My job was to tell the truth.  The client had bought tranches originally rated single-A from three deals originated by one originator.  There had been losses in the collateral, and the rating agencies had downgraded the formerly BBB tranches, but had not touched the single-A tranches yet.  The junk classes were wiped out.

Thus they were shocked when I told them their securities were worth $20 per $100 of par.  They had them marked in the $80s.

Bank: “$20?! how can they be worth $20.  Moody’s tells us they are worth $85!”

Me: “Then sell them to Moody’s.  By the way, you do know what the last trade on these bonds was?”

B: “$5, but that was a tax-related sale.”

Me: “Yes, but it shows the desperation, and from what I have heard, Bear Stearns is having a hard time unloading it above $5.  Look, you have to get the idea that you are holding the equity in these deals now, and equity has to offer at least a 20% yield in order attract capital now.”

B: “20%?! Can’t you give us a schedule for bond is worth at varying discount rates, and let us decide what the right rate should be?”

Me: “I can do that, so long as you don’t say that I backed a return rate under 20% to the regulators.”

B: “Fine.  Produce the report.”

I wrote the report, and they chose an 11% discount rate, which corresponded to a $60 price.  As an aside, the report from Moody’s was garbage, taking prices from single-A securitizations generally, and not focusing on the long-duration junky collateral relevant to these deals.

In late 2008, amid the crisis, they came back to me and asked what I thought the bonds were worth.  Looking at the additional defaults, and that the bonds no longer paid interest to the single-A tranches, I told them $5.  There was a chance if the credit markets rallied that the bonds might be worth something, but the odds were remote — it would mean no more defaults, and in late 2008 with a lot of junior debt financial exposure, that wasn’t likely.

They never talked to me again.  The bonds never paid a dime again.  I didn’t get paid for running my models a second time.

The bank wrote down the losses one more time, and another time, etc.  How do you eat an elephant?  One bite at a time.  It did not comply well with GAAP, and eventually the bank sold itself to another bank in its area, for a considerably lower price than when they first talked to me.

So what are the lessons here?

  • Ethics matter.  Don’t sign off on an analysis to make a buck if the assumptions are wrong.
  • Run your bank in such a way that you can take the hit, rather than spreading the losses over time.  (Like P&C reinsurers did during the 1980s.)  But that’s not how GAAP works, and the CEO & CFO had to sign off on Sarbox.
  • A model is only as good as the client’s willingness to use it.  There are lots of charlatans willing to provide bogus analyses — but if you use them, you know that you are committing fraud.
  • Beware of firms that won’t accept bad news.

I don’t know.  Wait, yes, I do know — I just don’t like it.  This is a reason to be skeptical of companies that are flexible in their accounting, and that means most financials.  So be wary, particularly when financials are near or in the “bust” phase — when the credit markets sour.

My boss walked in and said that we needed to terminate our annuity reinsurance treaty with an entity that I will call Bigco (this happened in July).  Senior management had deemed that we should do it, and in days we visited Bigco, assuming that the actuary in question would approve a termination of the treaty where:

  • There was no termination provision.
  • There was a guaranteed minimum return to the reinsurer.
  • The reinsurer had participation in the upside of profits.

Who negotiated such a treaty?  Very one-sided, and Bigco needed to deploy capital, not contract it.

Could a negotiating position be worse?  Yes, it could, just wait.

When we got to Bigco, we talked with the actuary for a little while, and then he handed us over to the head of M&A.  Uh-oh, he sized up the situation perfectly, and denied our request, unless we were willing to pay considerably above book value to repatriate the assets.

We went home depressed, and a few months after that my boss was summarily fired.  In those days, September was the firing time.  You can imagine what that did for morale.  Personally, I expect my boss was fired because he was most similar the the CEO, and had done things well in managing his line of business.

One day the chief actuary came to me and said, “We have to terminate that treaty.”  I explained to him the backstory, that we had offered to buy it back at an ROE of 9%, and Bigco was demanding 6%.  I said to him, “I’ve already compromised the 10% ROE objective of our company, I don’t want to go further.  I’m free to walk away, right, if we can’t get a decent price?”  He said, “No, the deal must be done.  Under no circumstances can you walk away.”

The sad thing was that any termination of the treaty would positively affect management bonuses.  (That was the real target.)

I had a strong sense that I should always serve the ultimate owners of the firm — the dividend receiving policyholders.  But this was at variance from that.

So, with the weakest bargaining hand that I can imagine, I used the following strategy.  I did nothing.  Nothing. Nothing until early December, where I called the M&A guy at Bigco and and told him, “I’ve had a change of heart.  I’ll accept an ROE of 6.9%.  That’s my final offer!”  This was ticklish because I *had* to get the deal done.

He bit on the offer, and I pressed him saying that between this time and the closing, my market value adjustment formula would rule.  He agreed.  (He probably had a profit goal as well, which was what I was counting on.)

But, he didn’t look closely at the Market Value Adjustment formula.  I gave him one that was volatility-loving, that would adjust of the greater of the absolute value of the yield changes in 3-month T-bills or 30-year Treasury Bonds.  Don’t criticize the guy too much, the Federal Reserve fell for the same tactic on GICs they bought from us.

Before the deal closed, the Fed started tightening monetary policy, and the Market Value Adjustment got us out at an ROE of 9.1%.  What a win, and for the policyholders.  Management got more as well, and I got almost nothing.

I took risks trying to do the right thing, praying the God would help me, and in this case, it worked.  Can you be more righteous than your management team?  In most cases, no, but in this case I succeeded.

I would say to all, try to serve the interests of owners rather than management.  Act like an owner, not like a manager hauling down a fat salary.

One thing that came out of our “employee empowerment project” was a need to improve our equity and bond fund offerings.  At the same time, a fund manager manager [FMM] came out of the woodwork and suggested to us that we could do multiple manager funds.  They had analyzed many managers and had found some that they thought were great.

The more we thought about it, the more we thought it would be a great idea. Here’s why:

  • Our own abilities to find superior managers were limited.
  • A few members  of our team (including me) possessed ability to analyze what FMM would bring us.  We thought we could add value.
  • We came up with a clever name, “The All Pro Funds.”
  • We also thought we could add value  in changing weightings every now and then, and firing managers that we felt had become uncompetitive because they were now running too much money, had critical staff losses, or were underperforming style-specific indexes by a wide margin.
  • We could increase our fee a little to pay FMM and us for the additional work entailed.

And whaddaya know?  It worked.  The portfolios in aggregate  outperformed  their indexes even after fees, and fund flows increased dramatically.  The representatives had a story to tell.  Morale improved everywhere.  We were rolling, until…

A day came where we heard from one of the underlying managers that FMM had recommended their termination because they wouldn’t rebate more of their fees back to FMM.  I would not say that we went ballistic when we heard this — instead, we went cold on FMM.  Act fast?  No, act deliberately.  The senior officers tasked me and the #2 guy in marketing to deal with the problem.

We had a rule in our division — we will pay disclosed compensation, or we will pay undisclosed compensation, but we will never pay disclosed and undisclosed compensation.  Why?  We wanted our clients to know that if compensation was disclosed, that’s all there was.  If there is no “sticker price” but you are happy with the services provided, and don’t need to know what any agent is making that’s fin with us.  But we will not pass more money quietly to those that have said, “This is the sticker price.”

FMM had violated our sense of ethics to the core.  The two of us decided to put out an RFP, asking them to bid to help manage the now $1 Billion of assets. We excluded FMM.  We chose 10 well known manager consultants. Most responded to the RFP and we invited 5 to come present to us on a given day in spring.

-=-==–=-==-=-=-=-

I need to mention one other thing.  When we first started dealing with FMM, we appreciated their qualitative research, which seemed to have some punch.  After a year, they discovered returns-based style analysis.  This allowed them to analyze many more managers just by looking at their returns, and correlating them to a variety of equity and other indexes.  They stopped the qualitative research.

The first time I saw it, I thought it was hooey, even as I think MPT is hooey.  When you have a lot of highly correlated indexes, any attempt to intuit the style of a given manager is problematic; the error bands get too wide.  It is too difficult to determine what the correct answer is.  The optimal answer mostly represents happenstance, and not fact.  Tiny tweaks to the data produce big changes in the answer.  Not a good system.

There was one incident where I met with their new quantitative analyst, a woman 10 years younger than me.  She ask if we understood how the method worked.  I replied with some mathematical jargon regarding the method, leading her to say, “Oh, so you *really* understand this.”

Also, when I analyze a manager, I like looking at what they own.  I like looking at their trades.  I want to see consistency with what they claim is their strategy.  I also like to hear why they do what they do, and what sustainable competitive advantage they think they have.  There is value in that style of analysis.  There is little value in analyzing returns.

=-=-=-===–==-==–

To our surprise, one well-known consultant [call them STAR] that had no for-profit clients was one of the five.  The leader said it was a one-time experiment, so they were evaluating us, as much as we evaluated them.

On the day when they came to present, the presentations were all over the map, from highly professional to “did not prepare.”  Some big names could not answer basic questions about what sustainable competitive advantages they brought to the process, or were fuzzy about how they earned their money.

STAR had the best presentation, services, model, ethics, etc.  It was almost “no competition,” and they liked us as well.  We hired them, much to the chagrin of FMM, who begged us to keep them.  It had the following positive results:

  • Management fees down by 60%
  • Fund manager fees down by 50%
  • Far better marketing cachet
  • Better models for investment analysis.

We reduced client fees, but had better margins, and still greater growth.  Our division was transformed thorough the two projects.  Before we started our ROE was around 8%, and we were growing AUM at a 5-10% rate.  By the time all these changes occurred, our ROE was 25%, and our growth rate was not far from that.  We were now the stars of the firm, even though the firm culturally could not acknowledge that, because the life division was so big.

I learned several things from this five-year escapade:

  • Creating a desirable investment product takes work.  If you do something different that seems to add value, it will attract clients. (“We manage the managers for you, so you don’t have to”)
  • Focus on ethics in those you work with.
  • Reduce fees where possible, both your own, and that of suppliers.
  • Name recognition helps.
  • Be careful what you accept as analysis.  Just because there is clever math does not mean it represents how reality works.
  • If you don’t take chances, you won’t achieve anything great.  We didn’t have to burn our old strategy, and move to multiple manager funds, but we did it, and it made clients a lot happier.  The added work was work that that we liked to do.
  • Even if you have a supplier that did something good for you, do not tolerate breaches in ethics.  Find someone else to help you even if it costs more.  That it cost us less was merely a plus.

One day, when I was least expecting it, the Spanish Inquisition arrived, otherwise known as internal audit.

IA: You run the GIC business.

Me: Yes.

IA: What functions do you control here?

Me: I market, price, cashflow test, and reserve the GICs.  I also direct hedging and investment policy.

IA: Isn’t that too large of a concentration of power in your hands?  You do everything.  There are no checks and balances.

Me: It allows us to run a better operation, because we feed back our results into our underwriting.  Besides, my boss reviews my work regularly.  I am not the only one analyzing my work.

IA: But leaving reserving and pricing in the hands of the same person is wrong.

Me: In many cases I would agree with you, but these are GICs; I have little freedom in setting reserves for them, the answers are formulaic, I can’t vary them.  Besides, take a look at our cash flow testing opinion.

IA: Huh?

Me: after reading this, you will see all the controls we put on the process.  We run far more rigorous tests than other insurers do to ascertain the profitability of our business.  Have a read.  Beyond that, our financials are reconciled to the penny every night.  It would be very difficult to have fraud here.

IA: You really seem to have too much power…

Me: We are not a large division.  We have four actuaries total.  We have different functions, and we can’t spare the effort to split pricing and reserving.  The boss watches over us; go ask him for his view of what  we do.

IA: I have, and he sounds like you.

Me: And he is the best.  He built this place, and it runs more smoothly than any other division of the company.

IA: Your division is funny.  You do things that we recommend against, but we can’t find anything wrong.

Me: We’re just doing our jobs.

IA: (Sigh) Okay, thanks, but our objections will be in the report to management.

Me: That’s fine; if the boss says to change things we will do it.

One of the most important aspects of insurance is to let the results of underwriting flow back into reserving and pricing.  You want to try to change your pricing of new business such that it reflects the true risks undertaken.

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Then there was the minor panic that happened in late 1993, early 1994.  Rates had been low for a long time, and the investment department decided to buy some 10- and 30-year Treasuries, because they couldn’t find anything with enough yield.  Thus my conversation with the manager of my portfolio:

Me: Why are we holding 10- and 30-year bonds?  The duration of my longest liability is five years.

IM: Well we couldn’t find anything you buy.  These are just placeholder assets.

Me: You could hold cash, or 3-year Treasuries.

IM: But we wouldn’t get the yield we need.

Me: I am less concerned about our income than that we cover our risks.  You have made my interest rate risk higher by a factor of two.

IM: That much?

Me: This is a leveraged operation.  We ordinarily run at a duration of 2.5.  You can’t give me assets with durations near 7 or 14.

IM: Don’t worry, assets that fit your need should show up soon, just give us time.

Me: I would rather wait in cash, but okay.

+++++++ Two months later +++++++++++

Me: We’re sitting on 10% losses on the long Treasuries now.  You are killing my year.  What are you going to do?

IM: (makes a gesture of praying)

Me: that’s not good enough!  You said you would find something soon and now the Fed is tightening.

IM: We’re looking, we’re looking.

Me: (sigh) I know, but put yourself in my shoes.  We control risk first and then seek yield.  This reverses our priorities.

IM: I know, but relative yield is hard to find these days

Me: I know, but absolute yields are rising, and we are losing in the process.

+++++++++++++++++++++++++++++++

We closed out the position two months later for a loss of 18%.  Had the bonds been held longer, it would have been worse.  As it was, once we cleared that out, I started selling GICs rapidly, and did not hedge the sales, because I had figured out that rates would keep rising for a while, as I wrote about here.

As noted in the article just cited, 1994 eventually ended up being a winner of a year, but it started with that inauspicious event.  Who could tell?  My main point is this: don’t give up your risk control discipline to make a few measly bucks.  In tough situations, focus on the risks, and ignore the yields.

There’s kind of a rule of thumb in Asset-Liability management, that you match liquidity over the next 12 months, and match interest rate sensitivity overall.  I would do more than that, creating my own randomized interest rate models, as well as a new way of creating structured randomness in simulation models.  For a brief period of time, I had one of the best multivariate randomness programs out there, eliminating the problem of correlations in higher dimensions common with Hammersly points.  (My work was not theoretical, but intuitive… once I saw how the randomness was created, I figured out how to de-correlate the higher dimensions (since it was based on prime numbers, create more number than you need, and use a higher prime number to select observations.)

Anyway, when I brought my full-interest rate curve scenarios to the investment department in 1994, they said to me, “These are the first realistic interest rate scenarios we have ever seen.  Did you constrain them?”  I told them “No, just weak mean reversion.  Noise dominates in the short run, mean reversion dominates in the long run.”

As a result, for the lines of business over which I had oversight, we measured our interest rate mismatch in terms of days, weeks, and months, but never years.  Please ignore this incident where things drifted, but worked out exceptionally well (really, that should be a part of this series).  We published a document to show everyone how well we managed interest rate risk in Provident Mutual’s pension division.  We used scenarios far beyond what was required to show how well we did our work.  The regulators never complained.

At that point in time, the ability to integrate residential mortgage-backed securities into cash flow analyses was rudimentary at best.  But I found ways to make it work, most of the time.  That said, I remember joking with the MBS manager in late 1993, and saying there was a new term for a well-protected PAC bond.  He asked, “What is it?”  I replied, “Cash.”  He sarcastically said, “Oh, you are so funny.”   That said, I pointed out to the investment department that some of their bonds that they thought would last another four years would disappear in 2-3 months.

Then there was the floating rate guaranteed investment contract project that I eventually killed because it was impossible.  You can’t argue with expectations that are unrealistic.  Even better, I beat the Goldman Sachs representative.

In running the GIC desk at Provident Mutual, I had to review a lot of strategies because making money on short-term bonds/loans was difficult, and difficult the degree that I doubted as to whether we were in a good business.  On the bright side, I protected the firm until the day that we  could not write any more  GICs, because our credit quality was too low.  That was the fault of the less entrepreneurial part of the company, so I couldn’t so much about it, except close my operations down.  I asked the senior management team to provide a guarantee to my GICs, but they refused.

As such, I shut the line of business down.  With clients that were unreasonable over credit quality, and management unwilling to extend credit protection to GICs, the battle over GICs was ended, and I sent the line into runoff.

Five years later, as we were now part of the same firm I stood at the estate of John Dwight, with a young woman that I had sold the last GIC of Provident Mutual to, I said, “The end of the GIC business of Provident Mutual.”  We talked, she smiled, but it was part of the end of an era, because GICs were a minority of the assets in Stable Value funds.

If nothing else, this helps to highlight the impermanence of all that is done in financial firms.  I know this in my own life, but I am sure that it is true for most people in finance.

When I worked for Pacific Standard, which had the dubious distinction of being the largest life insurance insolvency of the 1980s, I had few investment-related tasks.  Investments were handled by the overly aggressive parent company Southmark, which gave little attention to risk.

But I knew things weren’t going well, and so I interviewed widely, finally landing two job offers with Midland National and AIG.   I chose the spot with AIG, because they led me to believe I would work on the international side.  When I arrived, lo, I had a job on the domestic side.  As far as the job went, had I known I would be placed on the domestic side, I would have rather gone to Midland National.  They thought I had real leadership potential — whether true or not, that’s what I was told, and I would not have minded living in South Dakota, or nearby.  As it was, there were many good things that happen to me as a result of living in-between Wilmington, Delaware, and Philadelphia, living on the PA side of the line for reasons of adoption and homeschooling.

When I got to AIG, there was one main thing that involved my risk management skills.  AIG parent wanted growth in GAAP earnings.  They wanted to see a 15% ROE, which few in the life industry were attaining.  In order to do that, they entered into reinsurance treaties (before I arrived).  These would lever up the balance sheets of the subsidiary companies, without incurring debt.  Most of them passed risk to the reinsurers, one did not.

So, when I was called into an examination by the Delaware State Insurance Department auditor over the one treaty that did not pass risk, he said to me, “You know this treaty does not pass risk.”  I replied, “Under ordinary circumstances, I would agree, but the reinsurer has taken a significant loss from this treaty.”  He said, “What do you mean?”  I replied that when Congress passed the DAC tax, the reinsurer suffered the loss — they paid up front, and we pay over time, with zero interest.

He looked at me and said that reinsurance treaties did not exist to cover tax policy, and that the treaty was a sham.  I just shrugged.  I was not the creator of the treaty, and would not have done it if I had been at AIG two years earlier.

But the there were the two larger treaties that passed risk with a vengeance to a large reinsurer [LR] who is no longer a reinsurer (if anyone wrote treaties like these, he might not be a reinsurer anymore either).  In one sense, the treaties were structured like the trading requirements in CDOs.  If you must trade:

  • Get more income
  • Don’t give up rating
  • Don’t extend maturity
  • And a few more smaller things.

I was not there when the treaties were created.  Had I been there, I would have paid a lot more attention to them, and instructed the investment department to set up segregated portfolios, which was not done.  As it was, bonds that underlay the treaty were casually sold as if free to do so.

Now I arrive on the scene.  After reading the treaties, and looking at the data, I conclude that the treaties have been abused on our side.  I suggested to LR that I go through the history, and reallocate bonds that would have fulfilled the treaties strictures, an re-work the accounting so that the terms of the treaty would be fulfilled.  Initially LR agreed to this.

The treaty passed all investment risk to the reinsurer, so defaults would hit them.  What was worse, the liabilities underlying the treaty were structured settlements.  (Structured settlements result from a court case where someone is injured.  The defendant offers to buy from a reputable life insurer an annuity that will make the requisite payments.  Low bid wins, and if the plaintiff is badly injured, the cost goes down for payments that terminate at death.  That’s where most of the bad estimates com in.)  In those days, structured settlements were a “winner’s curse.”  If you won, it was because you mis-bid.  AIG Domestic Life Companies regularly overbid for their business (as did most of the industry).  LR did not do enough due diligence to see the underwriting errors.

I did a mortality study to estimate how badly we needed to increase reserves, and lo, it was more than $100 million, all of which would flow to LR.  LR decided to sue.  After I had gone on to Provident Mutual, AIG settled with LR.  Our missteps with the assets made the case tough, and the reinsurance treaty was rescinded.  That should have been enough to jolt AIG’s earnings for a quarter, but it did not.  Funny that, and it always left me a little suspicious of AIG.  (And LR.)

Before I left AIG, I had clipped the wings of the underwriters of the structured settlements so that they could not write on cases for the most severely disabled.  I also shut down a tiny line of variable annuities that was losing money left and right to an outsourcer who had a sweet contract from a prior management team, but upon leaving AIG I did not feel that great, because I had not built anything — most of my time had been spent trying to limit losses from prior bad underwriting and planning.  It wasn’t fun, and I loved my next company more because I got to build.

PS – a prior note on AIG.

This is likely to be the last series describing how I learned my skills that I still apply today.  I hope you enjoy it.

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It was mid-1988, and I had just earned my Associate in the Society of Actuaries [ASA] credential.  After my boss congratulated me, he told me I was now invited to the monthly management meetings.

In insurance terms, this era was the “bad old days.”  Risk-based capital regulations had not yet been developed, and aggressive companies like First Executive and Pacific Standard Life [my company] invested almost entirely in junk bonds.  These were some of the pigs Michael Milken was feeding junk bonds to.

What initially impressed me was that monthly income was so variable, and that most of the variation came from asset performance.  Now, as an actuary, I had more asset knowledge than most, but seeing the variation made me say to myself that if actuaries are risk managers in life insurers, the syllabus for teaching actuaries is wrong, because it focuses on liabilities, not assets.

Pardon this excursus — the Society of Actuaries in the US needs to be more like The Institute and Faculty of Actuaries in the UK.  Investing should be a core skill, not a peripheral skill.  Actuaries have the capability of exceeding the skill of CFA charterholders by a wide margin.  Assets vary far more than liabilities in an insurance company, most of the time.  Focus on what varies, and improve management skills there.

I was low enough in the hierarchy that there was nothing I could do to prevent Pacific Standard from failing in 1989.  That said, I accelerated my job search so that I left two months before Pacific Standard was taken into conservation by the California Department of Insurance.  But for me, that was out of the frying pan, and into the fire, because I went to work for AIG.

PS — I learned a few more things as well:

  • Highly levered companies are dangerous.  Southmark, which owned Pacific Standard, needed everything to go right because of the high degree of leverage.
  • When ever you hear of a management team that is highly litigious, stay away.  Phillips & Friedman surrounded themselves with a phalanx of lawyers, and got away with everything short of murder.  They will get it on Judgment Day, but not likely before.
  • When you interlace the capital of subsidiaries, it is a sign of desperation, indicating likely failure.  If you have subsidiary A buy the preferred stock of subsidiary B, and subsidiary B buy the preferred stock of subsidiary A, in the same amount, they both look a lot healthier, but nothing has happened, aside from an accounting ploy.  Pacific Standard died when the California Department of Insurance refused to accept some preferred stock as an admitted asset.
  • My first project was to set the GAAP reserve factors for Universal Life.   In hindsight, my boss manipulated me into creating the best profit stream in hindsight, which produced lousy future profits.  He stripped profitability out of the future for then present management bonuses.

I was approached by a younger friend for advice.  This is my response to his questions below:

Thank you for agreeing to do this for me. I would love to have an actual conversation with you but unfortunately, I think that between all of the classes, exams, and group project meetings I have this week it would prove to be too much of a hassle for both of us to try to set up a time.

1. What professional and soft skills do you need to be successful in this career and why?
2. What advice would you give to someone considering working in this field?
3. What are some values/ethics that have been important to you throughout your career?
4. I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?
5. What made you decide to make the switch to running your own business?

Thanks again,

ZZZ

What professional and soft skills do you need to be successful in this career and why?

I’ve written at least two articles on this:

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

Let me answer the question more directly.  You need to understand the basics of how businesses operate.  How do they make money?  How do they control risk?

Now, the academics will show you their models, and you should know those models.  What is more important is understanding the weaknesses of those models because they may weakly explain how stocks in aggregate are priced, but they are little good at understanding how corporations operate.  The real world is not as ideal as the academic economists posit.

It is useful to read broadly.  It is useful to dig into a variety of financial reports from smaller firms.  Why smaller firms?  They are simpler to understand, and there is more variation in how they do.   Learn to read through the main financial statements well.  Understand how the income statement, balance sheet, and cash flow statement interact.  Look at the footnotes and try to understand what they mean.  Pick an industry and compare all of the companies.  I did that with trucking in 1994 and learned a boatload.  This aids in picking up practical accounting knowledge, which is more powerful when you can compare across industries.

As for soft skills, the ability to deal with people on a firm and fair basis is huge.  Keeping your word is big as well.  When I was a bond trader, I ate losses when I made promises on trades that went wrong.  In the present era, I have compensated clients for losses from mistaken trades.

Here’s another “soft” skill worth considering.  Many employers are aghast at the lousy writing skills of young people coming out of college, and rightly so.  Make sure that your ability to communicate in a written form is at a strong level.

Oral communication is also important.  If you have difficulty speaking to groups, you might try something like Toastmasters.

Many of these things come only with practice on the job, so don’t think that you have to have everything together in order to do well — the important thing is to improve over time.  Young people are not expected to be as polished as their older colleagues.

What advice would you give to someone considering working in this field?

It’s a little crowded in finance.  That is partially because it attracts a lot of people who think it will be easy money.  If you are really good, the crowding shouldn’t be much of a hurdle.  But if you don’t think that you are in the top quartile, there are some alternatives to help you grow and develop.

  • Consider developing your skills at a small bank or insurer.  You will be forced to be a generalist, which sets you up well for future jobs.  It also forces you to confront how difficult the economics of smaller firms are, and how costly/difficult it is to change strategy.  For a clever person, it offers a lot of running room if you work for a firm that is more entrepreneurial
  • Or, consider working in the finance area of an industrial firm.  Finance is not only about selling financial products — it is about the buyers as well.
  • Work for a government or quasi-governmental entity in their finance area.  If you can show some competence there, it would be notable.  The inefficiencies might give you good ideas for what could be a good business.

What are some values/ethics that have been important to you throughout your career?

Here are some:

  • Be honest
  • Follow laws and regulations
  • Work hard for your employer
  • Keep building your skills; at 57, I am still building my skills.
  • Don’t let work rob you of other facets of life — family, friends, etc.  Many become well-paid slaves of their organization, but never get to benefit personally outside of work.
  • Avoid being envious; just focus on promoting the good of the entity that you work for.
  • Try to analyze the culture of a firm before you join it.  Culture is the most important aspect that will affect how happy you are working there.

I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?

This is a cute story: Learning Leadership.  I have also written three series of articles on how I grew in the firms that I worked for:

There’s a lot in these articles.  They are some of my best stories, and they help to illustrate corporate life.  Here’s one more: My 9/11 Experience.  What do you do under pressure?  What I did on 9/11 was a good example of that.

I know I have a lot more articles on the topic on this, but those are the easiest to find.

What made you decide to make the switch to running your own business?

I did very well in my own investing from 2000-2010, and wanted to try out my investing theories as a business.  That said, from 2011-2017, it worked out less well than I would have liked as value investing underperformed the market as a whole.

That said, I proceed from principle, and continue to follow my investment discipline.  It follows from good business management principles, and so I continue, waiting for the turn in the market cycle, and improving my ability to analyze corporations.

Nonetheless, my business does well, just not as well as I would like.

I hope you do well in your career.  Let me know how you do as you progress, and feel free to ask more questions.