Search Results for “rga reinsurance”

On Life Insurance and Life Reinsurance

Posted on 30 July 2012 by David Merkel

I get good questions from readers.? Here’s one from this post:

Is there a reason why life reinsurance companies are better positioned then life insurers?

Don?t they face the same problems that they won?t be able to generate as they roll their portfolios into lower yielding bonds going forward (since rates have come down so much)?

Basically just wondering why you think RGA is cheap at 84% of AOCI adjusted book but not the rest of the life insurance industry at 35%-75% of tangible book?

Is it mostly due to your opinion of management?

I started to leave a reply and the normally reliable software glitched, and I lost it. Dejected, I decided to make it a post.

First, life reinsurance is much less competitive than life insurance.? Globally and in the US, the top 5 life reinsurers have ~80% of the market share.? Life insurance is far more fragmented, and has a decent slug of mutual insurers who don’t have an explicit profit motive.? (Note: many of the large mutuals are exceedingly well run, which makes the competition even stiffer.

Second, life reinsurance is mostly mortality exposure-based, versus life insurers which are mostly investment spread based.? The law of large numbers favors the life reinsurers over the insurers.? Low interest rates will not affect reinsurers as much as insurers.? Hint to those who analyze life insurers and reinsurers: look in the statutory statements, which have a lot more data than the GAAP statements for odd reserves that indicate a significant chance of losses if interest rates continue to remain low.

Third, life insurers have weaknesses in reserving practices for variable products with secondary guarantees.? There is no good way to calculate what a proper reserve should be.? The implied options are odd, and have no natural hedges.

That’s why I only own one life insurance company; one that has simple products.? Aside from low interest rates, valuations are low at life insurers because of lack of certainty over reserves.

So, much as I like RGA management, they are not the main reason why I like the company.? RGA executes well, and has an excellent reputation in its industry.

Here’s another question that I received via e-mail:

Prices of financial services stocks are too cheap for me to resist these days. ?I see companies like Citigroup as being just given away by Mr. Market.

?Within insurance, my equity exposure is limited to AIG, which I consider to be well managed, misunderstood, and priced attractively enough to continue holding. ?Over the past month other insurers have started to grab my attention (HIG, MFC, MET, PRU). ?HIG stands out as being the least sensitive to the possibility of a decade of financial repression. ?Do you have any favorites that you would care to share? ?This topic could make for a timely blog posting.

I responded:

Value trap.? Focus on sustainable ROEs that will validate book value.? The accounting of AIG is a quagmire, even after their disposals.

There is a further difficulty with life insurers at present.? The GAAP accounting standards do not fairly reserve for secondary guarantees on insurance and annuity policies; truth, as a life actuary and a financial analyst, the options offered are so complex and long-dated, that I?m not sure there is a way to value them.? Over the last 10-20 years, we knew that this could be an issue, but we are now seeing the issue creep in as stock performance ebbs.

But if you disagree, consider PNX, it has all of the issues, and then some.? Be sure to get the Statutory books of the companies you buy here, because that drives dividend payments to the indebted holding company.

And one more e-mail:

Hi David,?? I have enjoyed reading your blog for many years (even before GGG recommended it)

I have two questions for you about insurance companies in general — I know you are very busy, I am just hoping you can point me to some websites where I can do my own homework.

(1) If I want to check the financials of a number of mutual insurance companies, is there a consolidated source??? Do I need to pull the annual statements of each one and are the different state accounting rules comparable?

(2) As I understand it (and I am quite new to this so I may have this wrong) — mutual insurance companies use “statutory accounting”, which is different from US GAAP.??? Is there a website or library book that explains the differences between these two methods????? Does statutory accounting differ from state to state?

Again, I am sure you are very busy and I will have to do my own research / homework.? You seem to be more knowledgeable than most about insurance accounting, and I am hoping you can point me to some documentation that will help me gain a better understanding.

My response:

1a)? Consolidated source: https://eapps.naic.org/insData/ , but most companies will send it to you if you ask.? Haven?t been turned down yet, aside from Berkshire Hathaway? and I?m working on that.

1b) Generally, you have to pull each one.? Some companies will do a combined set of schedules for their investments.? When I got AIG 3 years ago, there were 60+ books?

1c) There are slight differences by state, but most of the time you can neglect that.

2a) Mutual companies use statutory accounting, but so do stock companies for the state?s analysis of insurance subsidiary solvency.? And, though stock companies use GAAP for reporting to shareholders, many mutual companies will have an internal pseudo-GAAP basis for analyzing long-term profitability, and for management bonuses, yeh.? Statutory accounting is in some ways more critical than GAAP even for stock companies, because that determines how much cash can be distributed to the holding company, which is crucial if the holding company needs to make interest payments, or wants to make dividend payments.? This is one reason why actuaries often price products by calculating marginal distributable earnings.

2b) I have attached what I think is a short primer on GAAP vs Stat accounting.? This is a big topic, and the NAIC sells all manner of resources at high prices with all of the gory details.? This should give you a good start.? I general, the volunteers from the actuarial societies put out some good summary stuff, but you have to hunt for it.

Keep fighting the good fight.? Bloggers are the conscience of Wall Street and DC?

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Life insurance is tough because there is uncertainty on claim payment on timing, and uncertainty of investment earnings.? The latter is usually more serious, because the law of large numbers does not help.? Add in the valuation issues, and now you know why a life actuary primarily invests in P&C insurance companies, life reinsurers, and simple life companies.

Full disclosure: long RGA

Reinsurance Group of America

Posted on 24 September 2011 by David Merkel

I read an article by Zacks on RGA.? I thought it was poorly reasoned.? Here’s what I wrote as a comment:

“However, the primary factors to our Neutral recommendation are Reinsurance Group?s reliance on availability for affordable retrocession. The company had increased the maximum amount of coverage that it retains per life in the U.S. from $6.0 million to $8.0 million. This reduces the amount of premiums it pays to retrocessionaires, but increases the maximum effect a single death claim can have on its results, and therefore may result in additional volatility to its results.

Also interest rates are likely to remain low in 2011 and spreads narrow further. We expect to see additional pressure on the Reinsurance Group?s investment income. Moreover, management?s conservative positioning of the investment portfolio is expected to exert pressure on yield.”

I hate to say this, but you don’t know life reinsurance that well if this is your reasoning. Interest spreads are not a major factor in RGA’s profitability. Also, the retrocession cartel charges an arm and a leg for coverage. The earnings will be more volatile, but they have always been volatile with RGA. The time to buy is after a bad quarter, because mortality is random, but RGA underwrites well.

Let me get this straight. This company has a big moat; it’s part of the life reinsurance oligopoly. It’s trading at a forward P/E of 6, a trailing P/E of 5.5, and 65% of unadjusted book. This company is a leader in its industry globally, and you rate it a hold?

Let me tell you a secret. You almost never lose on companies with little debt, trading at single digit P/Es, and trading below book, conservatively stated.

I own this stock, and so do my clients.

RGA is trading cheap enough that I am considering making it a double-weight in my portfolio.? It is a single-weight at present.? It is genuinely rare that one finds such a quality company with protected boundaries trading at such levels.? There are five companies that dominate life reinsurance globally, and in my opinion, RGA is the best, though they are a close number 2 by most measures of market share.

I don’t like writing about individual companies, because when you are right, one person praises you.? When you are wrong 10 people criticize you.? But for all that I simply say that I am long RGA for myself and my clients.

Flavors of Insurance, Part V (Reinsurance)

Posted on 9 December 20109 December 2010 by David Merkel

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

Again, Not Worried About Reinsurance Group of America

Posted on 3 June 20083 June 2008 by David Merkel

From the 6/2 RealMoney Columnist Conversation:

		David Merkel
		Rebalancing Sales, and a Buy
		6/2/2008 4:08 PM EDT

Late last week, I had two rebalancing sells, Charlotte Russe and Smithfield. Today, two more, Honda Motor and Nam Tai Electronics. As the market has risen (or, some of my stocks at least), cash has been building up, and I have added some of my own free cash to the Broad Market portfolio. I’m at about 14% cash.

So, it’s time to buy something, though I am waiting on the market to show a little more weakness before I act. But, though dinner may wait, perhaps an appetizer is in order: today I added to my position in Reinsurance Group of America. MetLife finally decides to shed this noncore asset in a tax-free stock swap, allowing current MetLife shareholders to swap their MetLife shares for shares in RGA.

RGA should get a higher multiple as a “pure play” life reinsurer; that will come later. Today was the selling pressure in advance of the new supply. I like the management team at RGA, and think this will allow them the freedom to add value on their own. One other odd kicker… it might allow them to do more reinsurance business with MetLife, because they will be independent and thus truly be a third party.

Position: long CHIC SFD HMC NTE RGA

A few additional notes, for me long only means running with 0-20% cash. I don’t go above 20%; I don’t borrow. Under normal conditions, I like running around 5-7% cash. If the NAHC stake is counted in, (arbitrage gets a pseudo-cash return) then we are at that 20% upper limit.

That leads me to take a few actions — I have bumped up my central band for my holdings by 16%. Translated, the points at which I do buy and sell rebalancing trades has risen 16%, as has my normal position size. Looking back through the years, back to 1992 when I started value investing, my position sizes were 5% of what they are today, and back then I had 10 positions, not 35. There’s been growth. 🙂

My second action was a temporary purchase of some RGA. I doubled my position temporarily, because I think most analysts will smile on the deal, and RGA has always been a good buy at book value.

No telling whether buying at 1.0x book will continue to be a good idea in the future. RGA is a well-run company in an oligopolistic industry. The management is smart and conservative. They have international growth opportunities, and now, possible new business from MetLIfe. The moat is wide here. You can’t reverse engineer the #2 life reinsurer in the US and the World.

So, I’m happy with my position here. That said, I may trade away the speculative part of my holdings in the short run, and I may buy some MetLife as well. MetLife is cheap, though not as cheap as RGA, but I suspect when MetLife offers RGA shares in exchange for MetLife shares, they will have to make the tradeoff sweet in order to get some flexible institutional investors to do the swap. Why? MetLife is a large cap stock that is very diversified. RGA is a midcap that is not as diversified. MetLife is a well-respected brand name. RGA? Who?

Insurance is opaque; reinsurance is doubly so. There are no comparables for RGA. MetLife has Pru, Principal, Lincoln National, and a few more. So, I may speculate on MetLife in order to get some cheap RGA. Most likely, I’ll need to see the terms, but if RGA is up a lot tomorrow, and MetLife is not, I may just do the swap.

Note to my readers: one odd thing about my blog is that I write about a wide number of issues. I know I have been doing more on my stock investing lately, but that is partially due to the lack of news on the macro front. That’s the nature of what I do. I am an investor that pays attention to the global economy. I’m trying to make money off my insights, and not merely report on what is happening. I hope some of it rubs off on my readers also, and that you personally benefit from it. For those who find my blog to be a confusing melange — well, that’s who I am, a generalist whose interests are broad.

But, if you like the individual stock coverage, let me know. If you hate it, let me know also.

Full disclosure: long CHIC SFD HMC NTE RGA NAHC LNC

Not Concerned About Reinsurance Group of America

Posted on 18 April 200818 April 2008 by David Merkel

So Reinsurance Group of America missed estimates. Big deal; they’ve had good-to-excellent earnings for the last ten quarters; they have a bad quarter now and then when the “law of small numbers” catches up with them. Look at 2Q05 and 4Q01 for examples. The law of small numbers means that every now and then, you get a random gaggle of deaths with high face amounts, and the quarter is bad. This is often a good buying opportunity, because Wall Street, which only understands that the earnings missed, without understanding the underlying model, assumes that the miss will persist into the future. That has not been true of RGA.

I have met the CEO and CFO of RGA, and I think they know what they are doing, more than all of the other companies that do life reinsurance. They are the quality name in the space, including their more complex European competitors.

The stock price is currently way above my lower rebalance point, but I would be a buyer on weakness if I did not have a position. This is one of those stocks that you tuck away for 5-7 years, and you find that it doubles. The current oligopolistic nature of life reinsurance may shorten that timespan.

Full disclosure: long RGA

A few thoughts

Posted on 16 January 2024 by David Merkel

I know I haven’t been blogging for a while. I also haven’t been tweeting. I am shut out of X-Twitter because of two factor authentication issues. As such, I am doing a post today that is Twitter-like, giving my thoughts on a variety of news articles. Here we go:

President Xi’s hero, Chairman Mao said “Women hold up half of the sky.” And, that randy guy Mao certainly “held up half the sky” with many of them. But women in China will not “hold up half the sky” for President Xi. Women in China increasingly do not want to marry and have children. If present trends continue for 75 years (dubious to go out that far), India will be four times larger than China. Even the US will be bigger than China.

Inside a Flaming Jet, 367 Passengers Had Minutes to Flee. Here’s How They Did It. This is very impressive, and shows how a highly conformist society like Japan has its advantages.

‘“Everyone was screaming from the initial impact and then everything got eerily quiet because everyone was confused,” Hayashi said. The passenger next to him appeared to know about emergency procedures. “She started yelling, ‘Put your head down, keep your seat belts on, stay in your seat,’ ” he said.’

From Bloomberg’s evening summary (1/2/24):

“The most common concern or belief we have heard from investors is that overbought conditions and euphoric sentiment will set up for a reversal to start 2024 in both bond yields” and stocks, said Dennis DeBusschere, founder of 22V Research. “The overbought conditions and sentiment readings are tough to argue with.”

Nobel Prize Winner Cautions on Rush Into STEM After Rise of AI

No, keep your eyes on the prize. STEM majors can do creative work. Humanities majors can’t do STEM. Don’t go to college for a major that doesn’t pay you back.

LPs Doubt Venture Funds’ Startup Valuations

The incentives are perverse in setting marks for private equity. There is a tendency to overstate values, and face the problem later when the fund winds up and has to admit losses versus the overestimated marks.

Xi’s Solution for China’s Economy Risks Triggering New Trade War

China’s investment-driven economy is much less productive than most think. It overinvests in industries where the world already has too much capacity (think of what they did with steel), and creates product prices where their investments are practically wasted. This leads to overstated GDP statistics, and greater inequality in China. The Chinese Communist Party has a materialism fetish that makes them think only industry matters. And so they impoverish most of their citizens.

China Leaders Sought Quick Zhongzhi Resolution to Shield Markets

Note that the CCP takes no blame for this. While housing was a tailwind for their economy, they let the bubbles grow in multifamily housing, financial companies, and local government financing vehicles. They only cared that headline GDP statistics kept growing, not the net economic welfare of their citizens.

2023 saw record killings by US police. Who is most affected?

“From 2013 to 2022, 98% of police killings have not resulted in officers facing charges, Mapping Police Violence reported.”

Unless you can get rid of police unions, this is not likely to change. The unions take lower pay raises in exchange for making it difficult to fire officers.

Buying Home and Auto Insurance Is Becoming Impossible

Not so much impossible, but expensive. When the P&C insurance has back-to-back losses from underwriting, surplus is not adequate to write as much business at the same price. Premiums rise for almost everyone, but more so in recent disaster-prone areas… and that goes extra for states that over-regulate insurance.

BuzzFeed’s ‘Dire’ Debt Problem

I know this is kind of “old school,” but don’t buy stocks that don’t earn profits. I know this means I will miss rare unicorns. But most people don’t buy them near the beginning, anyway.

It’s also wise to avoid highly indebted small-cap stocks, whether owning the stock or the debt. It doesn’t take much to capsize a small company like $BZFD.

The Bond Market Rally Is Overlooking a Soaring $2 Trillion Debt Problem

I think deflation is more likely than inflation. The US and other nations are likely to use financial repression (again) to deal with their debt issues. Eventually that will fail in a messy way.

Trumponomics 2.0: What to Expect If Trump Wins the 2024 Election

More of the same, only louder and meaner.

Xi’s Chief of Staff Is Quietly Amassing Even More Power in China

Cai Qi – a man to watch. President Xi is losing touch with reality as almost no one dares to give him honest feedback.

Is private credit a systemic risk?

Probably not, unless investors as a whole underestimate their need for liquidity. Still, remember that new fast-growing asset classes have to go through a failure cycle in order to mature into an asset class where risks are priced mostly right.

Google Lays Off Hundreds in Hardware, Assistant, Engineering

I worked a firm that did annual layoffs. It really ruined employee morale.

There’s Finally Hope for the Office Real Estate Market

This might be a good opportunity. Things aren’t getting worse.

Iran Captures Oil Tanker Off Oman as Mideast Turmoil Deepens

Things are getting messy enough globally, and with US weapons stockpiles depleted, we could be on the edge of something that will prove hard to deal with.

Credit Card Delinquency Rates Climb to Decade High in Fed Study

Credit weakness on mostly the low end of the consumers. There has also been an increase in buy now pay later activity mostly in this same demographic area. It will be a mess, but not big enough to have material second order effects.

Larry Hogan Steps Down From Advocacy Group, Fueling Talk of 2024 Bid

He would be a good president – he’s the best governor the State of Maryland has had in my lifetime.

Fed Posts Largest-Ever Annual Operating Loss

If we are going to have fiat currency, let the Fed’s assets be only T-bills and gold. Don’t take on duration risk, including RMBS.

Taiwan Election Piles Pressure on Delicate U.S.-China Ties

Taiwan’s Raucous Democracy Is Another Challenge to Xi’s Ambition

Dolt that he is, Xi does not get that his recent actions have turned marginal Taiwanese away from reunification. Taiwan is very happy that it is a capitalist democracy. They don’t want to be ruled by authoritarians. Taiwan will not join Communist China without a fight that will destroy most of the value of Taiwan.

Fed Tiptoes Toward Dialing Back Key Channel of Monetary Tightening

The Fed should stop playing around with the size of its balance sheet, and shift its assets to what it was pre-GFC. Simplify. The Fed is doing too much, and as always, they don’t know what they are doing.

Reinsurers launching provisions amid continuing Middle East conflict

Insurers Seek to Exclude US, UK Ships From Red Sea Coverage

War is an undiversifiable risk. Pseudo-wars are similar, so reinsurers are quickly updating new contracts to reflect that.

The Humiliation of Davos Man

Humanity does not want to be one big happy family on the terms of the developed countries.

Inside a Plan to Save Homeowners Hundreds of Dollars Closing Their Mortgages

“The alternative, called an attorney-opinion letter, allows a real-estate attorney to essentially attest that there are no problems with a property’s title. The average borrower relying on such a letter has saved more than $1,000 compared with more traditional title insurance, Fannie said.”

Probably would work, though title insurance is almost bulletproof.

The M.B.A.s Who Can’t Find Jobs

This happens from time to time. When I was an undergrad (1982), out of curiosity I went to a presentation on whether you should get an MBA or not. The advice then was don’t get it, many employers don’t want to pay up for an MBA, so get your BA and apply for work.

Large Backers of Private Equity Are Asking For Their Money Back

Many large LPs are telling GPs they won’t invest in their new PE funds unless they pay them off for old funds that are past the ending date. PE is kind of like a life insurer that mis-reserved a block of their policies, allowing too much income to flow early, and then figures out too late that the block now has an embedded loss.

US Companies Pay Up to Hedge Debt After Interest-Rate Volatility Soars

Looks like many CFOs fear long rates rising again, and are willing to pay up for a cap on their financing rates.

Xi, Biden and the $10 Trillion Cost of War Over Taiwan

The $10 Trillion figure is a wild guess in my opinion, but this article is a good qualitative breakdown of all the risks involved.

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Maybe I will blog more in the future, but business has taken up a lot of time lately.

Thoughts on MetLife and AIG

Posted on 5 February 20165 February 2016 by David Merkel

In some ways, this is a boring time in insurance investing. ?A lot of companies seem cheap on a book and/or earnings basis, but they have a lot of capital to deploy as a group, so there aren’t a lot of opportunities to underwrite or invest wisely, at least in the US.

Look for a moment at two victims of the?Financial Stability Oversight Council?[FSOC]… AIG and Metlife. ?I’ve argued before that the FSOC doesn’t know what it is doing with respect to insurers or asset managers. ?Financial crises come from short liabilities that can run financing illiquid assets. ?That’s not true with insurers or asset managers.

Nonetheless AIG has Carl Icahn breathing down its neck, and AIG doesn’t want to break up the company. ?They will spin off their mortgage insurer, United Guaranty. but they won’t get a lot of help from that — valuations of mortgage insurers are deservedly poor, and the mortgage insurer is small relative to AIG.

As I have also pointed out before AIG’s reserving was liberal, and recently AIG took a $3.6 billion charge to strengthen reserves. ?Thus I am not surprised at the rating actions of Moody’s, S&P, ?and AM Best. ?Add in the aggressive plans to use $25 billion to buy back stock and pay more dividends?over the next two years, and you could see the ratings sink further, and possibly, the stock also. ?The $25 billion requires earning considerably more than what was earned over the last four years, and more than is forecast by sell-side analysts, unless AIG can find ways to release capital and excess reserves (if any) trapped in their complex holding company structure.

AIG plans to do it through?(see pp 4-5):

Reducing expenses
Improving?the Commercial P&C accident year loss ratio by 6 points
Targeted divestitures (United Guaranty, and what else gets you to $6 billion?)
Reinsurance (mostly life)
Borrowing $3-5B (maybe more after the $3.6B writedown)
Selling off some hedge fund assets to reduce capital use. (smart, hedge funds earn less than advertised, and the capital charges are high.)

Okay, this could work, but when you are done, you will have reduced the earnings capacity of the remaining company. ?Reinsurance that provides additional surplus strips future earnings out the the company, and leaves the subsidiaries inflexible. ?Trust me, I’ve worked at too many companies that did it. ?It’s a lousy way to manage a life company.

Expense reduction can always be done, but business quality can suffer. ?Improving the Commercial lines loss ratio will mean writing less business in an already overcompetitive market — can’t see how that will help much.

I don’t think the numbers add up to $25 billion, particularly not in a competitive market like we have right now. ?This is part of what I meant when I said:

…it would pay Carl Icahn and all of the others who would be interested in breaking up AIG to hire some insurance expertise. ?Insurance is a set of complex businesses, and few understand most of them, much less all of them. ?It would be easy to naively overestimate the ability to improve profitability at AIG if you don?t know the business,? the accounting, and how free cash flow emerges, if it ever does.

They might also want to have a frank talk with Standard and Poors as to how they would structure a breakup if the operating subsidiaries were to maintain all of their current ratings. ?Icahn and his friends might be surprised at how little value could initially be released, if any.

Thus I don’t see a lot of value at AIG right now. ?I see better opportunities in MetLife.

MetLife is spinning off their domestic individual life lines, which is the core business. ?I would estimate that it is worth around 15% of the whole company. ?In the process, they will be spinning off most of their ugliest liabilities as far as life insurance goes — the various living benefits and secondary guarantees that are impossible to value in a scientific way.

The main company remaining will retain some of the most stable life liabilities, the P&C operation, and the Group Insurance, Corporate Benefit Funding, and the International operations.

I look at it this way: the company they are spinning off will retain the most capital intensive businesses, with the greatest degree of reserving uncertainty. ?The main company will be relatively clean, with free cash flow being a high percentage of earnings.

I will be interested in the main company post-spin. ?At some point, I will buy some MetLife so that I can own some of that company. ?The only tough question in my mind is what the spinoff company will trade at.? Most people don’t get insurance accounting, so they will look at the earnings and think it looks cheap, but a lot of capital and cash flow will be trapped in the insurance subsidiaries.

There is no stated date for the spinoff, but if the plan is to spin of the company, a registration statement might be filed with the SEC in six months, so, you have plenty of time to think about this.

Get MET, it pays.

One Final Note

I sometimes get asked what insurance companies I own shares in. ?Here’s the current list:

Long RGA, AIZ, NWLI (note: illiquid), ENH, BRK/B, GTS, and KCLI (note: very illiquid)

Learning from the Past, Part 5b [Institutional Stock Version]

Posted on 1 May 2015 by David Merkel

Photo Credit: Ian || Watching Capital Implode is a Marvel to Behold!

This is one of the many times that I wish RealMoney.com had not changed its file structure, losing virtually all content prior to 2008. ?(It is also a reason that I am glad I started blogging. ?It’s more difficult to lose this content.) ?When I was a stock analyst at Hovde Capital Advisors, I made 2 humongous blunders. ?I wrote about them fairly extensively at RealMoney as the?situation unfolded, so if I had those posts, it would make the following article better. ?As it is, I am going to have to go from memory, because both companies are no longer in business. ?Here we go:

Scottish Re

Sustainable competitive advantage is difficult to find in insurance. ?Proprietary methods are as good as the employees creating and using them, and they can leave when they would like to. ?This applies to underwriting,?investing, and expense management. ?What else is there in an insurance company? ?There are back end processes of valuation?and?cash flow management, but those financial reporting processes serve to inform the front end of how an insurer operates.

One area that had and continues to have sustainable competitive advantage is life reinsurance. ?An global oligopoly of companies grew organically and through acquisitions to become dominant in life reinsurance. ?Their knowledge and mortality databases make them far more knowledgeable the life insurers that seek to pass some of the risk of the death of their policyholders to them. ?They can be very profitable and stable. ?I already owned shares of RGA for Hovde, and in 2005 wanted to expand the position by buying some of the cheaper and more junior company Scottish Re.

Scottish Re had only been in business since 1998, versus?RGA since 1973. ?These were the only pure play life reinsurers in the world. ?Scottish Re had grown organically and through acquisition to become the #5 member of the oligopoly. ?The top 5 life reinsurers controlled 80% of the global market. ?I made the case to the team at Hovde, and we took a medium-sized position.

The first thing I should have noticed was the high level of complexity of the holding company structure. ?Unlike RGA, they operated to a high degree?in a wide number of offshore tax and insurance haven domiciles — notably Bermuda, Ireland, Cayman Islands, and others. ?Second, their ownership diagrams rivaled AIG for complexity, and their market capitalization was less than 2% of AIG’s at the time. ?[Note: balance sheet complexity did not bode well for AIG either — down 98% since then, but it beats Scottish Re going out at zero.]

The second thing I should have noticed was the high degree of underwriting leverage. ?Relative to RGA, it reinsured much more life risk relative to the size of its balance sheet.

The third thing I should have noticed was the cleverness of some of the financing methods of Scottish Re — securitization was uncommon in life reinsurance, and they were doing it successfully.

The final thing that I should have noticed was that earnings quality was poor. ?They usually made their earnings, but often because their tax rate was so low… and the deferred tax assets were a large part of book value. ?(Note: deferred tax assets only have value if you are going to have pretax income in the future. ?That was soon not to be.)

In 2005, Scottish Re won the auction for buying up another member of the oligopoly, ING Life Re. ?I asked the CFO of RGA why they didn’t buy it, and his comment was that he didn’t think anyone would pay more than they bid. ?That should have led me to sell, but I didn’t. ?The price of Scottish Re drifted down, until August 3, 2006, when they announced second quarter earnings, reporting a huge loss, writing off a large portion of their deferred tax assets, and the stock price dropped 75% in one day. ?I eventually wrote about that at RealMoney, noting it was the single worst day in the hedge funds history, and it was due to my errors. ?You can also read my questions/comments from the conference call here?(pages 50-53).

If you look at the RealMoney article, you might note that we tripled our position at around $6.90?after the disaster. ?That took a lot of guts, and we didn’t know it then, but it was the wrong thing to do. ?The stock rallied all the way up to $10 or so. ?If it hit $11, we were going to sell out. ? That was not to be.

I spent hours and hours going through obscure insurance filings. ?I analyzed every document that I could get my hands on including?the rating agency analyses, because they had access to inside data in aggregate that no one else had outside of the company. ?The one consistent thing that I learned was that insolvency was unlikely — which would later prove wrong.

The stock price fell and fell all the way down to $3, with rumors of insolvency swirling, when Mass Mutual and Cerberus rode to the rescue on November 27, 2006, buying 69% of the company for a paltry $600 million in convertible preferred stock. ?At that point, I finally got it right. ?All of my prior research had some value, because when I read through the documents that day and saw the liquidity raised relative to the amount of ownership handed over. ?Given the data that they now handed out, I concluded that Scottish Re was worth $1/share, and possibly zero.

But there was a relief rally that day, and we sold into it. ?We ended up selling about 4% of the total market cap of Scottish Re that day at a price of $6.25.

The bright side of the whole matter was that we could have lost a lot more. ?Scottish Re was eventually worth zero, and?Mass Mutual and Cerberus took significant losses, as did the remaining shareholders.

As it was, the fault was all mine — my colleagues at Hovde deserved none of the blame.

The Lesson Learned

One year later, I wrote a note to the late Greg Newton who wrote the notable blog, Naked Shorts, when he was critical of Cerberus (they had a lot of failures in that era). ?This was the summary that I gave him on Scottish Re:

Cerberus got into SCT @ $3; it’s now around $2.? For me, on the bright side, when their deal with SCT was announced, I quickly went through the data, and recommended selling.? We got out @ $6.25.? That limited our losses, but it was still my biggest failure when I was at Hovde.? The mixture of leverage, alien domiciled subsidiaries, reinsurance underwriting leverage, plus complex and novel securitization structures was pure poison.? I was?mesmerized?by the?seemingly cheap valuation and actuarial studies that indicated that mortality experience was a little better than expected. ?I?violated my leverage and simplicity rules on that one.

He gave me a very kind response, better than I deserved. ?As it was Scottish Re went dark, delisting in May 2008, and trading for about a nickel per share at the last 10K?in July of 2008. ?It eventually went to zero.

The biggest lesson is to do the research better on illiquid and opaque financial companies, or, avoid them entirely. ?Complexity and leverage there are typically not rewarded. ?I’d like to say that I fully learned my lesson there, but I got whacked again by the same lesson on a personal investment later in 2008. ?That’s a subject for a later article.

I have one more bad equity investment from my hedge fund days, and I will write about that sometime soon, to end this part of the series.

Full disclosure: still long RGA for my clients and me

One Less Mentioned Reason for Stock Buybacks

Posted on 6 September 2014 by David Merkel

1357046602_c11590eace_z — Photo Credit: Bill Selak

Buybacks are not my favorite way to redeploy excess capital, in general. ?But let me describe to you when they are useful and when they are not [taken from this article]:

Buybacks are preferred on a taxation basis to dividends.
But buybacks are especially good when the stock is trading below its franchise value, and especially bad the further above franchise value the stock is trading.
Using slack capital to improve operations, or do little tuck-in acquisitions is probably best of all.? Organic growth is usually the best growth, and small acquisitions can facilitate that.? Small acquisitions are usually not expensive.? Be wary of acquisitions to increase scale, they don?t work so well.
Paying a dividend makes management teams more cognizant of the cost of equity capital, which makes them more effective.
In the reinsurance business in Bermuda, companies with slack capital tend to buy back shares below 1.3x book value, and issue special dividends if they are above that level.

The whole article is worth a read, but there is one more factor that drives buybacks, especially illogical buybacks where they pay more than the per share intrinsic value of the company: they don’t want to get taken over by another company. ?After all, the current management team may never have such nice jobs ever again.

Buying back stock at uneconomic prices temporarily keeps the stock price high, and removes cash from the balance sheet that an acquirer could use to help purchase the company. ?We haven’t seen it in a while, but some companies under threat of a takeover would do a semi-LBO and borrow a lot of money to buy back stock, making a purchase of the company?less attractive.

Thus, I’m not sure we could ever get rid of buybacks, even when they don’t make sense, except perhaps in the long run by selling the shares of companies that are too aggressive in the buybacks.

Closing Note

I rarely disagree with Josh Brown, but I did not find the?HBR article he cited?criticizing buybacks to be compelling. ?I would find it really difficult to believe that management teams avoid projects offering organic growth at rates exceeding the implied yield from buying back stock. ?Also, there are many different ways to run businesses in our country, and if public companies suffer from a buyback bias, then private companies might be able to think longer-term, and invest in profitable?organic ventures.

Thus I would not blame buybacks for other problems in society; I might blame too much investment in residential housing and financial institutions, but even then, I would not be certain. ?What we invest in as a society does affect future growth, but it is difficult to see where the end-investments take place. ?Money from a stock buyback might get redeployed into a business startup. ?It may be that public businesses are light on organic investing, and take less risk in investing via buybacks.?But that is why we have startups, private equity, etc., much of successful of which go public or get acquired by public companies.

Anyway, just a few thoughts…

The Best of the Aleph Blog, Part 25

Posted on 29 July 2014 by David Merkel

In my view, these were my best posts written between February and April 2013:

Wall Street Hates You

I have a saying, ?Don?t buy what someone wants to sell you. Buy what you have researched.?

And so I would tell everyone: don?t give brokers discretion over you accounts, and don?t let them convince you to buy unusual bonds, or obscure securities of any sort.? By unusual bonds, I mean structured notes, and eminent men like Joshua Brown and Larry Swedroe encourage the same thing: Don?t buy them.

The Education of a Mortgage Bond Manager, Part III

Why being careful with credit ratings is smart.

The Education of a Mortgage Bond Manager, Part IV

Be wary of odd asset classes; they are odd for a reason.

The Education of a Mortgage Bond Manager, Part V

Where I do odd things in order to serve my client.

The Education of a Mortgage Bond Manager, Part VI

The Education of a Mortgage Bond Manager, Part VII

The Education of a Mortgage Bond Manager, Part IX

Odd stuff, but particularly insightful into some of the perverse dynamics inside investment departments.

The Education of a Mortgage Bond Manager, Part VIII

How I led the successful effort to modify the Maryland Life Insurance Investment Law, and acted for the good of the public.

The Education of a Mortgage Bond Manager, Part X (The End)

Where I explain the odd bits of being portfolio manager, while succeeding with structured bonds amid difficult markets.

Berkshire Hathaway & Variable Annuities

I explain the good, bad, and ugly off of Berkshire Hathaway’s reinsurance deal with CIGNA.

Advice to Two Readers

Where I opine on some Sears bonds, and also on flu pandemic risk at RGA.

What I Would & Would Not Teach College Students About Finance

Mostly, I would teach them to think broadly, and realize the most of the complex investment math is easy to get wrong.

My Theory of Asset Pricing

My replacement for MPT using contingent claims theory.

On Insurance Investing, Part 4

On finding companies with conservative insurance reserving

On Insurance Investing, Part 5

On the squishy stuff, where there are no hard guidelines.

On Time Horizons

People shorten and lengthen their time horizons at the wrong time.

The Education of an Investment Risk Manager, Part IV

On two odd situations inside a life insurance company.

The Education of an Investment Risk Manager, Part V

On how we replaced a manager of managers.

Value Investing Flavors

Explains how there are many ways to do value investing.

Classic: Using Investment Advice, Part 1

Classic: Using Investment Advice, Part 2

Classic: Using Investment Advice, Part 3

Classic: Using Investment Advice, Part 4 [Tread Warily on Media Stock Tips]

Understand yourself, understand the advisor, understand the counsel that is offered, and finally, we wary of what you here through the media, including me.

Classic: Avoid the Dangers of Data-Mining, Part 1

Classic: Avoid the Dangers of Data-Mining, Part 2

There are many ways to torture the data to make it confess what you want to hear. ?Avoid that.

Classic: The Fundamentals of Market Tops

Where I explain what conditions are like when market tops are near.

At the Towson University Investment Group?s International Market Summit, Part 5

Where I answer the question:?Where does academic theory fail in finance and in economics?

Classic: Separating Weak Holders From the Strong

Classic: Get to Know the Holders? Hands, Part 1

Classic: Get to Know the Holders? Hands, Part 2

Articles that explain the fundamental??basis that underlies technical analysis.

Classic: The Long and Short of Trend Investing