Photo Credit: Dana || They charge more for "Arrest me red" too!

Photo Credit: Dana || They charge more for “Arrest me red” too!

This should be a relatively quick note on personal lines insurance. I’m writing this after reading the piece in this month’s Consumer Reports on Auto Insurance.  I agree with most of it.  For those that are short on time, my basic advice is this: bid out your auto, home, umbrella and other personal lines property & casualty insurance policies once every three years, or after every significant event that changes your premium significantly.

Here are a few simple facts to consider:

  • Personal lines insurance — auto, home, umbrella, rental, etc. is a very competitive business, and the companies that offer it all want an underwriting formula that would give them the best estimate of expected losses from each person insured.
  • After that, they want to know how much “wiggle room” that they would have to build in some profit.  Where might the second place bid be?  How likely are consumers to shop around?
  • Most insurers use a mix of credit scores and claim history to calculate rates.  Together, they are effective at forecasting loss costs — more effective than either one separately.
  • Read my piece On Credit Scores.  They are very important, because they measure moral tendency.  People with low scores tend to have more claims than those with high scores on average.  People with high scores tend to be more careful in life.  This is a forward-looking aspect of a person’s underwriting profile.
  • It’s fair to use “credit scores” because they are positively and significantly correlated with loss costs.  The actuaries have tested this.  Note that it is legal in almost all states to use credit scores, or something like them, but not all of them.
  • As the Consumer Reports article points out, many insurance companies take advantage of insureds that stick with them year by year, because they don’t shop around.  Easy cure: bid out your policy every three years at minimum.  If enough people do this, the insurance companies that overcharge loyal customers will stop doing it.  (Note: when I was a buy side analyst analyzing insurance stocks, one company implicitly admitted to doing this, and I was insured by them.  Guess what I did next?  It was not to sell the stock, though eventually I did when I saw that their premium increases were no longer increasing profits.)
  • Also be willing to unbundle your home and auto policies — there may be a discount, or there may not as the Consumer Reports article states.  I’ve worked it both ways, and am unbundled at present.
  • If they have that much money for amusing advertising, it implies that the market isn’t that rational.  Bid it out.
  • But — it is important to realize that insurers don’t all have the same formulas for underwriting, and those formulas are not static over time.  Bidding out your insurance makes sure you benefit from changes that positively affect you.
  • Insurers tend to get more competitive as the surplus they have to deploy gets bigger, and vice-versa when it shrinks after a large disaster.  If your premium goes up after a disaster, bid the policies out.  If it drifts up slowly when there have been no significant disasters, or claims on your part, they are taking advantage of you.  Bid it out.

Bid it out.  Bid it out.  Bid it out.  What do you have to lose?  If loyalty means something to the insurer, they will likely win the bid.  If it doesn’t, they will likely lose.  Either way you will win.  If you have an agent, they will note that you are price-sensitive.  The agent will become more of an ally, even if it doesn’t seem that way.

I went through this several times.  Most people who have read me for a while know that I have a large family — I am going to start teaching number seven to drive now.  I bid it out when kids came onto my policy.  It produced a change.  When two of my kids had accidents in short succession, my premiums rose a lot.  They would not underwrite one kid.  I got most of it back when I bid it out.  Since that time, the two have been claim-free for 2.5 years.  Guess what I am going to do next March, when I am close to the renewal where premiums would shift?  You got it; I will bid it out.

There is one more reason to bid it out: it forces you to review your insurance needs.  You may need more or less coverage than you currently have. You might realize that you need an umbrella policy for additional protection.  You may decide to self-insure more by raising your deductibles.  The exercise is a good one.

You don’t need transparency, or more regulation.  You don’t get transparency in the pricing of many items.  You do need to bid out your business every now and then.  You are your own best defender in matters like this.  Take your opportunity and bid out your policies.

Make sure that you:

  • Choose a range of insurers — Large companies, smaller local companies, stock/mutual, and any that favor a group you belong to, if the group is known to be filled with good risks.
  • Give them a standardized request for insurance, giving all of the parameters for your coverage, and data on those insured.
  • Tell them they get one shot, so submit their best bid now… there will be no second looks.
  • Some companies argue more about paying claims.  (AIG once had a reputation that way.)  Limit your bidders to those with a reputation for fairness.  State insurance departments often keep lists of complaints for companies.  Take a look in your home state.  Talk with friends.  Google the company name with a few choice words (cheated, claim denied, etc.) to see complaints, realizing that complainers aren’t always right.
  • Limit yourself to the incumbent carrier and 4-6 others.  Seven is more than enough, given the work involved.

So, what are you waiting for?  Bid out your personal insurance business.

Full disclosure: long AIZ, ALL, BRK/B, TRV for myself and clients (I know the industry well)

Everyone reading should know that I am an actuary, as well as a quant and a financial analyst.  Math is my friend.

Math is not the friend of many of my readers, so I usually don’t bother them with the math.  Tonight’s post will be no different.  It stems from my time of creating investment strategies for what was at that time a leading indexed annuity seller.

What is the return that you get from an indexed annuity?  It is the return from index options, subject to a certain minimum return over a 7-15 year period. Now, on average, what is the return you get from buying any fairly priced option?  You get the return on T-bills plus zero to a slight negative percentage.  So, if the option premiums paid are cumulatively greater than the guaranteed minimum return, the product should return more than the minimum on average — but likely not much more on average.

Why is that?  Options are a zero sum game, and usually there is no inherent advantage to the buyer or seller.  There are some exceptions to this rule, but it favors at-the money option sellers, never buyers. Buying options is what happens with indexed annuity products.

Now, over any short amount of time, like 5-10 years, you can get very different results than the likely average.  That doesn’t affect my point.  With games of chance, some get get good outcomes, and other get bad outcomes.

Now, the indexed product sellers will tell potential buyers that they will never lose money if the market goes down.  True enough.   What they don’t tell you is that over the long haul, you will most likely earn more investing in one of Vanguard’s S&P 500 funds or even their Balanced Index Fund.  You may even earn more investing in their high yield fund, or even their bond market index fund.

In exchange for eliminating all negative volatility, you end up getting very modest interest credits, while still being exposed to the credit risk of the insurance company.  In an insolvency, your policy will be affected.  The state guaranty funds will likely protect you if your policy is underneath the coverage limits, but still it is a bother.

Add to that the illiquidity of the product.  Yes, you can cash it in at any time, do 1035 exchanges, etc., but before the end of the surrender charge period you will pay a fee that compensates the insurance company for the amortized value of the large commission that they paid the agent that sold you the policy.  For most people, the surrender charge psychologically locks them in.

Thus I say it is better to be disciplined, and buy and hold a volatile investment with low fees over time, rather than own an indexed annuity that will tend to lock you in, and deliver lower returns on average.  That’s all, aside from the postscript.

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Postscript

How does an insurance company make a profit on an indexed annuity?  They take the proceeds of the sale, pay the agent, and use the rest to invest.  About 90% of the money will be invested in a bond that will cover the minimum guarantee.  The remainder will buy option premiums — the amount of money that gets applied to that is close to the credit spread on the bonds less the insurance company’s fees to pay the costs of the company and a charge for profit. Not a lot is typically left in a low yield environment like this.  The company tries to buy the most attractive options that they can on a limited budget.  Inexpensive options typically imply that most will finish out of the money, and/or when they do finish in-the-money, the rewards won’t be that large.

Photo Credit: Bowen Chin || What's more Illiquid than Frozen Tundra?

Photo Credit: Bowen Chin || What’s more Illiquid than Frozen Tundra?

My last piece on this topic, On Bond Market Illiquidity (and more), drew a few good comments.  I would like to feature them and answer them.  Here’s the first one:

Hello David,

One issue you don’t address in your post, which is excellent as usual, is the impact of what I’ll call “vaulted” high quality bonds. The explosion and manufacturing of fixed income derivatives has continued to explode while the menu of collateral has been steady or declining. A lot of paper is locked down for collateral reasons.

That’s a good point.  When I was a bond manager, I often had to deal with bonds that were salted away in the vaults of insurance companies, which tend to be long-term holders of long-term bonds, as they should be.  They need them in order to properly fund the promises that they make, while minimizing cash flow risk.

Also, as you mention, some bonds can’t be sold for collateral reasons.  That can happen due to reinsurance treaties, collateralized debt obligations, accounting reasons (marked “held to maturity”), and some other reasons.

But if the bonds are technically available for sale, it takes a certain talent to get an insurance company to sell some of those bonds without offering a steamy price.  You can’t sound anxious, rushed, etc. My approach was, “I’d be interested in buying a million or two of XYZ (mention coupon rate and maturity) bonds in the right price context.  No hurry, just get back to me with any interest.”  I would entrust this to one mid-tier broker familiar with the deal, who had previously had some skill in prying bonds out of the accounts of long-term holders before.  I might have two or three brokers doing this at a time, but all working on separate issues.  No overlap allowed, or it looks like there is a lot of demand for what is likely a sleepy security.  No sense in driving up the price.

Because it is difficult to get the actual cash bonds, it is tempting for some managers to buy synthetic versions of those bonds, or synthetic collateralized debt obligations of them instead.  Aside from counterparty risk, the derivatives exist as “side bets” in the credit of the underlying securities, and don’t provide any additional liquidity to the market.

My point here would be that these conditions have existed before, and I think what we have here is a repeat of bull market conditions in bond credit.  This isn’t that unusual, and it will eventually change when the bull market ends.

Here’s the next comment:

Hi David,

I hope you’re doing well.  I’ve been reading your blog for about a year now and really appreciate your perspective and original content.  Just wanted to ask a quick question regarding your most recent post on bond market liquidity. 

Our investment committee often talk about the idea of bond liquidity (and discusses it with every bond manager who walks in our doors), and specifically how there are systematic issues now which limit liquidity and considerably push the burden onto money managers to make markets vs. the past, when banks themselves were free to make more of a market with their own balance sheets.

My (limited) understanding is that legislation since 2008 has changed the way that investment banks are permitted to trade on their own books, and this is a big part of the significantly decreased liquidity which has thus far been a relative non-issue but which could rear its head quickly in the face of a sharp correction in bonds.

Do you have any thoughts about this newer paradigm of limited market-making at the big banks?  You didn’t seem to mention it at all in your article and I’m wondering if my thoughts here are either inaccurate or not impactful to the bottom line of the liquidity conversation.

I’m sure you’re a busy guy so I won’t presume upon a direct response but it may be worthwhile to post an update if you think these questions are pertinent.

Another very good comment.  I thought about adding this to the first piece, but in my experience, the large investment banks only kept some of the highest liquidity corporates in inventory, and the dregs of mortgage- and asset-backed bonds that they could not otherwise sell.  The smaller investment banks would keep little-to-no-inventory.  Many salesmen might have liked the flexibility of their bank to hold positions overnight, or buying bonds to “reposition” them, but the experiences of their risk control desks put the kibosh on that.

As a result, I think that the willingness of investment banks to make a market rely on:

  • The natural liquidity of the securities (which comes from the size of the issue, market knowledge of the issue, and composition of the ownership base), and
  • How much capital the investment bank has to put against the position.

The second is a much smaller factor.  Insurance companies have to deal with variations in capital charges in the bonds that they hold, and that is not a decisive factor in whether they hold a bond or not.  It is a factor in who will hold a bond and what yield spread the bond will trade at.  Bonds tend to gravitate to the holders that:

  • Like the issuer
  • Like the cash flow profile
  • Have low costs for holding the bonds

Yes, the changed laws and regulations have raised the costs for investment banks to hold bonds in inventory.  They are not a preferred habitat for most bonds.  Therefore, if an investment bank buys a bond in order to sell it (or vice-versa) in the present environment, the bid-ask spread must be wider to compensate for the incremental costs, thus reducing liquidity.

To close this evening, one more letter on bonds from a reader:

First off, thank you for taking the time to share your knowledge via your blog.  It is much appreciated.

Now for a bond question from someone learning the fixed income ropes…

What is the advantage/reasoning behind a company co-issuing notes with a finance subsidiary?  Even with reading the prospectus/indenture I can’t understand why a finance sub (essentially just set up to be a co-issuer of debt) would be necessary especially since the company is an issuer anyway and they also may have other subs guarantee the debt also.  I’m probably missing something obvious.

The answer here can vary.  Some companies guarantee their finance subsidiaries, and some don’t.  Those that don’t are willing to pay more to borrow, while bondholders live with the risk that in a crisis, the company might step away from its lending subsidiary.  They would never let the subsidiary fail, right?

Well, that depends on how easy it is to get financing alternatives, and how easy it might be for the parent company to borrow, post-subsidiary default.

If things go well, perhaps the subsidiary could be spun off as a separate company, or sold to another finance company for a gain.  After all, it has had separate accounting done for a number of years.

Beyond that, it can be useful to manage lending separately from sales.  They are different businesses, and require different skills.  Granted, it could be done as two divisions in the same company, but doing it in separate companies would force separate accountability if done right.

There may be other reasons, but they aren’t coming to my mind right now.  If you think of one, please note it in the comments.

I was riding home with child number seven after a basketball practice about four months ago — this is the child that if any of mine has the capability of taking over for me someday, this is the one. She said to me, “Dad, I always knew we were better off than most, but it finally sank home to me how much better off we are than most of the people we know.”

Me: “What do you mean?”

7: “I’ve been talking with my friends after basketball practice, after church, and other times, and I hear about what happens when their parents have a $500 surprise bill for a repair, and things like that.  They have to scrape for months to deal with the added expense, and they can’t do a lot of things that they do normally while they rebuild their finances.”

Me: “Okay, so what makes us different?”

7: “We just had three disasters hit us at the same time, and you just dealt with them for the long term without making a lot of noise about it.  Had that happened to any of my friends’ families, they would not know what to do, it would be impossible for them to do it without help.”

Me: “Actually there are a few of your friends whose families would likely survive what hit us easily, but yes, you’ve hit on something that I think is the most significant initial lesson on finance for the 75% of the population on the low end of incomes.  People need to start saving early, and build a buffer against disasters, etc.  If I were going to give a talk at most churches on personal finance, I would talk only about that, and almost nothing more.  Earn, budget, save, and be generous.  After that, we can talk about investing, but it is only relevant to a minority of the population with enough discipline to save early and often, initially aiming for 3-6 months of expenses.”

7: “When did you and Mom finally have that much saved?”

Me: “Going into our marriage back in 1986.  I had been a graduate student, and your mom a high school teacher in one of the poorest school districts in California, but we still both lived low on the hog, and saved money.  That gave us enough money that we were able to buy a small house at an opportunistic time six months after we married.  Within a year, we had rebuilt the buffer, and we haven’t been without it since.”

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In personal finance, you have to develop good habits early, and learn that life isn’t about how much you spend.  I try to teach my kids that — Seven understands it, as does three or four of her siblings.  The other three or four don’t understand, despite my best efforts — some of it seems to be personality-driven, but I have seen one or two of them change and get better at money management.  We’ll see… they are still developing.

In finance, you have to focus on what you can control.  You have reasonable control over ordinary spending.  You have less control over what you earn, and almost no control over accidents and investment returns.  Thus the first bit of advice is to live below your means and save.  The second bit is to plan against catastrophes on a reasonable level.  Insurance can be useful to protect against some of the worst outcomes.  Just remember, insurance is an expense and not an investment.

Along with the above article cited, note these four basic articles and one book review on personal finance:

The last one is useful for learning to live less expensively, while still having most reasonable comforts that others have.

Now, what I have written about above has been noted in the financial media lately regarding a study done by JP Morgan on how many people don’t keep a buffer around, no matter how much they earn.  Here are two articles that talk about that study (one, two — good articles both, read them if you can).  Personally, I’m not surprised having worked with people who earned a lot and spent to the limit.  They lived far more opulent lives than I do, but decided they would save later.

If you want to save, start now.  Most good habits have to be started now, or they won’t get started.  Most good intentions don’t die from a frontal assault, but from the idea that you have plenty of time to change.  As a result — you don’t change.  And that is not just you, it is me in my life also.  Change must start now, or it does not start.

Two more articles worth a read:

These largely follow my point of view on personal finances.  Save, protect against bad risks, and take moderate risks to earn money both in work and in investing.  You can do it too, but remember, it is not a question of knowledge, it is a question of whether you have the will to do it or not.  I wish you the best in your efforts.

Now if you haven’t done it yet, go build the buffer.

I can’t help but think after the financial crisis that we have drawn some wrong conclusions about systemic risk. Systemic risk is when the financial system as a whole threatens to fail, such that short-term obligations can’t be paid out in full.  It is not a situation where only big entities fail — the critical factor is whether it creates a run on liquidity across the system as a whole.

Why does a bank fail?  It can’t pay in full when there was a demand for liquidity in the short run.  Typically, there is an asset-liability mismatch, with a lot of payments payable now, and assets that cannot be easily liquidated for what their stated value reported to the regulators.

Imagine the largest bank failing, and no one else.  Yes, it would be a mess for the FDIC to clean up, but it could be done.   Stockholders and preferred stockholders get wiped out. Bondholders, junior bondholders, and large depositors take a haircut.  Future deposit insurance premiums might have to rise, but there would be enough time to do that, with banks adjusting their prices so that they could afford it.

But banks don’t fail one at a time, except perhaps in good times with a really incompetently managed bank.  Why do some banks tend to fail at the same time?

  • They own many of the same debt securities, or same types of loans where the underlying asset values are falling.
  • They own securities of other banks, or other deposit-taking institutions.
  • Generalized panic.

What can stop a bank from failing?  Adequate short-term cash flow from assets.  Why don’t banks make sure that they always have more cash coming in than going out?  That would be a lower profitability way of running a bank.  It is almost always more profitable to borrow short and lend long, and make money on the natural term spread that exists — but that creates the very conditions that makes some banks run out of liquidity in a panic.

You will hear the banks say, “We are solvent, we just aren’t liquid.” That statement is always hogwash.  That means that the bank did not adequately plan to have enough liquidity under all circumstances.

Thus, planning to avoid systemic risk across an economy as a whole should focus on looking for the entities that make a lot of promises where payment can be demanded in the short run with no adjustments for market conditions versus assets available to make payments.  Typically, that means banks and things like banks that take deposits, including money market funds.  What does it not include?

  • Life insurers, unless they write a lot of unusual annuities that can get called for immediate payment, as happened to General American and ARM Financial in 1999.  The liability structure of life insurance companies is so long that there can never be a run on the bank.  That doesn’t mean they can’t go insolvent, but it does mean they won’t be part of a systemic panic.
  • Property & Casualty and Health insurers do not have liabilities that can run from them.  They can write bad business and lose money in the short-run, but that doesn’t lead to systemic panic.
  • Investment companies do not have liabilities that can run from them, aside from money-market funds.  Since the liabilities are denominated in the same terms as the assets managed, there can’t be a “run on the bank.”  Even if assets are illiquid, the rules for valuing illiquid assets for liquidation are flexible enough that an investment firm can lower the net asset value of the payouts, while liquidating other assets in the short run.
  • Even any large corporation that has financed itself with too much short-term debt is not a threat to systemic panic.  The failure would be unique when it could not roll over its debts.  Further, it would take some effort to actually do that, because the rating agencies and lenders would have to allow a non-financial firm to take obvious risks that non-financial firms don’t take.

What might it include?

  • Money market funds are different because of the potential to “break the buck.”
  • Any financial institution that relies on a repurchase [repo] market for financing is subject to systemic risk because of the borrow short to finance a long-dated asset mismatch inherent in the market.
  • Watch any entity that has to be able to post additional margin in order maintain leveraged asset finance.

How then to Avoid Systemic Risk?

  • Regulate banks, money market funds and other depositary financials tightly.
  • Don’t let them invest in one another.
  • Make sure that they have more than enough liquid assets to meet any conceivable liquidity withdrawal scenario.
  • Regulate repurchase markets tightly.
  • Raise the amount of money that has to be deposited for margin agreements, until those are no longer a threat.
  • Perhaps break up banks by ending interstate branching.  State regulation is good regulation.

But aside from that, there is nothing to do.  There are no systemic risks from investment companies or those that manage them, because there can’t be a self-reinforcing “run on the bank.”  Insurance companies are similar, and their solvency is regulated far better than any bank.

Thus, there shouldn’t be any lists of systematically important financial institutions that contain investment managers or insurance companies.  Bigness is not enough to create a systemic threat.  Even GE Capital could have failed, and it would not have had significant effects on the solvency of other financials.

I think it is incumbent on those that would call such enterprises systemically important to show one historical example of where such enterprises ever played a significant role in a financial crisis like the ones that happened in the 1870s, 1900s, 1930s, or 2000s.  They won’t be able to do it, and it should tell them that they are wasting effort, and should focus on the short-tailed liabilities of financial companies.

This will be the last of my institutional error pieces. It is not that I have not made any other errors, but these were the big ones.

National Atlantic Holdings [NAHC]

I was wrong yesterday.  I actually do have a lot available that I have written on this failure, since I wrote about it here at Aleph Blog.  More than you can shake a stick at.

Let me start at the beginning.  NAHC was an insurer with a niche presence in New Jersey.  They competed only in personal lines, which usually is easy to analyze.  New Jersey was a tough but not impossible state to operate in, and NAHC was a medium-sized fish for the size of the pond that they were in.

Chubb was not in NewJersey at that point in time, and so they wanted to insure autos, homes, and personal property, particularly that of wealthy people.

I thought it was an interesting company, trading slightly below tangible book, with a single-digit multiple on earnings, good protective boundaries, and a motivated management team.  The CEO owned over 10% of the firm, which seemed to be enough to motivate, but not enough to ignore shareholders.

In 2005, we bought a 5%+ stake in the company, which in 2006 became 10%+, and eventually topped out at 17%.  We might have bought more with the approval of the NewJersey Department of Insurance, which was easy at lower levels, and harder at higher levels, which was an interesting anti-takeover defense.

The company showed promise in many ways, but always seemed to have performance issues — little to medium surprises every few quarters.  The stock price didn’t do that much bad or good.  When I left Hovde at the end of July 2007, the position was at a modest gain.  Hovde had a hard time finding long names in that era, so the performance up to that point wasn’t that bad.

If you want to see my original logic for buying the stock after I left Hovde, you can read it here.

Here was the stock price graph from May 2007 to May 2008:

NAHC_current_loss

My old employer Hovde owned 17%.  I eventually owned 0.15%, at the prices you see there, at an average cost of $6.67 for me.  I eventually sold out at an average price of around $6.10.  (In the above graph, “Exit” was not a sale, but where I cut off the calculation.)  This wasn’t my worst loss by any means, but it cost my former employer badly, and it was my fault, not theirs.

What Went Wrong?

  • Their competitive position deteriorated as companies that previously avoided New Jersey entered the state.
  • They announced that they had reserving errors, and reported moderate losses as a result.
  • They announced a sale to Palisades Insurance, a private New Jersey insurer for $6.25/sh, valuing the company at less than 60% of tangible book value.  The fairness opinion was a bad joke.  The company would have been worth more in run-off.
  • Really, the management team was weak.

The first problem would be a tough one to solve.  On the second problem, I never got a good answer to how the loss reserves got so cockeyed, and somehow no one was to blame for it.  This is personal lines insurance — the reserves validate themselves every year.

But the third problem made me think the management was somewhat dishonest.  A larger company could have paid a higher price for NAHC, but that probably would have meant that management would lose their jobs.  They gave shareholders the short end of the stick for the good of management, and perhaps employees.

My biggest error was giving too much credit, and too much patience to the management team.  I met far better management teams in my time as a buy-side analyst, and they were on the low end of the competence scale.  I let cheapness and a strong balance sheet blind me to the eroding competitiveness, and weak ability to deal with the problem.

Ultimately, Hovde found itself in a weak position because it could not file for appraisal rights, a fraud case would have been weak, and the NJ Department of Insurance would not let them acquire enough to block the deal.  Besides, once arbs got a hold of over 40% of the shares, the deal was almost impossible to block.

As I often say, risk control is best done on the front end.  On the back end, solutions are expensive, if they are available at all.

The front end for you can be learning from my errors.  Wise men learn from the mistakes of others.  Average men learn from their own mistakes.  Dumb men never learn.

In closing, be conservative in investing, and be wise.  I thought I was being both, so seek the counsel of others to check your logic.

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

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

This will be the post where I cover the biggest mistakes that I made as an institutional bond and stock investor. In general, in my career, my results were very good for those who employed me as a manager or analyst of investments, but I had three significant blunders over a fifteen-year period that cost my employers and their clients a lot of money.  Put on your peril-sensitive sunglasses, and let’s take a learning expedition through my failures.

Manufactured Housing Asset Back Securities — Mezzanine and Subordinated Certificates

In 2001, I lost my boss.  In the midst of a merger, he figured his opportunities in the merged firm were poor, and so he jumped to another firm.  In the process, I temporarily became the Chief Investment Officer, and felt that we could take some chances that the boss would not take that in my opinion were safe propositions.  All of them worked out well, except for one: The — Mezzanine and Subordinated Certificates of Manufactured Housing Asset Back Securities [MHABS].  What were those beasts?

Many people in the lower middle class live in prefabricated housing in predominantly in trailer parks around the US.  You get a type of inexpensive independent living that is lower density than an apartment building, and the rent you have to pay is lower than renting an apartment.  What costs some money is paying for the loan to buy the prefabricated housing.

Those loans would get gathered into bunches, put into a securitization trust, and certificates would get sold allocating cash flows with different probabilities of default.  Essentially there were four levels (in order of increasing riskiness) — Senior, Mezzanine, Subordinated, and Residual.  I focused on the middle two classes because they seemed to offer a very favorable risk/reward trade-off if you selected carefully.

In 2001, it was obvious that there was too much competition for lending to borrowers in Manufactured Housing [MH] — too many manufacturers were trying to sell their product to a saturated market, and underwriting suffered.  But, if you looked at older deals, lending standards were a lot higher, but the yields on those bonds were similar to those on the badly underwritten newer deals.  That was the key insight.

One day, I was able to confirm that insight by talking with my rep at Lehman Brothers.  I talked to him about the idea, and he said, “Did you know we have a database on the loss stats of all of the Green Tree (the earliest lender on MH) deals since inception?”  After the conversation was over, I had that database, and after one day of analysis — the analysis was clear: underwriting standards had slipped dramatically in 1998, and much further in 1999 and following.

That said, the losses by deal and duration since issuance followed a very predictable pattern: a slow ramp-up of losses over 30 months, and then losses tailing off gradually after about 60 months.  The loss statistics of all other MH lenders aside from Vanderbilt (now owned by Berkshire Hathaway) was worse than Green Tree losses.  The investment idea was as follows:

Buy AA-rated mezzanine and BBB-rated subordinated MHABS originated by Green Tree in 1997 and before that.  The yield spreads over Treasuries are compelling for the rating, and the loss rates would have to jump and stick by a factor of three to impair the subordinated bonds, and by a factor of six to impair the mezzanine bonds.  These bonds have at least four years of seasoning, so the loss rates are very predictable, and are very unlikely to spike by that much.

That was the thesis, and I began quietly acquiring $200 million of these bonds in the last half of 2001.  I did it for several reasons:

  • The yields were compelling.
  • The company that I was investing for was growing way too rapidly, and we needed places to put money.
  • The cash flow profile of these securities matched very well the annuities that the company was selling.
  • The amount of capital needed to carry the position was small.

By the end of 2001, two things happened.  The opportunity dried up, because I had acquired enough of the bonds on the secondary market to make a difference, and prices rose.  Second, I was made the corporate bond manager, and another member of our team took over the trade.  He didn’t much like the trade, and I told my boss that it was his portfolio now, he can do what he wanted.

He kept the positions on, but did not add to them.  I was told he looked at the bonds, noticed that they were all trading at gains, and stuck with the positions.

Can You Make It Through the Valley of the Shadow of Death?

I left the firm about 14 months later, and around that time, the prices for MHABS fell apart.  Increasing defaults on MH loans, and failures of companies that made MH, made many people exceptionally bearish and led rating agencies to downgrade almost all MHABS bonds.

The effects of the losses were similar to that of the Housing Bubble in 2007-9.  As people defaulted, the value of existing prefabricated houses fell, because of the glut of unsold houses, both new and used.  This had an effect, even on older deals, and temporarily, loss rates spiked above the levels that would impair the bonds that I bought if the levels stayed that high.

With the ratings lowered, more capital had to be put up against the positions, which the insurance company did not want to do, because they always levered themselves up more highly than most companies — they never had capital to spare, so any loss on bonds was a disaster to them.

They feared the worst, and sold the bonds at a considerable loss, and blamed me.

[sigh]

Easy to demonize the one that is gone, and forget the good that he did, and that others had charge of it during the critical period.  So what happened to the MHABS bonds that I bought?

Every single one of those bonds paid off in full.  Held to maturity, not one of them lost a dime.

What was my error?

Part of being a good investor is knowing your client.  In my case, the client was an impossible one, demanding high yields, low capital employed, and no losses.  I should have realized that at some later date, under a horrific scenario, that the client would not be capable of holding onto the securities.  For that reason, I should have never bought them in the first place.  Then again, I should have never bought anything with any risk for them under those conditions, because in a large enough portfolio, you will have some areas where the risk will surprise you.  This was less than 2% of the consolidated assets of the firm, and they can’t hold onto securities that would likely be money good amid a panic?!

Sadly, no.  As their corporate bond manager, before I left, I sold down positions like that that my replacement might not understand, but I did not control the MHABS portfolio then, and so I could not do that.

Maybe $50 million went down the drain here.  On the bright side, it helped teach me what would happen in the housing bubble, and my next employer benefited from those insights.

Thus the lesson is: only choose investments that your client will be capable of holding even during horrible times, because the worst losses come from panic selling.

Next time, my two worst stock losses from my hedge fund days.

Despite the large and seemingly meaty title, this will be a short piece.  I class these types of investors together because most of them have long investment horizons.  From an asset-liability management standpoint, that would mean they should invest similarly.  That may be have been true for Defined Benefit [DB] pension plans and Endowments, but that has shifted over time, and is increasingly not true.  In some ways, the DB plans are becoming more like life insurers in the way they invest, though not totally so.  So, why do they invest differently?  Two reasons: internal risk management goals, and the desires of insurance regulators to preserve industry solvency.

Let’s start with life insurers.  Regulators don’t want insolvent companies, so they constrain companies into safe assets using risk-based capital charges.  The riskier the investment, the more capital the insurer has to put up against it.  After that, there is cash-flow testing which tends to push life insurers to match assets and liabilities, or at least, not have a large mismatch.  Also, accounting rules may lead insurers to buy assets where the income will show up on their financial statements regularly.

The result of this is that life insurers don’t invest much in risk assets — maybe they invest in stocks, junk bonds, etc. up to the amount of their surplus, but not much more than that.

DB plans don’t have regulators that care about investment risks.  They do have plan sponsors that do care about investment risk, and that level of care has increased over the past 15 years.  Back in the late ’90s it was in vogue for DB plans to allocate more and more to risk assets, just in time for the market to correct.  (Note to retail investors: professionals may deride your abilities, but the abilities of many professionals are questionable also.)

Over that time, the rate used to discount DB plan liabilities became standardized and attached to long high quality bonds.  Together with a desire to minimize plan funding risks, and thus corporate risks for the plan sponsor, that led to more investments in bonds, and less in equities and other risk assets.  Some plans try to cash flow match expected future plan payments out to a horizon.

Finally, endowments have no regulator, and don’t have a plan sponsor that has to make future payments.  They are free to invest as they like, and probably have the highest degree of variation in their assets as a group.  There is some level of constraint from the spending rules employed by the endowments, particularly since 2008-9, when a number of famous endowments came to realize that there was a liability structure behind them when they ran low on liquidity amid the crisis. [Note: long article.]  You might think it would be smart to have the present value of 3-5 years of expenditures on hand in bonds, but that is not always the case.  In some ways, the quick recovery taught some endowment investors the wrong lesson — that they could wait out any crisis.

That’s my quick summary.  If you have thoughts on the matter, you can share them in the comments.

 

Photo Credit: Alcino || What is the sound of negative one hand clapping?

Photo Credit: Alcino || What is the sound of negative one hand clapping?

As with many of my articles, this one starts with a personal story from my insurance business career (skip down four paragraphs to the end of the story if you want):

25 years ago, when it was still uncommon, I wanted to go to an executive course at the Wharton School for actuaries that wanted to better understand investment math and markets.  I went to my boss at AIG (a notably tight-fisted firm on expenses) and asked if the company would pay for me to go… it was an exclusive course, and very expensive compared to any other conference that I would ever go to again in my life.  I tried not to get my hopes up.

Lo, and behold!  AIG went for it!

A month later, I was with a bunch of bright actuaries at the Wharton School.  The first thing I noticed was aside from the compound interest math, and maybe some bond knowledge, the actuaries were rather light on investment knowledge, and I would bet that all of them had passed the Society of Actuaries investment course.  The second thing I noticed were some of the odd investments described in the syllabus: it was probably my first taste of derivative instruments.  At the ripe old age of 29, I was learning a lot, and possibly more than the rest of my classmates, because I had spent a lot of time studying investments already, both on an academic and practical basis.

I had already studied the pricing of stock options in school, so I was familiar with Black-Scholes.  (Trivia note: an actuary developed the same formula for valuing optionally terminable reinsurance treaties six years ahead of Black, Scholes and Merton.  That doesn’t even take into account Bachelier, who derived it 73 years earlier, but no one knew about it, because it was written in French.)  At this point, the professor left, and a grad student came in to teach us about the pricing of bond options.  At the end of his lesson, it was time for the class to have a break.  I went down to make a comment, and it went like this:

Me: You said that we have to adjust for the fact that interest rates can’t go negative.

Grad student: Of course.

Me: But interest rates could go negative.

GS: That’s ridiculous!  Why would you ever lend money and accept back less than you gave them, and lose the time value of money?!

Me: Almost of the time, you wouldn’t.  But imagine a scenario where the demand for loanable funds leaves interest rates near zero, but the times are insecure and violent, leaving you uncertain that if you stored your cash privately, you would run too large of a risk of having it stolen.  You need your cash in the future for a given project.  In this case, you would pay the bank to store your money.

GS: That’s an absurd scenario!  That could never happen!

Me: It’s unlikely, I admit, but I wouldn’t say that you can never have negative interest rates.

GS: I will say it again: You can NEVER have negative interest rates.

Me: Thanks, I guess.

Well, so much for the distant past.  Here is why I am writing this: yesterday, a friend of mine wrote me the following note:

Good evening.  I trust you had a blessed Lord’s Day in the new building. 

Talking bonds today with my Econ class.  Here’s our question. Other than playing a currency angle why would anyone buy European debt with a negative yield?  The Swiss and at least one other county sold 10 year notes with a negative yield.  Can you explain that?  No interest and less principle [sic] at the end.

Now, I didn’t quite get it perfectly right with the grad student at Wharton, but most of it comes down to:

  • Low demand for loanable funds, with low measured inflation, and
  • Security and illiquidity of the funds invested

The first one everyone gets — inflation is low, and few want to borrow, so interest rates are very low.  But that doesn’t explain how it can go negative.

Things are different for middle class individuals and large financial institutions.  Someone in the middle class facing negative interest rates from a checking or savings account could say: “Forget it.  I’m taking most of my money out of the bank, and storing it at home.”  Leaving aside the inconvenience of currency transaction reports if the amount is over $10,000, and worries over theft, he could take his money home and store it.  Note that he does have to run a risk of theft, though, so bringing the money home is not costless.

The bank has the same problem, but far larger.  If you don’t invest the money, where would you store it?  Could you even get enough currency delivered to do it?  if you had a vault large enough to store it, could you trust the guards?  Why make yourself a target?  If you don’t have a vault large enough to store it, you’re in the same set of problems that exist for those that warehouse precious metals, but with a far more liquid commodity.

Thus in a weak economic environment like this, with low inflation, banks and other financial institutions that want certainty of payment in the future are willing to pay interest to get their money back later.

Part of the problem here is that the fiat currencies of the world exist only to be units of account, and not stores of value.  Thus in this unusual environment, they behave like any other commodity, where the prices for futures are often higher than the current spot price, which is known as backwardation.  (Corrected from initial posting — i.e. it costs more to receive a given cash flow in the future than today, thus backwardation, not contango.)  The rates can’t get too negative, though, or some institutions will bite the bullet and store as much cash as they can, just as other commodities get stored.

To use another analogy, a while ago, some market observers couldn’t get why anyone would accept a negative yield on Treasury Inflation Protected Securities [TIPS].  They did so because they had few other choices for transferring money to the future while still having inflation protection.  Some people argued that they were locking in a loss.  My comment at the time was, “They’re trying to avoid a larger loss.”

Thus the difficulty of managing cash outside of the bond/loan markets in a depressed economy leads to negative interest rates.  The financial institutions may lose money in the process, but they are losing less money than if they tried to store and protect the money, if that could even be done.