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Tower Group Errata

Monday, April 7th, 2014

I try to run an ethical blog here, so when I make mistakes, I admit them.  In this case, I don’t think the errors make a lot of difference to the investment decision, but I will confess to being wrong on  details in my last post.  I made the statement:

Though there are no financing contingencies to this deal, ACP Re can walk away with no penalty if it merely wants to do so.

That’s wrong.  ACP Re can walk away of its own accord if there is a material adverse change, and under some conditions, they would receive a breakup fee.  As such, it is not a “free look.”  But it is one-sided in this sense: if the reserves are too low, ACP Re can declare a material adverse change.  If they are fair or high, ACP will happily do the merger and enjoy the profits.

On the delay of the 10-K, which is more than a month late, I repeat that most of the figures in the balance sheet are easy to calculate.  I was trained as an actuary, albeit a life actuary, though I was an insurance buy-side analyst for 4.5 years.  The difficult question with any P&C insurer is whether the reserves are correct, and even actuaries inside a company are never fully sure of the reserves.  That’s why reserves at P&C insurers are usually set conservatively, even though GAAP says to use best estimate.  It is not a bad thing to bend GAAP accounting to be conservative, and be slow in recognizing income.

My experience with insurers that are tardy with their financials is that it is wise to steer clear.  Aggressive insurance management teams tend to go through a string of corrections before the financials are set right.

Between 1998-2000, I used to do arbitrage on small deals.  On net, I did fair with it, but the deals where I lost, you could feel a kind of “sag” where you would not ordinarily expect it.  Good arb deals show strength after an initial period of selling by those that do not want to hang around for the arb.

Now, I don’t think my reasoning is depressing the stock price, but it is interesting that the stock price keeps heading lower, and slowly.  I have a saying that slow moves tend to persist, while fast moves tend to mean-revert.

I don’t have any inside information, but this situation feels bad.  Ordinarily with takeovers, the bid for stock is far more firm.

Full disclosure: No positions in any of the companies mentioned

Best of the Aleph Blog, Part 24

Friday, April 4th, 2014

These articles appeared between November 2012 and January 2013:

On Time Horizons

Investment advice without a time horizon is not investment advice.

This Election Will Solve Nothing

So far that is true of the 2012 elections.

NOTA Bene

We need to add “None of the Above” as an electoral choice in all elections.

Eliminating the Rating Agencies, Part 2

Eliminating the Rating Agencies, Part 3

Where I propose a great idea, and then realize that I am wrong.

The Rules, Part XXXV

Stability only comes to markets in a self-reinforcing mode, from buy and hold (and sell and sit on cash) investors who act at the turning points.

The Rules, Part XXXVI

It almost never makes sense to play for the last 5% of something; it costs too much. Getting 90-95% is relatively easy; grasping for the last 5-10% usually results in losing some of the 90-95%.

Charlie Brown the Retail Investor

Where Lucy represents Wall Street, the football is returns, and Charlie Brown is the Retail Investor. Aaauuuggh!

On Hucksters

Why to be careful when promised results seem too good, and they get delayed, or worse.

Bombing Baby BDC Bonds

Avoid bonds with few protective covenants, unless the borrower is very strong.

On Math Education

Why current efforts to change Math Education will fail.  Pedagogy peaked in the ’50s, and has been declining since then.

On Human Fertility, Part 2

On the continuing decline in human fertility across the globe.

If you Want to be Well-off in Life

Simple advice on how to be better off.  Warning: it requires discipline.

Young People Should Favor Low Discount Rates

If we had assumed lower discount rates in the past, we wouldn’t have the problems we do now.  (And maybe DB pensions would have died sooner.)

Problems in Life Insurance

On why we should be concerned about life insurance accounting.

Investing In P&C Insurers

On why analyzing P&C insurers boils down to analyzing management teams.

Selling Options Cheaply (Did You Know?)

Naive bond investors often take on risks that they did not anticipate.

Book Review: The Snowball, Part One

Book Review: The Snowball, Part Two

Book Review: The Snowball, Part Three

Book Review: The Snowball, Part Four

Book Review: The Snowball, Epilogue

My review of the most comprehensive book on the life of Warren Buffett.

On Watchlists

How I met one of the Superinvestors of Graham-and -Doddsville, and how I generate investment ideas.

Why do Value Investors Like to Index?

How I admitted to not having  a correct perspective on value indexing.

Evaluating Regulated Financials

Why regulated financials are different from other stocks, and how to analyze them.

Locking in a Smaller Loss

Why people are willing to lock in a loss against inflation, because of bad monetary policy.

Why I Sold the Long End

Great timing.

The Evaluation of Common Stocks

Value investing is still powerful, but the competition is a lot tougher.

The Order of Battle in Financial Planning for Ordinary Folks

The basics of personal finance

Sorting Through the News

How to use my free news screener to cut through the news flow, and eliminate noise.

On Financial Blogging

So why do we spend the time at this?

Matching Assets and Liabilities Personally

How to manage investments to fit your own need for cash in the future.

Penny Wise, Pound Foolish

How short-sighted, incompetent managers destroy value.

Expensive High Yield – II

No such thing as a bad trade , only an early trade… high yield prices moved higher from here.

2012 Financial Report of the US Government

Chronicling the financial promises made by the Federal Government

On Insurance Investing, Part 1

On Insurance Investing, Part 2

On Insurance Investing, Part 3

The first three parts of my 7-part series on how to understand this complex group of sub-industries.

How to Become Super-Rich?

Even Buffett didn’t get super-rich by only investing his own money.  He had to invest the money of others as well.  The super-rich form corporations and grow them; they build institutions bigger than themselves.

The Product that Never saw the Light of Day

On the Variable Annuity product that would simply be a tax scam.  Later I would learn that product exists now, just not in the form I proposed 8 years earlier when it didn’t exist.

Classic: Choosing an Insurance Company?

Friday, March 28th, 2014

This was published in the “Ask Our Pros” column at RealMoney.  I don’t know when, and I don’t have the actual question, but looking at my answer, I think I know what was asked.

I’ve been cheated in the past by insurance companies.  How can I choose an insurance company that won’t cheat me?

This is a question after my own heart.  I worked in the life insurance business as an actuary for 17 years, serving in almost every area that life insurance companies have.

Life insurance agents and products have a bad reputation in the financial press.  Much of that bad reputation is deserved.  Products are often sold that pay agents well, but do not meet the needs of clients.  Agents influence the flow of information between the company and policyholder, and sometimes tell different stories to each side.

The life insurance industry has tried over the years to control the sales process better, so that only suitable products get sold.  Regulators have demanded it, industry groups want a better reputation, and individual companies have learned that writing bad business is unprofitable.  There are regulatory rules, industry conduct codes, etc.  It is difficult to root out bad apples among agents, which can flit from company to company; companies with bad records tend to get disciplined by the regulators and the courts.

Life insurance and annuities are products that are generally sold, not bought, excluding fancy tax reduction schemes used by high net worth individuals.  Typically, though, they get sold to people who will not plan for their own financial well-being, and would not save, invest, and protect their families on their own.  It is an expensive way to invest, but it is better than not investing at all.

There is a need for agent-sold financial products to help those that will not plan for themselves.  This provides a real service, though never as good as what an intelligent investor would do for himself, if he had the time to research everything out.

Disability and health insurance often get a bad rap over claims payment practices, often deservedly so.  Part of the reason for that is that people don’t want to pay the full price of these products; companies respond with lower priced products and get more hard-nosed about claims.  Part of the research that any person should do about an insurance company is their claims payment practices.  State insurance commissioners keep a record of which companies get complaints, and which do not.  Insurance fraud further pushes up costs, and makes companies scrutinize claims more.  Trial lawyers further push up costs by making medical malpractice expensive through exorbitant tort claims.

Auto and home insurance usually don’t draw the same level of complaints as the above areas.  There are some companies that try to be too sharp about claims practices; this is something to watch out for in any insurance company.  Auto insurance (or the equivalent) is mandatory; mortgage companies require home insurance.  The market is regulated, and usually highly competitive.

Another area of complaint is private mortgage insurance [PMI].  PMI benefits the lender, but is paid for by the homeowner.  The benefit to the homeowner is that he can buy a home, and not make a down payment of at least 20%.  The lenders require PMI when the ratio of the first mortgage to the appraised home value is greater than 80%.  New laws require PMI to go away when the ratio drops below 78%.  Homeowners can petition the lender when the ratio is at 80%.  (The lender will probably require a new appraisal.)

Now all this said, insurance companies have had a lower return on equity in the past 20 years than all other companies on average.  Insurance companies don’t make all that much money.  So where does the money go?  1) Agents.  2) Benefit payments.  3) Home office expenses.  Investment income usually subsidizes insurance companies; they lose money on underwriting on average, and when the pricing cycle is weak, they lose substantial amounts.  Since the inception of health insurance, the insurance industry may have lost money in aggregate.

In Summary:

  • Plan your investment and protection needs yourself, or find a trusted advisor to help you.  Investment knowledge pays its own dividends.
  • Study a company’s claims paying practices before buying.
  • Review expense and surrender charges and other contract terms.
  • Choose an insurance company off its reputation, and not price only.

Return to Tower Group

Wednesday, March 26th, 2014

A while ago, I wrote a piece on Tower Group after its stock price imploded, before it went down more, and attracted an acquisition offer from entities affiliated with the main owner of AmTrust Financial Services for $3/share.  Here’s another letter, from a different respective reader:

Hello, David:

I’ve been a longtime reader of your columns (back to RealMoney) and have a lot of respect for your opinion as an investor and analyst, particularly your insights into insurance companies.

Merger arb has been a (small) part of my toolkit for the last 15 years but haven’t yet seen an insurance merger quite as complicated as TWGP’s acquisition by ACP Re and AFSI.  With an 8% discount to the offer price and about 4 weeks until the shareholder meeting, this one looks intriguing.

There’s a (wordy) analysis of the deal terms here:  http://seekingalpha.com/article/2106193-towers-merger-offers-opportunity-for-double-digit-annualized-returns .

A couple of specific questions about the deal, if you feel inclined to respond:

1.  Does Karfunkel’s potential conflict of interest in selling the part of TWGP he doesn’t want (commercial, personal) to the publicly traded company he chairs (AFSI) raise enough of a red flag that regulators may intervene?

2.  Are the NOLs owned by TWGP usable by ACP if there is a reverse takeover (TWGP the surviving entity) under Bermuda law?

3.  Does the price at which Karfunkel is selling the pieces to public entities using mostly public shareholders’ money raise any red flags to you?

As I said, I respect and enjoy your work and hopefully you enjoy it enough to continue.

First I will handle the questions.  Then I will hand out a few opinions.

On question 1, the answer is not likely.   The regulators will disallow any situation where an acquisition would significantly impair the ratio of capital to required capital to bear risk [RBC].  Now, shareholders could be another matter.  In this acquisition, two public companies that the Karfunkel families control are buying up the renewal rights to Tower Group Commercial Lines business (AmTrust Financial – AFSI), and Personal Lines business – (National General Holdings Corp - NGHC, which recently went public).

With renewal rights, the AFSI & NGHC acquire the assets and the right to renew existing business at terms mutually acceptable to clients & companies, but they do not acquire anything that pertains to claims from business existing prior to the deal.  In return, they pay money to ACP Re, Karkunkel’s private company owned by his grantor trust.

On question 2, the answer is not likely.  When Argonaut bought out PXRE in a reverse merger, the NOLs were disallowed.  Now, I’m not a tax expert, so maybe someone reeeeally clever can fox their way around this, but to me the answer is no.

On question 3, the answer is I don’t know.  The public companies that he controls have the advantage that they aren’t taking on much risk in a renewal rights transaction.  Whether they are paying the right price or not depends heavily on whether the reserving for claims at the Tower Group entities is overstated or understated.  Prior under-reserving may not have been fully corrected.  With smaller companies near bankruptcy, like Tower Group, there is the risk of death via many cuts.

That brings me to my main insight.  Though there are no financing contingencies to this deal, ACP Re can walk away with no penalty if it merely wants to do so.  If they find a material adverse change, the deal can die, and TWGP will have to pay ACP Re a breakup fee.

Like Fairfax Financial’s offer to buy Blackberry, Prem Watsa had the equivalent of a “free look.”  Tower Group is desperate enough that they gave a “free look” to the Karfunkels and their allied companies.  The deal is not a lock, and a lot depends on what is written when the late 10-K is finally filed.

Why delay the 10-K?  My best guess is trying to get the claim reserves right.  After having to revise reserves twice before, the odds of further revisions are significant.  You have to understand that claim reserves for P&C companies are not a science, particularly for long-tailed lines, and Tower Group was overly aggressive in those lines.

But delay in filing the 10-K is not a positive sign.  If you have confidence in the actuarial analysis of reserves, why delay the filing?  Every other aspect of a P&C insurance company can be calculated within a few weeks of the year’s end.  No mysteries, except for the reserves.

So, if ACP Re concludes that the likely claim payments from the legacy business are likely to be larger than the net amount they are paying for the legacy business ($67 million), ACP Re can walk away, with no breakup fee.  In that scenario Tower Group could head to bankruptcy.

So, when I consider the arbitrage opportunities available by buying Tower Group common stock, I would pass.  As a rule, I don’t short, though I would be tempted to do so here.  Tower Group is a very complex company for its size, and as such, I have less confidence in its financials.  Complexity in financial companies creates inflexibility, which can lead to trouble when regulators deny moving cash from one company to another, which might lead to default on debts.

Avoid this situation, and all of the companies involved.  Buffett has his “Too Hard” pile.  This one is too hard, because no one can know the claims that will be paid from aggressively written legacy business.

Full disclosure: no positions in the companies mentioned

 

On National Western Life

Tuesday, March 25th, 2014

From respected reader:

Just did a quick calc based on NWLI earnings and thought I would pass onto you as I know you at least used to hold it as a double weight.  Let me know if you think there are major holes in this theory:

From the Annual Report:

“The yield on debt security purchases to fund insurance operations rebounded somewhat to 3.53% in 2013 from 3.37% in 2012 but was still below the 4.18% yield attained in 2011.”

So, investment yields improved, but are still down.  Their unrealized gains in securities dropped from $541 million to $146 because of this, so this part of the “hidden value” in the shares went down.

But if rates can get back up to that 4.18%, a quick calc says that would cause annual earnings on their $9 billion investment portfolio to increase $58 million.  If 2/3′s of this is credited to annuity holders, it leaves $19.5 million before tax for shareholders.  32% tax from 2013 gives after tax earnings increase of $13 million or $3.57 increase in earnings per share.

If we could get yields back up to 5.5% like they were a few years ago, using the same calc would give an increase in EPS of $9.38, or a 1/3 increase in earnings.

It is still a double-weight here.  It is not as cheap as it once was, but it is still cheap.  Financial stocks should always be valued on a combination of price-to-book and price-to-expected-earnings.

Why?  Because accrual items in the accounting can either be aggressive, fair or conservative.  If aggressive, earnings will be overstated, and book value understated.  If conservative, earnings will be understated, and book value overstated.  For the most part, the two measures balance the squishy accounting.

Now as for the disclosures in the NWLI 10K, we need to note that more than 2/3rds of the bonds that they hold are “held to maturity.”  That’s unusual, as is their policy where they don’t buy high yield bonds.  Held to maturity means the value of the bonds amortizes over time, but price moves don’t affect the accounting, unless default is likely.  Thus if interest rates rise, book value will not be affected much, but earnings will rise on a GAAP basis.

NWLI has a conservative investing culture, and in the present aggressive environment that is a *good thing.*  Adjusting for the held to maturity securities, the adjusted price-to-book is 55%, and my estimate of future earnings is one-ninth of the current price.  It is rare to find stocks trading at a significant discount to book and a single-digit P/E.

Full disclosure: long NWLI

Managing Berkshire Hathaway by Committee?

Tuesday, March 25th, 2014

While reading about portfolio companies today, I ended up reading this piece about Berkshire Hathaway.  Not that great of an article, and it got worse when I read this:

Then there is the big question, “Who will replace Warren Buffett (Trades, Portfolio)?” He is now 83 years old. There is no official word on who will take over, but in his letters to shareholders he takes time to praise many of the investment managers working for him. The current consensus seems to be that Berkshire will be run by committee. The company has plenty of assets and superior management, so it should continue to operate efficiently. [emphasis mine]

That’s not the way BRK works.  BRK is a group of businesses, run by men (male & female) who love their businesses, and would rather be running their businesses than taking a vacation.  When Buffett dies, and he *will* die one day, much as shareholders might like to hope otherwise, BRK will likely be managed much as it is today.  BRK relies on self-motivated managers that do their part to  make the company work.  Given the level of independence, it is the only way it can work, absent the possibility of considerable centralization after Buffett’s death.

The same applies to the management of the small central office.  Public stock portfolio management is separate from the purchase of private companies (with some informal overlap).  Operational management is limited, aside from efforts to fix lagging subsidiaries (think of Tracy Britt Cool).  The next CEO of BRK will have to have multiple skills, but he won’t have to “do it all” as Buffett does.  He will have to delegate yet further.

Think: how many people can understand all of the following:

  • The economics of a wide number of industrial businesses
  • The economics of one of the biggest insurers & reinsurers of the world
  • The quantitative aspects of Buffett’s derivative bets
  • Clever investing in public equities
  • Ability to acquire attractive public and private companies and on attractive terms
  • Minimizing tax impacts in the process
  • How to continually motivate the managers of a spread-out empire of companies

The successor to Buffett will likely be little different than Buffett — a capital allocator who motivates his many managers.  At the size of BRK, private equity skills may be more valuable than public equity skills.  BRK is a conglomerate, with considerable diversification.  Even a passing look at the corporate org chart screams “Big!”

You want a sharp delegator/decision-maker at the head of BRK.  He will hand off many responsibilities to others, but hold onto the core jobs of allocating capital, and evaluating/rewarding managers.

Anything else is suicide for BRK.  That said, it’s not impossible that a future CEO would radically streamline BRK, and turn it into something more like GE.  That would be a big mistake, but it would look like low hanging fruit, because of the many similar businesses that could be combined.  Purchasing and central office services could be combined as well.  That might improve profits in the short-run, but it would destroy the unique corporate culture that Buffett has created.

Far better to have a “fixer” correcting the edges of the corporation like Tracy Britt Cool, or David Sokol, than to wholly change the healthy culture of a corporation, with uncertain rewards.

Full Disclosure: Long BRK/B for myself and clients

 

On the Structure of Berkshire Hathaway, Part 2, the Harney Investment Trust

Friday, March 14th, 2014

In Omaha, there is Farnam Street.  Among value investors, it is well-known, because the small main office of Berkshire Hathaway [BRK] is located there.  Less well known is Harney Street, but from an insurance standpoint it is important, because Berkshire Hathaway’s largest insurance subsidiary, National Indemnity, is located there.  One of the major assets of National Indemnity is the Harney Investment Trust, of which National Indemnity is the sole beneficiary.

Before I go further, I want to say there is a lot I don’t know about what I am going to write.  Let me tell you what sources I have looked at:

  • SEC filings of companies where the Harney Investment Trust was a greater than 5% shareholder.
  • Legal documents from Bankruptcies and other corporate legal events where Harney Investment Trust was a party.
  • All of the statutory filings for Berkshire Hathaway’s primary insurance companies in 2012.
  • All of National Indemnity’s statutory filings on assets 2002-2013.
  • All of National Indemity’s statutory audits, 2002-2012.

Now, if you read through BRK’s filings to the SEC, you won’t find many mentions of the Harney Investment Trust.  You have to read the insurance regulatory documents to find it, and even if you do that, you will still be puzzled.  Why?

  • Over the last 12 years, the National Association of Insurance Commissioners does not require “Other Assets” on Schedule BA to provide enough data so that an external user can make the change in book value or market value make sense.  It has gotten better over time, but it is still not enough.  You want to have enough data such that it explains the change in market and book value to the nearest thousand dollars.
  • There are a few errors that are obvious.  Some easy calculations don’t add.  Current year starting values are not the same as last year’s ending values.
  • A few numbers between the statutory filings and audits don’t agree.

Now, some of that is due to bad regulation.  The data reported for schedule BA assets could be streamlined such that it reports the change in the balance sheet for each asset on a book and fair market value basis.

But more of it is due to BRK’s lack of willingness to discuss/mention the Harney Investment Trust.  I did a lot of digging on this, and found  little that was definitive.  One seemingly intelligent opinion I found here.  I will quote the most relevant portion from “globalfinancepartners”:

Regarding the large surplus at Berkshire – it is largely because many subsidiaries are owned inside the insurance companies – especially within National Indemnity.  100% of the stock of BNSF, for example, valued at BRK’s cost of $34 Billion – is owned by National Indemnity and counts towards the statutory surplus.  Also, National Indemnity owns 100% of the shares of GEICO.  Then in addition there are the securities, of course.

GEICO, in turn, owns 100% of the shares of Clayton, McLane, TTI, as well the marketable securities.

I’ll attach an NAIC filing if you really want to geek out.  But unfortunately, the mystery stock Buffett has been accumulating and receiving confidential status on through the SEC is hidden like always inside the “Harney Investment Trust” – Buffett’s go-to vehicle for keeping stock trading hidden from regulatory filings.  (Harney Street is in Omaha)

He gets it, mostly, and concludes that Buffett uses the Harney Investment Trust to hide his buying and selling of positions.  Assets inside the Trust do not get reported one-by-one on the insurance Schedule D.

Now, before I close, I want to share the data that I have harvested from the Statutory statements, and make a few more comments.

Year

2001

2002

2003

2004

2005

Cost   8,063,249,239   6,098,184,425    4,345,049,427      7,566,419,887
Addl Investment      4,314,851,219
Fair Value   10,532,124,694
Book   9,814,864,000   9,325,481,908   8,326,636,998    5,326,049,532      9,524,818,329
Change     (220,350,768)       859,931,290  (1,141,017,994)      1,958,398,441
Accretion
OTTI
FX Change
Inv Income          455,078,969
Book Sold   5,405,086,442   4,640,112,416    2,934,268,712      1,121,718,176
Change           (40,084,139)
Consideration   6,156,977,208   5,492,507,843    3,827,449,032      1,561,718,363
Gain       751,890,766       852,395,427         893,180,320          399,916,048
income
% Assets

25.77%

18.33%

10.45%

15.36%

Am Cost   8,355,067,000   8,063,249,000   6,098,184,000    4,345,049,000      7,566,420,000
URGC   1,459,797,000   1,711,427,000   3,810,157,000    2,316,272,000      2,965,705,000
URCL                                  -       144,894,000                                  -                                   -                                     -
Fair Value   9,814,864,000   9,629,782,000   9,908,341,000    6,661,321,000   10,532,125,000
CommentsDisagreeing figs

 

Year

2006

2007

2008

2009

Cost      6,964,633,697   20,139,079,483      5,921,482,114      5,786,018,179
Addl Investment          982,768,239   15,783,905,450      9,781,668,840   10,865,269,974
Fair Value   12,117,706,779   21,921,621,265      4,923,093,676      6,769,046,868
Book   11,123,440,646   21,921,621,265      4,801,843,191      5,800,502,260
Change      3,098,256,653      1,751,436,622    (2,840,908,667)      1,108,867,879
Accretion          119,595,243          197,707,597
OTTI          288,188,143      2,590,146,282
FX Change           (57,873,620)             36,966,246
Inv Income      1,261,755,231          663,463,512          987,469,687          826,207,723
Book Sold      1,746,959,239      2,653,395,647   24,830,673,311      8,645,957,509
Change        (100,447,051)              (3,398,147)             37,662,286
Consideration      1,999,993,027      6,522,527,452   24,010,303,351      9,017,341,154
Gain          353,480,839      3,869,131,805          179,640,040          371,383,645
income                3,658,670             62,505,008
% Assets

16.56%

29.56%

7.78%

7.39%

Am Cost      6,964,634,000   20,139,079,000      5,921,482,000      5,786,018,000
URGC      5,153,073,000      1,782,542,000                                     -          983,029,000
URCL                                     -                                     -          998,388,000                                     -
Fair Value   12,117,707,000   21,921,621,000      4,923,094,000      6,769,047,000
CommentsBought out other trustsCleaned House
Year

2010

2011

2012

2013

Cost      9,457,498,340      7,464,877,852   7,064,639,865   5,004,510,446
Addl Investment      7,068,414,613   12,784,563,299   4,186,877,510   3,254,233,606
Fair Value   11,700,226,848      7,807,366,099   9,066,610,408   7,675,070,719
Book   10,720,330,531      7,450,894,712   8,417,129,742   7,511,081,043
Change      1,271,863,576    (1,276,652,476)   1,332,026,027   1,163,420,948
Accretion             17,914,824           (25,309,149)             2,759,586             2,810,400
OTTI          476,659,635          190,142,457       115,680,863
FX Change              (5,766,223)                   (911,734)             1,296,067                  659,774
Inv Income          554,369,500          719,996,080       389,469,312       403,093,171
Book Sold      2,944,738,747   14,566,437,847   4,479,185,215   5,214,644,823
Change                7,728,019                4,705,665             4,970,996     (102,528,623)
Consideration      3,576,396,272   14,738,706,689   4,833,798,698   5,785,003,373
Gain          631,657,525          141,268,842       354,613,478       570,358,551
income             76,920,680             25,137,655          11,091,687       118,147,838
% Assets

9.60%

6.45%

6.59%

Am Cost      9,457,498,000      7,464,878,000   7,064,640,000
URGC      2,343,171,000          866,984,000   2,083,717,000
URCL          100,442,000          524,226,000          81,747,000
Fair Value   11,700,227,000      7,807,636,000   9,066,610,000

Notes: OTTI: other than temporary impairments.  URCG: Unrealized Capital Gains. URCL: Unrealized Capital Losses.  Other categories are hard to define, though I am sure the NAIC has definitions, though they don’t give complete changes in balance sheets.

Another thing that I could not make to match from the statutory statements was the securities that went in and out of the trust.  Aside from some Treasury bonds  in 2002, here are all of the reported transactions where securities moved from National Indemnity to the Trust, and vice-versa.

YearActionTickerSharesValueConsiderationCapital Gain (loss)

2003

InMTB         927,760              3,655,241

2003

InWFC     6,138,800         127,795,056

2003

InAXP     5,308,500         101,902,002

2003

InMCO   16,140,300         340,631,841

2003

PoofLVLT   32,691,065         100,000,000

2004

InTMK         872,200           20,268,837

2004

InHRB   14,350,600         222,546,836

2004

InCDO     1,195,274                              1

2004

InCOST     5,254,000         146,595,428

2004

InGCI     3,447,600           81,873,173

2004

InMLI     1,361,900           30,408,193

2004

InSEE     1,113,300           32,102,292

2004

InUSG     6,500,000           37,180,000

2005

OutTMK         872,200           20,268,837         49,826,080               29,557,243

2005

OutHRB   14,350,600         222,546,836       703,179,400             480,632,564

2005

OutCDO     1,195,274                              1         26,666,563               26,666,562

2005

OutCOST     5,254,000         146,595,428       254,346,140             107,750,712

2005

OutGCI     3,447,600           81,873,173       281,668,800             199,795,627

2005

OutMLI     1,361,900           30,408,193         43,853,180               13,444,987

2005

OutSEE     1,113,300           32,102,292         59,305,491               27,203,199

2005

OutUSG     6,500,000           37,180,000       261,755,000             224,575,000

2008

InUSB   20,768,728         657,202,698

2008

InWFC   52,372,788     1,819,017,267

2008

InCOP   71,896,273     5,878,643,401

2008

InCOST     5,264,000         146,595,428

2008

InKFT   89,222,400     2,957,096,963

2008

InPG   17,200,318     1,026,726,674

2008

InUSG   10,102,918         202,419,056

2008

InWMT   18,998,300         901,731,797

2008

OutPG   20,000,000     1,193,846,154   1,468,400,000           (274,553,846)

2009

InCOP   29,711,330     1,163,495,683

2009

InMTB             6,300                 447,467

2009

InPG   14,328,093         855,276,936

2009

InTMK     1,656,900           60,572,017

2009

InWMT   14,892,842         746,046,432

2009

InWFC   21,030,680         473,941,080

2009

InGSK     1,510,500           78,918,016

2009

InPKX     1,087,000           44,260,228

2009

InSNY     2,896,133         119,233,280

2009

OutCOP   71,896,273     5,690,321,498   3,724,226,941         1,966,094,557

2009

OutMCO   15,000,000         163,880,137       284,850,000           (120,969,863)

2009

OutPG   26,000,000     1,552,000,000   1,607,320,000             (55,320,000)

2010

InJNJ   13,274,736         851,173,066

2010

OutCOP   25,227,450         987,906,942   1,288,365,871           (300,458,929)

2010

OutKFT   57,684,645     1,885,271,843   1,567,868,651             317,403,192

2010

OutMTB     4,680,322           36,930,716       216,105,603             179,174,887

2010

OutPG   15,000,000         895,384,615       909,450,000               14,065,385

2011

InCOP   21,109,637         826,653,385

2011

InGCI     1,740,231           13,921,848

2011

InIBM   63,905,931   10,856,339,550

2011

InMTB     4,671,245           38,003,193

2011

InPG   12,669,252         756,256,889

2011

InWFC   28,446,437         718,140,133

2011

OutJNJ   12,951,761         829,897,088       801,466,418               28,830,670

2012

InWFC   32,872,641     1,090,916,624

2012

OutPG   29,754,036     1,776,087,072   1,984,891,742             208,804,670

In means assets came into National Indemnity, and out means the reverse.  Poof means something came into National Indemnity, and left in the same calendar year.

Notably, in 2008, Buffett had most of the assets exit the trust into National Indemnity, when they were in a position of unrealized capital loss.  I don’t fully understand the tax and capital effects here, but it seems that Buffett found it to his advantage to move assets out of the trust, and into National Indemnity once the assets were unrealized capital losses.

I think the guy I quoted is correct.  Buffett uses the Harney Investment Trust to hide his acquisitions and dispositions of stock.  The NAIC should end this, and make Schedule BA assets that are easily separable appear on Schedule D, where they belong.  Schedule BA should be for assets that are not publicly traded.  Partnerships with assets that would fit on Schedule D should  be on Schedule D.

Summary

Buffett tries to take an ethical stance in investing, and makes many statements about the way investing ought to be done.  Using a trust to avoid disclosure of holdings and transactions is not in the spirit of GAAP or statutory accounting/disclosures.   This practice should be ended.  Warren, step up your game before you have to and end the Harney Investment Trust.  I write this as a fan who owns BRK/B shares.

And, to my dedicated readers, if you have more data, or a better means of analysis of the data I have gathered, by all means offer your help.  Thanks, David

Full disclosure: long BRK/B for clients and me

On the Structure of Berkshire Hathaway

Wednesday, March 12th, 2014

Berkshire Hathaway [BRK] is a unique company.  You have a property-casualty insurance giant owning many businesses directly through insurance subsidiaries, including huge businesses like a Class 1 Railroad — BNSF.

Yes, National Indemnity owns BNSF in entire, and many other businesses as well.  I thought the pre-crisis org chart of AIG was complex — because of the many industries that it covers, BRK is far more complex.   In the 2012 statutory statements, it runs for 22 pages.  Let me list the top-level subsidiaries, and any significant lower level subsidiaries they own.

  1. Affordable Housing Partners (common for reducing taxes w/ section 42 housing)
  2. Albecca (Larson-Juhl)
  3. AU Holding Company (Applied Underwriters
  4. Ben Bridge Corporation
  5. Benjamin Moore
  6. Berkshire Hathaway Credit Corp (BH Media — all the little newspapers)
  7. Berkshire Hathaway Finance Corp
  8. BH Columbia Inc (Columbia Insurance, Medical Protective Corp [which owns Lubrizol debt])
  9. BH Housing LLC
  10. BH Shoe Holdings, Inc.
  11. BH-IMC Holdings B.V. (“Iscar”)
  12. BHSF (SF = Scott Fetzer)
  13. Blue Chip Stamps, Inc.  (Really, still around?)
  14. Borsheim Jewelry Company
  15. Brookwood Insurance Company
  16. Business Wire, Inc.
  17. Central States of Omaha Companies, Inc.
  18. CORT Business Services Corp
  19. CTB International Corp.
  20. Cypress Insurance Company
  21. Forest River, Inc.
  22. Fruit of the Loom, Inc.
  23. Garan, Inc.
  24. Gateway Underwriters Agency
  25. General Re Corporation (seems to own much of Fruit of the Loom)
  26. Helzberg’s Diamond Shops
  27. International Dairy Queen
  28. Johns Manville Corp
  29. Jordan’s Furniture
  30. Justin Brands (Acme Brick)
  31. Marmon Holdings
  32. MidAmerican Energy Holdings (CalEnergy, HomeServices of America, Magma Power, NV Energy, Pacificorp)
  33. MiTek Industries
  34. MS Property
  35. National Fire & Marine Insurance Company
  36. National Indemnity (Flightsafety, BNSF, CLAL, GEICO, Clayton Homes, McLane, TTI)
  37. National Liability & Fire Insurance Company
  38. Nebraska Furniture Mart
  39. NetJets, Inc.
  40. Northern States Agency, Inc.
  41. OTC Worldwide Holdings (Oriental Trading Company)
  42. Precision Steel Warehouse, Inc.
  43. R. C. Willey Home Furnishings
  44. Richline Group, Inc.
  45. See’s Candy Shops
  46. Shaw Industries Group
  47. Star Furniture Company
  48. The Buffalo News, Inc.
  49. The Fechheimer Brothers Company
  50. The Lubrizol Corp
  51. The Pampered Chef, Lrd.
  52. US Investment Corporation
  53. Wesco-Financial Insurance Company
  54. XTRA Corp

BRK is huge, and Buffett prefers owning whole companies to portions of companies, because then the entire free cash flow is available to him, not just the dividends.

The first question to answer is why does Buffett have some industrial companies inside his insurers, and some not?  That has to do with risk-based capital.  P&C insurers have to put up capital equal to 22.5% on equity of affiliated insurers, and 15% on non-affiliated common stocks, and 20% on Schedule BA investments that are similar to stocks.  These are more liberal than the standards for life companies, which  have a 30% charge on stocks.   (Which doesn’t make sense, because life insurers have longer balance sheets, and have a better ability to hold equities, but I digress…)

But even if they have to put up capital to own the companies, BRK has a negative cost of capital inside its insurers, because they make underwriting profits.  What a business — make money on insurance, and on businesses owned by the insurance subsidiary.

One more thing about BRK’s insurance subsidiaries — in general, because they have so much asset risk, they don’t write as much insurance as other companies of their size would.

Tomorrow, I will write part 2 on this, regarding the one anomaly I found going through BRK’s statutory books, the Harney Investment Trust.  Till then.

Full disclosure: long BRK/B for clients and me

On the “770″ Account

Thursday, March 6th, 2014

A letter from a reader:

Dave,

My Mom asked me about 770 accounts (apparently, she wants to open one). I’ve reserched [sic] them, but can’t quite figure out if it’s legit or not. So much, what I’ve found is that it is really some kind of insurance policy, it’s tax free, and it’s not openly advertized [sic].

Do you know anything about these accounts? Are they safe? Are they worth it?

Dear Friend,

We are talking about permanent life insurance here.  I’ve written about this at least once before.  The types of policies they talk about maximize the savings element inherent in permanent life insurance, and minimize the death benefit.  Monies in the insurance policy accrue tax free, and at death they escape estate taxes.  What could be better?

Well, permanent insurance is laden with fees, and agents love to sell it if they can, because the commissions are huge.  Mortality charges are significant as well.  As I often say with this kind of product, insurers love to create complex products because average people can’t tell whether they are getting a good deal or not.  (Hint: usually, you are not getting a good deal.)

Life insurance is a very expensive way to manage assets, between the agents and the operating costs of the company.  At present, insurance company assets yield more than market rates, which gives a subsidy to customers, but the day will come, like the late 70s — early 80s, where it was very much the reverse.

Aside from scamming the tax man, and providing protection to loved ones at your death, life insurance is a lousy vehicle for building wealth.  If you have built wealth already, it is an excellent way to preserve it for your heirs.  But it won’t make you rich, and all of those advertising such accounts and those like them, make huge commissions off of permanent life policies if they are the agent.  They make out far better than you will.

Are they safe?  Yes, life insurance is safe.  Are they worth it?  No.  Not that I am bullish on the stock market now, but under most conditions, the stock market outperforms the returns that insurance companies before expenses, much less after expenses.

This can make a lot of sense if you are rich already, but it will never make you rich.  Having reviewed many of the advertisements for these products, they use a Madoff-like technique that tells you that you are being let in on a secret way of wealth.  It’s all garbage, because permanent life insurance has been around for over 100 years.

Hey, let me tell you a secret.  Did you know that insurance stocks  have outperformed most other industry groups over the last 40-50 years?  Buffett will tell you, insurance is a great business.  Now, maybe I can give this a cryptic name, like a 321 fund, and tell people that owning the 321 fund is a way to wealth.  (Psst… the same is true of the stocks of money managers… they do much better than mutual funds.)

Sadly, you would likely do better with my 321 fund, the the 77o account, especially if it is held within a tax-deferred account.

Be wary of any pitch that is too good to be true.  Don’t buy what someone wants to sell you.  Buy what you have researched and want to buy.  Oh, and buy the 321 fund — really, buy it. ;)  (I feel ashamed.)

Final Note

THERE ARE NO SECRETS IN MONEY MANAGEMENT!  THERE ARE NO SECRETS IN MONEY MANAGEMENT!  THERE ARE NO SECRETS IN MONEY MANAGEMENT!

There is no secret club.  There are no secret formulas. There are a lot of clever lawyers, accountants, and actuaries that the wealthy employ, but for average people, the high fixed costs won’t make it work.

If you want to be wealthy, you have to run your own firm, run it well, providing value to many.  Don’t listen to those who say they have an easy way to wealth.  They are lying, and are looking to make money off of you.  Those who give you free advice are using you in some way.  (Wait, what does that make me to be? Sigh.)

Signing off, your servant David, who does this for his own reasons…

Thoughts on the Berkshire Hathaway Annual Letter & Report

Saturday, March 1st, 2014

I’m going to try to take this topically.  Here goes:

On Acquisitions

Buffett still has a strong desire for more acquisitions.  After $18B to buy 52.6% of Heinz (counting in the low strike warrants), and all of NV Energy through MidAmerican, there were additional bolt-on acquisitions $3.1B after additional payments of $3.5B to buy the rest of Marmon  and Iscar.  After all that, the cash level at BRK was virtually unchanged from the beginning of 2013.

He might like to own far more of Heinz in the future:

Though the Heinz acquisition has some similarities to a “private equity” transaction, there is a crucial difference: Berkshire never intends to sell a share of the company. What we would like, rather, is to buy more, and that could happen: Certain 3G investors may sell some or all of their shares in the future, and we might increase our ownership at such times. Berkshire and 3G could also decide at some point that it would be mutually beneficial if we were to exchange some of our preferred for common shares (at an equity valuation appropriate to the time).

And he might want to buy more utilities:

NV Energy, purchased for $5.6 billion by MidAmerican Energy, our utility subsidiary, supplies electricity to about 88% of Nevada’s population. This acquisition fits nicely into our existing electric-utility operation and offers many possibilities for large investments in renewable energy. NV Energy will not be MidAmerican’s last major acquisition.

The Powerhouse Five

MidAmerican is one of our “Powerhouse Five” – a collection of large non-insurance businesses that, in aggregate, had a record $10.8 billion of pre-tax earnings in 2013, up $758 million from 2012. The other companies in this sainted group are BNSF, Iscar, Lubrizol and Marmon.

If you look at BRK earnings now, leaving aside derivatives, one-third of earnings come from insurance, and the rest stems from the industrial & utility enterprises.  [Note: Buffett uses the word "sainted" which he used in the 1980s to describe a group of much smaller private companies that he owned in full then.  He doesn't mean holy, but leading and valuable.  They are driving the economics of BRK.

None of the Powerhouse Five did badly in 2013, though Marmon was a little weak.  It's difficult to find any part of BRK that did badly in 2013.  BNSF was particularly impressive, and I am glad that I thought it was a good move when Buffett bought it, because too many criticized it at the time.

As an aside, it's interesting how much MidAmerican is pouring onto wind and solar power.

Debt

I've always thought Buffett was clever with debt issues.  He never guarantees the debt when he takes over a company.  He is willing to live with the complexity of subsidiary debt issues.  But hear these quotations from the Annual Report:

  • Berkshire does not guarantee any debt or other borrowings of BNSF, MidAmerican or their subsidiaries.
  • BNSF’s borrowings are primarily unsecured.
  • All, or substantially all, of the assets of certain MidAmerican subsidiaries are, or may be, pledged or encumbered to support or otherwise secure the debt. These borrowing arrangements generally contain various covenants including, but not limited to, leverage ratios, interest coverage ratios and debt service coverage ratios.
  • The borrowings of BHFC, a wholly owned finance subsidiary of Berkshire, are fully and unconditionally guaranteed by Berkshire. 

Buffett only guarantees the debt of a small finance subsidiary, and nothing more.  The rest of the debt is non-recourse to BRK, and so bondholders take their chances on a subsidiary failing.

Derivatives

Our credit default contracts generated pre-tax losses of $213 million in 2013, which was due to increases in estimated liabilities of a municipality issuer contract that relates to more than 500 municipal debt issues. Our credit default contract exposures associated with corporate issuers expired in December 2013. There were no losses paid in 2013. Our remaining credit default derivative contract exposures are currently limited to the municipality issuer contract.

The equity puts are way out of the money, and only municipal issues remain among his fixed income derivatives.  BRK "made" $4B on the derivative positions in 2013, something that will be impossible to repeat.

Give Buffett credit, though, because he structured some clever trades that have made a lot of money.  Value investing won vs option pricing.  At present, the future performance of the derivatives is close to immaterial, unless we have significant municipal defaults.

Insurance

A few qualitative notes: Buffett mentions that GEICO has passed Allstate to become #2 in Auto insurance.  He later mentions State Farm (#1 in Auto, I think the first time he has mentioned it):

Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. For example, State Farm, by far the country’s largest insurer and a well-managed company besides, incurred an underwriting loss in nine of the twelve years ending in 2012 (the latest year for which their financials are available, as I write this). Competitive dynamics almost guarantee that the insurance industry – despite the float income all companies enjoy – will continue its dismal record of earning subnormal returns as compared to other businesses.

But after mentioning State Farm's abysmal underwriting, though Buffett doesn't say it is such, he mentions how well BRK has done:

As noted in the first section of this report, we have now operated at an underwriting profit for eleven
consecutive years, our pre-tax gain for the period having totaled $22 billion. Looking ahead, I believe we will
continue to underwrite profitably in most years. Doing so is the daily focus of all of our insurance managers who
know that while float is valuable, it can be drowned by poor underwriting results.

BRK had a light year for catastrophes, which inflated their income somewhat.  It also seems that they put the poor deal that they did with Swiss Re behind them.

Buffett also talked about the "float" growing -- assets held for future payment where no interest has to be paid.  It's $70B+ now.  More on that later.

Buffett also trumpeted a move into Specialty Insurance.  He poached a team from AIG in 2013 to start this.  Specialty Insurance means niche markets with very careful underwriting guidelines.  I'm sure that Berkshire will do this well.

Finally, the insurers have good underwriting and reserving.  BRK still has a underwriting profit over the past eleven years, and they continue to release reserves from prior year claims.

The Structure of Berkshire Hathaway [BRK]

Though insurance no longer provides the majority of income for BRK, it is crucial to BRK’s functioning.  The insurance companies own almost of the industrial and utility enterprises.  BRK has little in fixed income and cash vs insurance reserves.  Buffett says:

 

Payments of dividends by our insurance subsidiaries are restricted by insurance statutes and regulations. Without prior regulatory approval, our principal insurance subsidiaries may declare up to approximately $13 billion as ordinary dividends before the end of 2014.

 

There is a rule of thumb in P&C insurance.  Claim reserves are funded by high quality bonds of equivalent length  Unearned premiums are funded by short-term debt like commercial paper.  Surplus funds are invested in risk assets, like equities.

With BRK, more is invested in risk assets than the rule of thumb would allow.  I’m not sure how the Risk-based Capital formulas allow this.  Other insurance companies can’t do this.

Notes

Buffett uses his private investments in real estate investing to show the difference between private & public investing.  This explains why we should be slow to trade.  He also says:

Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.

And as such, an investor in that state of ignorance should index.

Other Notes

Those who want to ask questions at Buffett’s annual meeting should send questions to: Carol Loomis, of Fortune, who may be e-mailed at cloomis@fortunemail.com; Becky Quick, of CNBC, at BerkshireQuestions@cnbc.com; and Andrew Ross Sorkin, of The New York Times, at arsorkin@nytimes.com.

Some have complained about a lack of transparency at BRK, and I have to disagree.  BRK is a collection of small and large businesses.  The annual report adequately talks about all of BRK, but gives less time to smaller issues.  BRK is the fifth largest company by market cap, and Buffett reveals more of his intentions then most CEOs.

I have more to say regarding Intrinsic Value & Compounding, but that will have to wait.

Full disclosure: Long BRK/B for myself and clients

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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