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Flavors of Insurance, Part XII (Summary — The End)

Flavors of Insurance, Part XII (Summary — The End)

The insurance industry is a diverse place, with many places to make and lose money. In order to remain on the winning side, I? recommend four basic principles, which were mentioned above:

1.????? Stick with conservative managements. You make money in insurance by not losing it.? Conservative underwriting and reserving allow managements to make economically rational decisions, rather than fruitless market share wars, or giving into sell side analysts with a fixation on top-line growth.

2.????? Focus on companies with sustainable competitive advantages. Insurance is a competitive business; companies that do not have an edge against their competition will likely earn subpar returns.

3.????? Consider companies that can (and do) earn a high ROE over a full underwriting cycle. Anyone can earn money when the market is hard, but who protects your investment when the market for insurance is soft?? Intelligent insurance managements adjust their competitive posture to the market environment.

4.????? Finally, buy them cheap, and sell them dear. Within the above three principles, focus on companies that are out of favor, and sell companies when their prices outstrip their fundamentals. This last principle is the most obvious, which is why it operates inside the contours of the first three principles.

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Bringing it to the Present

I still think these four principles are valid.? They aren’t flashy, and they take some thought, but they focus the analysis in an industry that is difficult to understand.

I try to focus on companies that are good operators; they manage their base of insurance businesses well, rather than those that are clever investors, because the ability to be clever investors over the long run is much harder than being a well-run insurer.

With that, I bring my “Flavors of Insurance” series to an end.? I hope you enjoyed it.? I always wanted to publish it, and if I hadn’t tripped across a very bad copy of it, and had my son Timothy correct the OCR version, this never would have seen the light of day.? So what I wrote 6-7 years ago can benefit a wide audience.? And remember, aside from the “Bringing it to the Present” parts, the original was written in one excruciating, draining day– a labor of love that was frustrated, but now realized.

Flavors of Insurance, Part XI (Banks and the Insurance Business)

Flavors of Insurance, Part XI (Banks and the Insurance Business)

My bias in understanding banks in the insurance business is that banking and insurance are fundamentally different businesses, but there are areas of overlap where the participation of banks sense. In Europe, indiscriminate mingling of the two businesses has usually led to losses. Why?

Though banking and insurance are both described to be financial services, they are different in the terms of financing done, arid service provided. Here are some of the key differences:

  • Product complexity: Insurance liabilities are typically more complex than bank liabilities; there are more factors that can affect the overall cost of the promises that an insurer makes to a policyholder, than a bank makes to a depositor.
  • As a result, the liabilities underwritten by an insurance company are usually riskier than those underwritten by a bank.
  • Because of the relative riskiness of the asset and liability structures, including the greater length of guarantees made, insurance companies generally run at a higher ratio of book equity to assets.
  • With the longer liability structures, and a highly competitive environment, the investment policy of most insurance companies is more aggressive than that of most banks. Interest rate risk is not generally a problem; most companies attempt to squeeze out interest rate risk by approximately matching assets and liabilities. Most of the risk comes from investing in equities, lower grade corporate debt, and equity risk from the writing annuities. (As the market rises and falls, so do fees received.)
  • Liabilities are more expensive to originate and service at insurance companies.
  • There is a high amount of idiosyncratic expense associated with running an insurance company. When a bank buys an insurance company, there are usually few expense savings.
  • Though there are diversification advantages from a holding company owning both banks and insurers, this advantage often outweighed by the different skills needed to manage the different entities well.

The European experience with banks and insurance companies under the same roof has been mixed. One success has been banks coming to dominate distribution of life insurance products. Banks distribute more than 50% of all life insurance policies in most countries in developed continental Europe. The tendency for banks to sell insurance is strongest in countries where banks are dominant financial institutions aside from insurance.

But there have been failures as well. Most of the failures have been due to a lack of understanding of how different banking and insurance really are. Others have been due to taking too much risk, particularly in unfamiliar countries. Here are some examples:

  • CSFB buying Winterthur did not grasp how sensitive the performance of Winterthur was to the performance of the equity markets. When the equity markets fell, CSFB had to pump in $2.4 billion of capital.
  • Allianz did not grasp the poor asset quality of Dresdner, particularly in the midst of a bad market for investment banking
  • Zurich Financial Services was overly aggressive in the expansion plans in the US, leading them to overpay for marginal asset management companies like Kemper and Scudder.
  • Aegon, ING, and Prudential plc all suffered by building up leverage through 2000, particularly in their US life insurance subsidiaries, and then got whacked by the combination of the bear markets in equity and credit.

To summarizing the European experience positively, if a bank has strong customer relationships, it can earn additional margins through distribution of insurance products. Negatively, conservatism pays in entering new lines of business and new countries.

The US experience with banking and insurance together has been more limited, due to laws such as McCarran-Ferguson and The Bank Holding Company Act. McCarran-Ferguson, passed in 1945, entrenched the exclusive authority of the states to regulate insurance. The Bank Holding Company Act of 1956, amended in 1970, restricted the insurance activities of bank holding companies.

Until HR 10 was passed in 1999, the Federal Reserve gradually relaxed regulations on bank involvement in insurance companies so long as earnings from insurance activities remained below a threshold. In April of 1998; the merger announced between Citicorp and Travelers forced the need for structural legal change, leading to the passage of HR 10, otherwise known Gramm-Leach-Bliley. HR 10 allowed for the formation of financial holding companies that could engage in banking, investment banking, and insurance, with regulation of mixed entities to be done functionally down at the operating companies, in much the same way it would be done for standalone entities.

When HR 10 was passed, there was a lot of expectation in the insurance industry that the new law would have no large effect. Some observers suggested that life and personal property/casualty insurers might be bought by banks because of investment and product marketing synergies. But most thought that banks would not buy insurance companies, and insurance companies would not buy banks. This expectation has largely been met. Aside from Citicorp, only Bank One has acquired an insurance underwriter of significant size.

Even with Citigroup (ne? Citicorp) the acquisition of Travelers was re-thought. In 2002, Citigroup spun the property/casualty operations off as Travelers Property Casualty, which had a short-lived existence as a standalone company before merging with The St. Paul. Citigroup kept the Travelers life and investment operations (and the logo).

Bank One acquired the US life insurance operations of Zurich Financial Services. This allows Bank One, soon to be a part of JP Morgan Chase, to underwrite life insurance. They presently use it to sell term insurance and annuities.

So, why didn’t banks attempt to enter the life and personal property casualty lines, in general? The quick answer was that they didn’t need to; many already had the benefits that come from distribution of insurance products, without the additional risk of underwriting, the additional hassle of state regulation, and the complexities of managing two disparate businesses. Additionally, the sale of insurance products has tended to be a high ROE business, whereas underwriting, given the stiff capital and reserving requirements, tends to be a low ROE business.

Banks sell 23% of all annuities sold. At present, most of the insurance business that banks do is the sale of annuities. Here is a breakdown of insurance sales done by banks in the US (from LIMRA, as reported in the National Underwriter):

Product

Percentage of Sales
Annuities 68%
Benefits and other commercial lines 16%
Personal Property-Casualty 7%
Credit 5%
Individual Life and Health 4%

Aside from annuity sales, the other major area of insurance activity for banks is the brokerage of employee benefits and commercial insurance. Banks have been aggressive buyers of local insurance brokers; one-third of all sales of local insurance brokerages since 1995 have been sold to banks.

There is logic to banks engaging in insurance brokerage. It deepens commercial relationships within a bank’s footprint, and can even lead to opportunities to expand the geographic scope of a bank as it buys insurance brokerages outside its footprint. Insurance brokerage relationships can lead to new banking clients, and vice-versa.

There are two banks among the top ten insurance brokers in the US: Wells Fargo is fifth, and BB&T is sixth, behind the big insurance brokerage specialists Marsh and McClennan, Aon, Arthur J Gallagher, and Brown and Brown. There are cultural differences between banking and insurance brokerage. A large commitment to insurance brokerage by a bank implies that the brokerage arm will behave like the big insurance brokerage firms that they compete with. Banks with a small commitment to insurance brokerage tend resemble the small brokers that the bank acquired. And in general, insurance brokerage tends to be a more aggressive sales- and customer service-driven culture.

We are not yet at the end of the involvement of banks in the insurance business. Intelligent bankers will use insurance as yet another way to deepen the relationships that they have with commercial, and to a lesser extent, retail clients. In general, we do not expect many banks to take on underwriting risk.

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Bringing it to the Present

All of this is still true today, and banks don’t know what to do with insurance, aside from a few of them selling annuities, like CDs, and being insurance brokers through their business banking relationships.

The last major bit of the Travelers acquisition was unwound as well, as MetLife bought the Life & Annuity business of Travelers for an attractive price.

One correction: in general, we now know that insurers do asset-liability management far better than the banks, and that the banks were considerably overlevered compared to the stable insurers.

I still think the best summary here is: banks can be good marketers of insurance.? They are a logical distribution channel for many lines.? But they don’t do a good job managing insurers.

Insurers may be better at managing their own pup banks, like Allstate and MetLife, but the length of the time of success is too short to be definitive.? Be skeptical of large efforts to blend banking and insurance; it usually doesn’t work.

Full Disclosure: Long ALL

Flavors of Insurance, Part X (Conglomerates)

Flavors of Insurance, Part X (Conglomerates)

One major trend that has existed in the insurance industry over the past several decades is increased specialization. This is true globally, but is most true in the US. In general, being good at one area of the insurance business does not confer significant advantages in other areas. This is true in underwriting, which is a specialized talent in each area of insurance. It is also true in market. Cross-selling opportunities across lines of business are not great enough to justify the effort. There are small consolidation advantages in shared corporate staff, and it may be cheaper to finance a large organization than two smaller ones, but those are slim advantages to conglomerate over. In general, we do not expect an increase in the number of major conglomerates; rather, the trend is toward increasing specialization, with increasing scale within a company’s area of specialization.

The most successful conglomerates have tended to be holding companies that allow individual operating companies to act with little coordination. They require results from the subsidiaries, and intervene when the holding company does not get results. The holding company directs the allocation of capital to the businesses that offer the best prospective returns. In one sense, some insurance conglomerates invert the insurance model; they are essentially investment companies, with insurance liabilities issued to provide funds to invest in favored projects. With ordinary insurers liability issuance leads the process.

The excellent performance of the conglomerates group is unique to two companies that are large and do it particularly well: AIG and Berkshire Hathaway. As these companies get larger, it will be increasingly difficult for them to achieve above average performance. It will also be more difficult to do as well without their unique current leaders.

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Bringing it to the Present

Well, when I wrote about this in 2004, I had not yet focused on the growth of debt inside AIG.? The firm I was with owned AIG, and sold into the flood of buying that occured when AIG was added to the Dow.

But I can adjust my views.? Before the time Greenberg was being shown the door, I was bearish on AIG because I thought that leverage was too high, far greater than the rating agencies should allow, which explained why AIG credit traded more like a single-A credit.? I also reflected on my prior days at AIG with more insight than when I was younger, and wondered if it might not be possible that the accounting at AIG was very liberal.? While working there, I was involved with uncovering five reserving errors, each of which should have led to a hiccup in earnings, and in one case, a severe loss.? But the earnings kept going up.

When I have written things like this, I have never gotten flak from people inside AIG; rather, I get e-mails from people inside AIG that have had similar experiences.? Part of the problem was the culture of fear.? When telling the truth is initially derided with force, even if it is eventually accepted if you are strong enough, you will get few people taking the risk to tell the truth.

But without Greenberg, AIG was doomed in the short run.? No one else could manage it, even if it was crooked in some ways.? The truth withheld re-emerged, and those in charge got whupped for the sins of Greenberg.

But what of insurance conglomerates generally?? I don’t recommend them, because synergies are few, and focus is necessary for most effective insurance companies.

Flavors of Insurance, Part IX (Title)

Flavors of Insurance, Part IX (Title)

The title insurance industry is small. How small is it? If you added together the market capitalizations of all title companies, it would be smaller than half the market capitalization of the largest life company. It would be less than 5% of the size of AIG.

Most people view title insurance as a necessary evil, or even a pseudo-tax, when they purchase or refinance a home. The main reason for that is that few people ever experience a fraudulent conveyance of a title to a property. Loss ratios are mid-single digits in percentages. There is no underwriting cycle in title insurance because claims are not a big enough part of the business.

Most of the economic challenge of running a title insurer comes from expense control. Distribution expenses are big; they range around half of premiums. Profit margins are typically a mid-single digit percentage of premiums as well. General and administrative expenses absorb the rest of the premiums.

Title insurers exist to protect purchasers of homes and their lenders from fraud in the conveyance of the title to the property. Title insurance is different, because it protects against events that have happened prior to the inception of the policy. Title insurance allows the gears of buying and selling homes to grind smoothly in the US. If our local governments did a better job of tracking property transactions, perhaps title insurers would not exist, as is true in most of Europe.

Because a large number of title policies are originated because of refinancing, and refinancing comes in waves, expense management is a priority for title insurers. Today, most title insurers employ temporary workforces that they grow substantially during refinancing waves. It is more costly to have temporary employees, but it makes responding to large changes in demand possible.

That interest rates have fallen so much has driven many of the title insurers to seek avenues of diversification, because opportunities to originate policies because of refinancing will likely not be as big in the next ten years as it was in the last ten. Most of the diversification is taking place in real estate related industries, thus leveraging off of existing competencies and relationships. Other efforts have been into other financial businesses including asset management, trust services, and credit verification services. The jury is still out on whether these diversification efforts will pay off; still to this point, no major company in the space has less than 75% of profits coming from lines of business other than title insurance.

For a business that sounds so marginal, why have the stocks done so well over the past ten years? A combination of three factors made it so: first, valuation levels were low back in 1994, as refinancing slowed down marked when rates began to rise. Second, there are barriers to entry; creating a new title insurer would involve creating or purchasing new databases of property records, which would be prohibitively costly. Third, falling interest rates since 1994 created three major refinancing waves that allowed for the issuance of many additional policies. Because interest rates are low now, and valuations considerably higher than where they were in 1994, we are less optimistic on high returns for the sub-industry for the immediate future. It is also possible that new title products, such as lien protection products, may eat into gross margins. That hasn’t happened so far, but it is another thing to watch.

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The big four became the big three.? LandAmerica died, which was the company I thought was the most reckless (note my comments at RealMoney).? The two large companies, FAF and FNF went through transformations, selling off their arms that did everything except title, unlocking a lot of value in the process.

Lien protection products ended being a big zero.? Perhaps that could have been a way for the GSEs to justify their existence, but no.

And yet, title insurers took some real losses from the financial crisis.? Not surprising, given the open-ended nature of title claims, and the degree of potential for fraud when real estate is sagging dramatically.

Just as residential real estate will take a while to settle, so will it be the same for title insurers.

Flavors of Insurance, Part VIII (Financial)

Flavors of Insurance, Part VIII (Financial)

Financial guarantee insurers insure creditworthiness in a number of related, but different areas. They insure home mortgages for lenders who accept low down payments. They insure the debt of municipalities, who often find it cheaper to sell insured debt. In structured finance they guarantee the senior-most debt branches of residential mortgage [RMBS], commercial mortgage [CMBS], and asset-backed securities [ABS]. In the corporate credit arena, they guarantee the senior-most debt branches of collateralized debt obligations, and occasionally, single issuer project finance.

There are generally two types of companies in this sub-industry, with a slight overlap of business between them. One group guarantees low down payment mortgages for lenders. The other group engages in the rest of the businesses listed above. Financial guaranty and mortgage insurance are regulated separately from other types of property and casualty insurance. For the most part, companies that engage in these lines of business are specialists, though their continued high profitability is attracting new entrants.

Financial guaranty insurers have a primary function of credit enhancement for the corporate, municipal and consumer credit. In this function, securitization both competes with and facilitates their business. RMBS, CMBS and ABS can be structured as insured deals, or as deals where the senior bonds are protected by subordinated bonds sold to institutional investors at yields appropriate to compensate them for the risk. Even so, insured bonds trade with greater liquidity than uninsured bonds. The financial guaranty insurers are vital to the smooth functioning of structured finance.

The mortgage insurers have faced problems in the recent past. Loss experience on subprime borrowers has been disappointing. There have been bulk loan transactions that have also had poorer loss experience than ordinary transactions that flow one-by-one from lenders. Mortgage insurers are adjusting their pricing to reflect the differing loss costs.

In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.

There are yet other threats that mortgage insurers face. Fannie and Freddie could get their charters adjusted to allow them to accept uninsured mortgages with lower down payments. Large lenders could decide that they don’t need insurance for loans that they keep on balance sheet. Second mortgages compete with mortgage insurance. Inflated appraisals inflate the true amount at risk to the mortgage insurers. Finally, refinancing makes it difficult for the insurers to retain business on their books.

Aiding the mortgage insurers is the continued price appreciation of housing, which lowers the incidence and severity of claims. Homes are critical to most people who own them; it usually is the last thing that people will miss a payment on. Finally, there are significant barriers to entry for new competitors in the mortgage insurance business.

With the financial guaranty insurers, the issues are different. The amount of leverage is huge; the face amount of debt insured at a AAA financial guaranty insurer can be more than one hundred times greater than their surplus. Financial guaranty insurers underwrite to a zero loss tolerance. In other words, every transaction is expected to produce no losses; anything less than that would make the ratings agencies downgrade them severely.

Balance sheet complexity is large in terms of the many contingencies insured. Remember our phrase “too smart for your own good risk?” That may apply here. The rating agencies consistently affirm that these insurers are AAA, but we will argue that the rating agencies are co-dependent with them. The financial guaranty insurers indirectly generate a lot of revenue for the rating agencies. If an insurer begins to slip, initially it would pay the ratings agencies to delay the recognition of that, and work with them to lower leverage; the damage to the ratings agencies and financial guarantee insurers from a downgrade of a financial guarantee insurer to less than AAA would be huge. It would throw into question many of the fundamental underpinnings of the structured securities markets. It would also lead to turbulence in the AAA-only portion of the fixed income markets, which are quite large, but can’t deal with any degree of uncertainty.

Against this, the financial guarantee insurers have the following big advantage: they only guarantee the timely payment of principal and interest of obligations. If it is to their advantage to pay off the obligation immediately, they will do so. If it is to their advantage to string out the payments, they can do that as well. In a time of financial stress, the financial guaranty insurers can pay off claims slowly, and reduce the writing of new business, which would allow them to delever rapidly.

The twin engines of the rise of structured finance and low down payments on mortgages amid a rapidly growing housing market have fueled the performance of this sub-industry. The stocks in this industry have performed well. Valuations today are not outlandish, but they are kept low by the concerns that we have listed above.

In general, we believe that the future will be more risky for this sub-industry than the past. Both engines of growth will be slower in the future. In addition, the mortgage insurers have to contend with borrowers that are reliant on the low interest rates on ARMs in order to continue making payments on their homes. Consumer credit is overextended, and that will affect the loss experience on RMBS and ABS.

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I wish I had screamed louder.? Yes, I told the party line story back in 2004, but I tried to highlight the risks involved.

When I went to work for Hovde, I had a hierarchy of trust for reserving:

  1. Life
  2. Personal lines / Health
  3. Commercial Lines
  4. Reinsurance
  5. Title
  6. Financial

Financial insurers and mortgage insurers have proven less than sound.? They are just another example of what happens when leverage collapses.

As a bond manager, I never trusted the rating agencies on structured finance.? I wanted my AAA bonds to be AAA without support.

The financial insurers were too critical to the system.? We needed them to work.? That should have been the signal that something was wrong.? When something has to work, we are in big trouble, that is a sign that things are out of balance.

As it is now things are broken, and we are in an intermediate state where we are waiting for guarantors to be created.? The system needs third parties to take risks for pay.

Flavors of Insurance, Part VII (Health)

Flavors of Insurance, Part VII (Health)

Health insurers have changed over the past thirty years. Thirty years ago, health insurers were strictly indemnity-based, and there were many of them. Many multiline insurers had health insurance subsidiaries. The creation of HMOs and Preferred Provider Organizations [PPOs] were innovations that helped lead to a consolidation in the sector. Today few health insurance providers are part of multiline insurers. Health insurers are specialists.

Another trend among health insurance is the slow but steady demutualization of Blue Cross/Blue Shield affiliates. The greatest expression of this is found in the merger of Anthem and Wellpoint, where the combined entity covers thirteen states, and makes it the second largest health insurance provider in the US.

Health insurance only became a profitable venture on an underwriting basis recently. If you added up underwriting profits and losses from health insurance through the 1990s, the profitability was breakeven. Since then, expense control on medical providers and at health insurers helped bring the group to sustained profitability. Part of that might be attributable to larger health insurance companies gaining additional bargaining power. The increase in market share of the major health insurers has helped to raise barriers to entry in the space. It is difficult to replicate the advantages of the largest health insurers in terms of buying power, or in terms of the ability to service national accounts.

People in the United States want the best of two incompatible worlds with health care. They want it to be inexpensive to users, and yet be available “on demand” with services of the highest-tech nature. Individuals and firms want it to be socialistic if their own costs are heavy, and “free market” if they are small. Add onto this the demand of perfection of results, enforced by tort attorneys, which drives up costs. Doctors practice defensive medicine in order to avoid malpractice claims, which is costly.

Because of their buying power, government-related purchasers of health care also tend to be price-sensitive purchasers of health care, leading health care providers to shift costs to private purchasers that are price-insensitive in the short run. Health insurers are middlemen in this situation, attempting to deal with the conflicting goals of controlling costs, while providing an amount of services that keeps users of the system happy.

Because of the foregoing, costs have been rising at rates in excess of the inflation rate in the general economy. There is consistent political pressure against the profits of health insurers, but it has not affected profit margins over the past three years. The health insurers have been able to pass through their cost increases so far, but the possibility of government actions makes future results less predictable.

The stock performance of the health insurers was fairly flat through the end of the nineties. In the 2000s, return improved dramatically, due to the advantages of scale and expense control. The advantage of scale is not going away, but the above average profits of the last four years may prove difficult to maintain, as the government will find it difficult to not increase regulation in response to complaints over high health insurance premiums in the face of what are viewed as high profits.

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Bringing it to the Present

After fighting off federal regulation 2004-2008, health insurers did a deal with the devil, deciding that it would be better to be health utilities than dead.? At this point, I do not know how things will go:

  • Will ObamaCare be ripped out two+ years from now?
  • Will ObamaCare be defunded?
  • Will ObamaCare persist?
  • And if there are changes, what will replace the current system?

The one thing presently in favor of the health insurers is the graying of the Baby Boomers.? There will be increased need, but how will it be filled?

Flavors of Insurance, Part VI (Brokers)

Flavors of Insurance, Part VI (Brokers)

Commercial purchasers of insurance often hire insurance brokers to search for the best coverage from a price and quality standpoint. In return for their services, insurance brokers receive a commission that is a percentage of the premium. Insurance brokers bear no underwriting risk; the primary risk of an insurance broker is that margins get squeezed when P&C rates go soft. This has the countervailing advantage for investors, that after a major catastrophe, the brokers will always do well, because rates rise, and the brokers have no risk of getting tagged for claims.

Part of the story for the insurance brokerages has been the continuing acquisition of small “Mom-and-Pop” insurance brokerages. Twenty years ago, the insurance brokerage space was fragmented. There is still a decent amount of fragmentation today, but now there are major firms that define the sub-industry.

Among the biggest firms, there are sometimes other business lines that form a significant part of the total enterprise. Human resources consulting, benefits consulting, risk management consulting are common ancillary enterprises. Less common are asset management services, and owning insurance companies, but some of the bigger firms do those.

Expense control and discipline in acquisitions are critical aspects of a successful insurance brokerage, as the lack of either one will impair long term earnings power. Our biggest concern with acquisitions is that the prices paid to “roll up” smaller insurance brokerages will eventually rise to levels that make their purchase uneconomic, but the purchases will continue in a foolish attempt to gain market share.

The insurance brokers had a great run of growth through the nineties. Since 2000, their performance has been flat for a number of reasons: underperformance of non-insurance brokerage operations, and slowing organic growth. With P&C premium rates moving from slow positive growth to flat at present, flat performance from the sub-industry for the near term is what we would expect.

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Some things I got right here, and others wrong.? On net, the group didn’t do much since I wrote the above in 2004.? But almost all of the little companies got acquired, often by private equity, even a few that I thought were garbage.? The big players suffered through the scandal of contingent compensation, while the little players ignored the threat successfully, because the threat from Spitzer and other AGs would not stand up in court.? The big players buckled under the load of bad PR.

So, among the publicly traded companies five remain — Marsh & McLennan, Aon, Willis Group, Brown & Brown, and AJ Gallagher.? I own none of them, and looking at the valuations and soft P&C insurance markets, I have no interest at all.? Short them if you like, though I won’t.

One closing note, contingent commissions have returned.? In any sort of business transaction where there are multiple parties at the table, be aware of who is allied with whom.? Do not assume that there are neutral parties.? Who is paying whom?? If buying from someone, be skeptical about trusting the opinions of “neutral parties” that are paid by them.

Flavors of Insurance, Part V (Reinsurance)

Flavors of Insurance, Part V (Reinsurance)

Reinsurance takes on the risk profile of the insurers that they reinsure. Put simply, reinsurers pay a portion of the claims reinsured in excess of a threshold, in exchange for a premium paid to assume the risk.

Ten years ago, the major European reinsurers, together with Lloyd’s of London dominated reinsurance. Many major US companies had significant reinsurance operations. These statements are less true today. The European reinsurers have been downgraded because of past poor underwriting, reducing their current reinsurance capacity. US firms have tended to specialize over the last decade. Many companies closed, sold, or spun off their reinsurance operations.

There has been a tendency for reinsurers to migrate to Bermuda over the past ten years. There is a combination of professionalism, favorable regulation, and low taxation that encourages reinsurers to set up shop in Bermuda. A great deal of opportunistic capital shows up and forms new companies after major disasters, in order to take advantage of the higher premium rates available. This has had the effect of making it hard for older reinsurers to heal after a major catastrophe, such as Hurricane Andrew or 9/11. They bear the claims, but get less of the benefit of higher premiums because of all of the new competition.

This makes the character of a reinsurer’s management team all the more important. It is very difficult to bounce back from big underwriting losses, so conservatism in reserving and rate-setting is required for long term financial success. One key to assessing conservatism is whether a reinsurer will slow down in a soft market, and return capital to shareholders. It takes humility and discipline to sit back when market conditions aren’t favorable, and your competitors are growing their premium volumes rapidly.

In one sense, because of opportunistic capital, the reinsurance industry resembles a series of Lloyd’s syndicates. After a major catastrophe, new companies form that have no legacy liabilities, and write fresh business at high premium rates. They are similar to Lloyd’s syndicates at their start. Old reinsurers tagged with claims from the catastrophe resemble Lloyd’s syndicates with open years that they can’t close, because the claims have not settled, or the claims impair their capital. The older reinsurers, once hobbled, will have a tendency to slow down, and perhaps merge their way out of existence.

One more new issue is reinsurance receivables. With all of the credit downgrades, many insurers find themselves with reinsurance receivables from claims that they submitted, but have not settled yet. There are quite a few insurers and reinsurers that have reinsurance receivables greater than their capital and surplus. In a crisis, where prompt payment from reinsurers is needed, a high degree of reinsurance receivables from low rated insurers could result in ratings downgrades, and possibly insolvency. This has led many insurers to request collateralization of reinsurance when dealing with lower rated reinsurers. To the extent that reinsurers agree to collateralization, it makes their assets less flexible, and reduces the degree of leverage that they can operate at. Most reinsurers are resisting posting collateral, but so long as reinsurance receivables don’t get paid rapidly, and credit quality is low, the demand for collateral can only grow.

Investment policy for reinsurers is similar to that of the companies that they reinsure. Most reinsurers run conservative portfolios, because they take enough risk underwriting reinsurance. Some newer reinsurers are using hedge funds as part of their investment strategy, thinking that they can earn more investment income, but with lower risk. The jury is still out on this approach. We fear that some of the reinsurers are taking on what we call “too smart for your own good” risk, and that hedge fund investments will prove to be less diversified than they expected in a crisis, perhaps even a crisis with insurance claim applications, like 9/11.

Reinsurers mirror the hard and soft P&C markets globally, but with greater volatility. The hard market 1994-1997, gives way to a soft market 1998-2000, followed by the 2000-present hard market. Property reinsurance rates are slowly falling at present, but rates are adequate for profitability. Casualty and Life reinsurance rates are rising but at slowing rate; the amount of rise varies considerably by line of business. In general our outlook for reinsurance stocks is positive, but highly selective. Stick with conservative management teams and you will do well over the full underwriting cycle.

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Bringing it to the Present

This was written before the hurricanes of 2004 and 2005.? Think about it.? After 2005, there was a belief, supported by the concept of global warming, that hurricanes would be far more than in the past.? I did not buy that.? Two years of bad hurricanes is not a trend; four might be.

Cut to today.? Five wimpy hurricane seasons.? No earthquakes. Few huge European Windstorms. Few hurricanes hitting Japan.

That doesn’t mean the future will be good.? In fact for reinsurers, because surplus is so adequate, premiums may be too low.? But valuations of reinsurers are low, reflecting that risk.? I ind the sector reasonable but not cheap.

Full disclosure: long PRE, RGA

Flavors of Insurance, Part IV (Commercial)

Flavors of Insurance, Part IV (Commercial)

I am rarely a fan of commercial lines insurers. Over the past ten years, it has been the lowest returning sub-industry in insurance. There are several reasons for this: first, asbestos has been an open-ended drag on the industry’s surplus. Second, many commercial lines companies underwrote coverages where those insured understood the risk better than the companies. Examples of this include directors and officers, errors and omissions, surety, environmental, and political risk. Third, the devolving legal landscape has often left commercial lines insurers at a disadvantage in the courtroom. Policies get interpreted as providing coverage in ways not contemplated at the contract’s inception. Fourth, wars over market share depress premium levels.

Commercial coverages are typically larger in size, and do not share in the law of large numbers to the same degree that life and personal lines do. Underwriting results have a greater degree of variability because of this. The greater degree of profit and loss potential attracts less cautious insurance executives, underwriters, and investors. This can lead to tremendous results in the stock market if you buy the commercial lines stocks just as the underwriting cycle shifts from phase 2 to phase 3, such as in 2000. It can be equally bad if you buy them as the underwriting cycle shifts from phase 4 to phase 1, such as in 1998-1999.

Reserving for commercial lines insurers is similar to that for personal lines insurers, but the main difference comes from the uncertainty of claims reporting in long-tailed coverages. With auto and home coverages, most claims are filed and settled within a few months. Almost no claims extend over two years. Now considerable environmental damage coverage: claims could be filed decades after occurrence, settlement could take years, and the size of the claim could be significantly larger than anticipated. This makes reserve setting for commercial lines insurers more of an art than a science.

Secular shifts in society can utterly change the probability and severity of claims. As an example, consider directors and officers [D&O] coverage before and after 2000. Many of the events in the corporate scandals investigated in the last few years came from events in the 1990s. Insurers writing D&O coverage in the 1990s had to raise their reserves for accident years the 1990s but the financial result was felt between 2001 and 2003.

Many industry analysts, including the rating agencies, still believe that reserves are insufficient by roughly $50 billion, and that this black hole is spread among the commercial lines insurers and reinsurers of the world. The soft market accident years of 1997-2001 are blamed for this insufficiency. The question that wins the big money for this space goes to the clever analyst that can figure out to whom the black hole belongs.

The $50 billion insufficiency is probably why the stocks of the commercial lines insurers have gone nowhere over the past six years, even in the face of a very hard insurance market over the past three to four years. Commercial lines insurers are in phase 4 of the underwriting cycle, with modest valuations at present. Until the insufficiency is dealt with, or proven false, it is our belief that commercial lines stock will remain rangebound.

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Bringing it to the Present

Well, in 2004, I was wrong here.? Leaving aside AIG, and its losses, and understated reserves, the commercial lines sector did quite well.? Yes, it is very difficult to value commercial lines insurers, because the reserving is less than scientific.? But the difficulties alleged by the rating agencies failed to appear, unless they were somehow sloshed into the hurricane disasters of 2004-5, or like eating an elephant — one bite at a time.

Earnings quality of commercial insurers is always lower than that of personal lines insurers, so the group should trade at a discount to personal lines, as it does now.? And all that said, personal lines insurers did outperform the commercial insurers, even excluding AIG.

Full disclosure: long CB (they are not cheap for insurance prices, but they don’t argue over paying claims)

Flavors of Insurance, Part III (Personal Lines)

Flavors of Insurance, Part III (Personal Lines)

If someone wants to drive a car or take out a secured loan, personal lines insurance typically needs to be bought to protect the interests of other drivers, and lenders, respectively.

Personal lines coverages are simpler in their form, in that they typically renew annually. Commissions are smaller than for life products. Reserves divide into two classes, those for the premium paid but not yet earned, and those for claims incurred. Incurred claims fall into two categories: those reported to the company, and an estimate of those incurred but not yet reported to the company [IBNR].

Personal lines insurers have two sources of profit, underwriting and investment income. The track record of the industry has been less than stellar. Most companies over the past fifteen years have lost money on underwriting and made money on investments. In general, the best managed, and most profitable personal lines writers give up sales growth in order to have an underwriting profit.

This has been less true of homeowners? insurance, where personal lines writers have consistently lost money on underwriting. Part of the reason for that is homeowners is often treated as a poor stepchild to auto insurance, and only used to generate additional automobile premium.

Performance of the personal lines insurers over the past ten years reflects the relatively hard market through 1997, with strong investment performance through 1999 not getting reflected in stock prices. Money was flowing away to technology stocks. In March of 2000, the next hard market began, and the stocks personal lines insurers rebounded, despite relatively poor performance in the investment markets.

At present, the personal lines insurers are entering phase 1 of the underwriting cycle. Premium rates are trending flat in automobile, and rising in the low single-digit percents for homeowners, but the increases are slowing. Valuations are not excessive, so there should not be a major selloff, unless premium rates soften dramatically. We expect premiums to remain flat for a while, so personal lines stocks should perform at roughly the rate of the return on equity for now.

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Bringing it to the Present

We are back to Phase 1 of the underwriting cycle.? There have been no big disasters, God-given or man-made to deplete surplus, for a long time.

My view is that the personal insurers should always trade at a premium to the commercial insurers because they are safer.? It is always easier to run a short-tail company than a long-tail company.? At present, that relationship is normal.

Personal lines companies have a tailwind in that the zeitgeist has policymakers taking actions to prevent accidents — graduated licensing, anti-drunk driving, making cars safer for drivers even it creates more cars that get totaled, while passengers survive better.

Valuations are reasonable-to-cheap in aggregate here, and the same is true of the life sector.? I am overweight insurers by a factor of six, relative to their weight in the indexes.? They comprise all of my exposure to financials.

Full disclosure: long ALL, SAFT

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