Picking up where the last post left off:

13) So Buffett told us he has a successor lined up, but won’t tell us who, but will tell us that the successor doesn’t know that he is the successor.  Really does not seem like much of an improvement over the past, except that the CIO function is getting better defined with Todd and Ted.

14) Todd & Ted share their performance 80/20 — 80% of their own and 20% of their colleagues performance.  Seems like a fair idea, balancing the team vs the individual.

15) The regulated subsidiaries, and manufacturing, services and retailing did well. That operating income growth is what drove the year.  The turnaround at NetJets was also a help, and that was fast.

16) We are still waiting to see what problems BRK’s decentralized system can develop.  To this point, the flexibility for managers within a structure that oversees reinvestment of cash flow is admirable.

17) The economic spread of BRK businesses is significant, and I would argue, unrivaled in terms of conglomerates.  It almost makes me think that Buffett is aiming for owning an extra-productive slice of US/World GDP.  It makes acquisition criteria #1 less relevant, because if you are small and private, and want to be acquired by BRK, it means that you analyze BRK, identify the portion of it that you are most similar to, and talk to the CEO of that segment, not Buffett.

18) That brings up my view of Buffett at present.  He has changed as the amount of assets under management has grown.  The last phase for Buffett is not large cap value manager, but private equity manager / conglomerateur.  He uses the float that his insurers produce to invest in a wide number of enterprises that will produce excess returns.  He does not run a closed end fund, but runs a conglomerate.

19) Interesting to see Nebraska Furniture Mart open its third store.  Logical to do, if the experience is replicable.

20) “We do not talk one-on-one to large institutional investors or analysts.” Bravo.  Would that this would be true of more companies.  When I represented a large holder of Safety Insurance, the management asked me what we wanted in terms o market disclosure.  I said that it did not matter to us, and that we would be happy if they never talked to the media/analysts, and only emitted 10-Qs and 10-Ks, even without notifying us as to timing.

21) Buffett notes that a decent number of borrowers that lost their homes did well in the crisis, because of all the money they extracted from loans.  That might be similar to a private equity manager profiting through deals to borrow where he pays himself a dividend.

22) Owning 11% of Munich Re gives Buffett additional influence over the reinsurance market.

23) Because of the need for collateral, BRK will not be making any more significant derivative bets.

24) Buffet repeats his screed that he issued to Fortune regarding bonds and gold.  I repeat my screed.  It’s all logical, Warren, but you have to think more broadly and read about the gold medal gold model.

25) It makes sense that flying to Kansas City is a better strategy than going to Omaha.  But as this becomes widely used, make sure you reserve a car early.

26) If you want to ask Buffett a question at the annual meeting, you can do it by e-mailing the following:

• Carol Loomis, of Fortune, who may be e-mailed at cloomis@fortunemail.com
• Becky Quick, of CNBC, at BerkshireQuestions@cnbc.com
• Andrew Ross Sorkin, of The New York Times, at arsorkin@nytimes.com

(In your e-mail, let the journalist know if you would like your name mentioned if your question is selected.)

27) There will be insurance analysts at the annual meeting, and they are Cliff Gallant of KBW, Jay Gelb of Barclays Capital and Gary Ransom of Dowling and Partners.  I have a lot of respect for Gary Ransom — listen to the questions that he asks.

28) Minus & Plus: Negative change in AOCI & comprehensive income of noncontrolled interests down.  Strong CFO, net of capex, supports goodwill.

29) At for BRK’s big options: BAC in the money, GS at, GE/DOW out of the money.

30) Do parts of all asbestos liabilities eventually go to Berkshire Hathaway for reinsurance?  Who don’t they reinsure?  “The liabilities for environmental, asbestos and latent injury claims and claims expenses net of reinsurance recoverable were approximately $13.9 billion at December 31, 2011.”

I know that Buffett thinks he can earn money off of the float on these claims in excess of the implied interest rate.  But when he begins to become the preferred habitat for reinsurance, he makes BRK more volatile with respect to legal judgments.

31) “Without prior regulatory approval, our principal insurance subsidiaries may declare up to approximately $9.5 billion as ordinary dividends before the end of 2012.” And that is because only 10% of the regulatory surplus of $95 billion can be released.

32) BRK, unlike many firms, has more reasonable assumptions on DB pensions: expected return: 6.9%, discount rate 4.6%.

33) To date, share repurchases have been insignificant.  Looks like $67 million from the Statement of Shareholders Equity.

34) “On January 31, 2012, we issued an additional $1.7 billion of parent company senior unsecured notes, the proceeds of which were used to fund the repayment of $1.7 billion of notes maturing in February 2012.”

Why not pay down short-term debt?  BRK has the cash, and you state that you have an aversion to debt, particularly at the holding company level, but you are not acting like you have an aversion to debt over the last 10 years.

To Buffett: is there a level of debt at which you would be uncomfortable at the parent company, or subsidiaries?  Also, would you ever make an effort to get the AAA rating back?

35) BRK has a very diversified reserving book if you look at page 84 of the annual report — impressive.

36) I appreciate acquisition principle 6, which deal with aspects of value that accounting does not capture.  Buffett takes the right position to value those fully, because you will eventually get that value, and others will not pay up for it.

37) Buffett makes a lot out of the virtues of deferred taxes and float. He argues “they are liabilities without covenants or due dates attached to them.”  This is true, though deferred tax liabilities assume that you will make money, and will continue to grow.  Float is similar, it assumes you will underwrite well, and it would be nice if you grew.

38) Buffett says toward the end of the annual report:

There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.

I’ve written about this before.  Some managements teams with skill should retain all earnings, and not pay a dividend.  Management teams without skill should act like REITs and pay out 90% of taxable income (or free cash flow).

39) Buffett says he was wrong on housing.  I think he is still wrong on housing; it will take a lot longer for this situation to normalize.  The key variable is the proportion of houses with debts exceeding a 90% LTV.  Those houses are illiquid; can’t be sold except in a short sale.

40) One final wild idea: would BRK consider buying out the corpus of AIG?  I have better small insurance acquisition targets than that, but buying out AIG would be delicious given the comments Greenberg made to Buffett back when BRK was smaller.  He was very dismissive of BRK.  Also, Buffett could fold ILFC into NetJets (or vice-versa), sell off the life companies, and impose greater discipline on the P&C underwriting.  Personally, if BRK made a bid for AIG at $32, I think Buffett could make a lot out of it, and he would not have to worry about a lot of fuss, because the major holder is the US Government.

Start with the basics, this is on the Annual Report, not just the shareholder letter.  I may have a second report out after the 10K is released.

1) One thing that was fascinating was the large number of low level acquisitions happening in the subsidiaries, and the desire for more of them.  There is interest at Lubrizol, McLane, TTI, CTB, Marmon, etc.

2) With BRK and IBM, Buffett hopes that public buyers and sellers will be stupid, and sell their shares at levels far below what the eventual prices will be, allowing the remaining shareholders to do better, as management buys in shares at a bargain, benefiting the persisting shareholders.

3) Buffett makes it clear, though that no matter how much cash has has, if prices are dropping rapidly, he won’t put a floor under the stock.  He’ll let the stock fall, and buy bit-by-bit through the whole process.  Indeed, it might be to his advantage to let the price fall below the 110% of Book level for a time to unnerve those that may be gaming the situation.

4) BRK does not talk its book as a result.  They would rather have the stock cheap for buybacks.  (Eeenh… but wouldn’t they rather have the stock higher to aid acquisitions?)

5) And if they firmly know what the value will be in the long run, they would love it if other investors would be scaredy cats and sell out to management at cheap levels so that they could have more of the value as they do not sell.  (Buffett does not phrase it that way, but this is a zero-sum game as far as trading goes.)

6) Buffett talked a lot about goodwill this year, much more than in prior years.  Goodwill makes up about 30% of BRKs book value.  I appreciated his argument regarding goodwill at the insurance companies — if your underwriting profits over nine years exceed goodwill the goodwill is most secure.

7) That said, partly due to lower interest rates, underwriting profitability has been higher for the P&C industry as a whole.  BRK may be better in aggregate, but some of Buffett’s industry comments are not warranted.  BRK is better in degree, not kind.

8 ) Buffett has the key of good P&C underwriting/management when he says “be willing to walk away if the appropriate premium can’t be obtained.”  That’s the only way to do it, with the price that your company will shrink when the rest of the industry is nuts.

9) All that said, the insurance lines did not do well this year, particularly not BH Reinsurance Group, which is Ajit Jain’s baby.  Part of that was the large catastrophes this year, some of it seems to come from not knowing how to run a life reinsurer.

10) Retroactive reinsurance showed gains, because losses on Swiss Re’s P&C experience was better than expected.  However, that was wiped out by Swiss Re Life & Health America’s business doing much worse than expected.

In one sense, a big question for BRK is whether they will spend the money to get the expertise necessary to run a big life reinsurer profitably.  So far, the answer seems to be no.  In my opinion, they need to hire experts, or buy out RGA.  Why buy the line from Sun Life when you could have RGA?

11) On principle 11 — BRK distinguishes itself among private equity buyers by leaving distinctive corporate cultures in place , and not interfering with them.  That may not help the present, but it helps the future, as wealthy people selling out take less, because they know their friends in the business will be left intact.

That won’t attract all sellers, but it will attract some.

And note that BRK will cut their losses on hopeless subsidiaries, or those beset by labor woes.

12) As usual, BRK’s reserve development is good, with releases coming from prior years.

More in the next part on Monday.

Full disclosure: long RGA

Recently I decided to spend some time analyzing the insurance industry.  It’s a different place today than when I became a buy-side analyst nine years ago.  Why?

First, for practical purposes, all of the insurers of credit are gone.  Yes, we have Assured Guaranty, and MBIA is limping along. Old Republic still exists. Radian and MGIC exist in reduced states.  The rest have disappeared.  In one sense, this should not have been a surprise, because the mortgage and credit guaranty businesses never had a scientific model for reserving.  I’m not even sure it is possible to have that.

Second, the title insurers are diminished.  Some, like LandAmerica are gone. Fidelity National seems to be diversifying itself out of insurance, recently buying up a restaurant chain.

Third, health insurers face an uncertain future.  Obamacare may disappear, or Obamacare could slowly eliminate insurers.  It’s a mess.

But beyond all of that, valuations are depressed across the insurance industry.  Part of that may stem from ETFs.  Insurers as a whole are smaller than the banks, but not as much smaller as they used to be.  Now, if you are a hedge fund, and you want to short banks, you probably have the best liquidity shorting a basket of financials, which shorts insurers as well.

That may be part of the issue.  There are other aspects, which I will try to address as I go through subindustries.

Offshore

By “Offshore” I mean P&C reinsurers and secondarily insurers that do business significantly in the US, and who list primarily on US exchanges, but are not based in the US.  Most of them are located in Bermuda.

In 2011, many of them were challenged by the high levels of catastrophes globally.  But the prices of the reinsurers did not fall because pricing power returned, and investors expect higher future earnings as a result.

Before I go on, I need to explain that what I will use to give a rough analysis of value is a Price-to-Book vs Return on Equity analysis [PB-ROE].  For more details, you can read my article here.  The short explanation is that companies in the insurance business (and other financials) are constrained by the amount of equity (net worth) that they have.  The ability to earn a return as a percentage of the equity [ROE] drives the market valuation as a fraction of the equity [P/B].

Here is a scatterplot for PB-ROE for the Offshore group:

Companies above the line may be overvalued, and companies below the line may be undervalued.  ROE is what is expected by analysts for the next fiscal year, not what has been obtained in the past.

The fit is fairly tight, and indicates mostly logical valuations for this group.  The companies that are possibly overvalued are: Arch Capital [ACGL] and Global Indemnity [GBLI]. Possibly undervalued: Everest Re [RE] and Endurance Specialty [ENH].

Now, this simple model can fail if you have an intelligent management team that has a better model.  Arch Capital may be that.  But with an expected ROE of less than 10%, it is hard to justify their valuation, when the average stock in this group needs an expected 13% ROE to be valued at book.

Why such a high ROE to get book?  Earnings quality.  Reinsurers have noisy earnings due to catastrophes.  You don’t give high valuations to companies that run hot or cold.  But the trick here is to see who is accumulating book value the fastest – they tend to be the stars over time.

Life

The life insurance business would be simple, if it indeed were only life insurance.  Much of the industry is handed over to annuities, and all manner of asset gathering.  Even life insurance can be made more complex through variable and variable universal life, where assets are invested in stocks, and do not receive a rate from the company.

Part of the trouble is that variable products are not simple, but the insurers offer guarantees for a fee.  When I see those products, my reaction is usually, “How do they hedge that?!”

Thus I am concerned for insurers that are “equity-sensitive” as I reckon them.  Here is the PB-ROE scatterplot:

A very tight fit.  The insurers that are undervalued are equity-sensitive ones: Phoenix Companies [PNX], American Equity Investment {AEL] , Lincoln National [LNC], and ING [ING].  Those that are overvalued are FBL Financial [FFG], and CNO Financial [CNO].  CNO has issues from long-term care, a coverage I dislike a great deal.  FBL is worth exploring.

One more note: to get book value in Life Insurance, you need an 11.7% ROE on average.  That’s high, but I expect that is so because investors are skeptical about the accounting.

Property & Casualty

This graph gives PB-ROE for the entire onshore P&C insurance industry:

It’s a good fit.  Again, the casualties of the last year weigh on the property-centric insurers, but for the most part, this is logical.

Potential underperformers include Hallmark Financial Services [HALL], Hilltop Holdings [HTH], Eastern Insurance Holdings [EIHI], Old Republic International [ORI], and Erie Indemnity [ERIE].  Below the line: Hartford Financial Services [HIG], Allstate [ALL], Tower Group [TWGP], and Horace Mann [HMN].

Because of the lower risk in P&C insurers, a firm only needs to earn an ROE of 6.6% to have a book value valuation.

Health

With Obamacare, I don’t know which end is up.  It could end up being a giant sop to the health insurers, or it could destroy the health insurers in order to create a government single-payer model, rather than the optimal model for cost reduction, where first parties pay directly, or pay insurers.  You want reductions in medical costs, get the government out of healthcare, and that includes the corporate deduction for employee health insurance.

My rationale is this: it could mess up the private market enough that the solution reached for is a single payer solution. I’ve talked with a decent number of health actuaries on this. The ability to price risk is distinctly limited. Young people pay too much, older folks too little. That’s a formula for antiselection. I think Obamacare was badly designed. I will not achieve its ends, and when the expenses start coming in, they will be far higher than anticipated. That has been the experience of the government in health care in the US. Utilization is underestimated, the further removed people from feeling its costs.

There are many models for profitability here, which makes things complex, but here is the present PB-ROE graph:

It’s a pretty good fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and CIGNA [CI].  And the following overvalued:  Molina Healthcare [MOH] and Wellcare Health Plans [WCG].

I don’t regard myself as an expert on the health insurance sub-industry, so treat this with skepticism.  I include it for completeness, because I think the PB-ROE concept has value in insurance.  One more note, the PB-ROE model thinks of this as a safe investment subindustry, because to have a book value valuation, you have to have an ROE of 7.8%.

Other Insurers and Insurance-Related Companies

This is a group that is a non-group.  It  comprises brokers, service providers, title and financial insurers.  Here’s the PB-ROE graph:

Pretty tight for a non-group.  Perhaps it is because it derives off of a much larger group, some of which has died off, leaving behind profitable entities.

As it is the potential outperformers include  Assured Guaranty [AGO], the largest remaining financial guaranty insurer, Fortegra Financial Corporation [FRF] a third party administrator of sorts, and what remains of the title insurance industry, Fidelity National [FNF], First American [FAF], and Stewart Title [STC].  That is one beaten-down group, and, one that would benefit a lot if housing bounced back.  There is a lot of potential earnings power there, and it trades for little above book value.

Potential underperformers include AJ Gallagher [AJG] and E-Health [EHTH].  I’ve dealt with AJ Gallagher professionally, and have respect for their management team, but maybe the valuation is stretched there.  E-Health is a health insurance broker, and over its existence hasn’t done anything deserving of a premium valuation.

And, for this non-group, it is riskless enough that you only need a 4% ROE to have a book value valuation.  This is one beaten-down sector of the market, and one that I do not own any of, but that I will eventually return to, because I have owned I in the past.  Should residential real estate finally normalize, many of these companies will fly.

I write this as one that was bearish on housing-related stocks since 2005.  There is potential here.

Summary

Insurance is complex, and the accounting is doubly complex, which is a major reason why many stay away from it.  But insurers as a group have had reliable and outsized returns over the rememberable past, which should encourage us to do a little kicking of the tires when so much of the industry trades below its net worth and is still earning money with little debt.

In my opinion, this is a recipe for earnings in the future, and why I own a lot of insurers for myself, and for clients.

Full disclosure: long ENH, but I may take other positions for clients in the next month

Finance Business

• Breaking Ranks: Former Broker Turns Bomb Thrower http://t.co/q1vpz9dh @reformedbroker interview previews his book: http://t.co/Yigg2sEE $$ Feb 24, 2012
• Why CLO managers continue to struggle http://t.co/a13j8jVG Low issuance, warehousing is tough, need more subordination, fewer senior buyers Feb 24, 2012
• My Favorite Quote from Baupost’s 2011 Annual Letter http://t.co/VOvbqab3 DIstressed bond mgrs get itchy in bull phase & buy new junk @ par Feb 24, 2012
• SEC IFRS Plan Endorsement http://t.co/8xguvs2G IFRS is not worth giving up comparability or sovereignty for. Project is a total loser. $$ Feb 24, 2012
• Very cool, congrats RT @Finovate: @AlphaClone to offer Alternative Alpha ETF from U.S. Bancorp http://t.co/srufb3qd Feb 23, 2012
• SEC May Ticket Speeding Traders http://t.co/oNCbF7pa Worthy of an experiment like the kind they did to study the “uptick rule” $$ Feb 23, 2012
• AQR’s Aaron Brown on Red-Blooded Risk http://t.co/ZM7hn5P4 When I was a bond mgr, could sense some aspects of risk listening 2 broker’s tone Feb 23, 2012
• The Volcker Rule is not going to bring your house back http://t.co/ADKMABfE Prop trading was not a leading cause of the financial crisis. $$ Feb 23, 2012
• Pimco Said to Quit Mortgage Bond Group http://t.co/YsQZs1IE Feels wrong parties (their clients) r paying 4 bad servicing,instead of banks Feb 23, 2012
•  If you want, I can dig up an old research piece on analyst coverage — there are basically 3 factors that explain 70… http://t.co/tBinshJJ Feb 21, 2012
• Stressed VAR is still a “protractor in the jungle” http://t.co/GRGgwvsd Risk management sh/not b done w/central measures but stress tests $$ Feb 21, 2012
• How One Company Teaches Employees the ABCs of Finance http://t.co/fqO19foq More companies should do this, they would b more profitable. $$ Feb 18, 2012
• Gross Fund at 66% Premium Shows Pimco Allure in Quest for Yield http://t.co/LY8Rv4SS Yield illusion distracts many investors. Avoid it. $$ Feb 17, 2012
• Read:Which three of DOL’s new 401(k) rules represent the biggest land mines for financial advisors and plan sponsors? http://t.co/ZVoMPmQu Feb 15, 2012
• The 400% Man http://t.co/nrRhYIZl Wish I could meet some of his disappointed investors who came to kick the tires and were disappointed. Feb 15, 2012
• Contra:Foot-Dragging on IFRS Decision Could Strip SEC of Power http://t.co/VNUFhWD5 The US could lose representation on IASB. Good, drop out Feb 14, 2012
• Notes from iGlobal’s Global Distressed Investing Summit: Part 2 http://t.co/9iOty0Iz Leveraged loan market seems to be in decent shape $$ Feb 14, 2012
• Pimco: $25 Billion Foreclosure Deal to Hit Pensions Harder Than Banks http://t.co/DKFtMI9B Gives MBS buyers a reason 2 sue originators $$ Feb 13, 2012
• Missing at MF: $1.6 Billion http://t.co/QSUMYbNO Included for the 1st time is roughly $700 million in client money residing in the UK $$ Feb 13, 2012
• Stockbrokers: A Guide to Private Placement Due Diligence http://t.co/tbwtu6Jy Illiquid investments are ways to cheat average people. $$ Feb 11, 2012
• Why illiquid? Can’t recover the commission otherwise.  Can deceive people that their investment is worth more than it… http://t.co/cYjvUhWx Feb 11, 2012

Market Strategy

• Jim Stack was right, and he’s still bullish http://t.co/GfEqtTKl Basically a forward P/E plus momentum argument, & lack of sharp falls $$ Feb 24, 2012
• S&P 500 Gets 9% Cheaper on Record Profits http://t.co/DWPGz5Y2 Makes a P/E argument; profit mrgns will eventually revert, may take a while Feb 23, 2012
• The dangers of dividend-paying stocks http://t.co/FymTmAAi Hint: they are stocks. No maturity date, no certain cash flow, low BK priority $$ Feb 23, 2012
• Falkenblog: Low Vol Commodity Timing Strategy http://t.co/M4FFRoCx Low volatility seems to work in a large number of areas, this is one $$ Feb 23, 2012
• Retro Investing—Look Back to Get Ahead http://t.co/vYiPCu9J The 50s, w/post-WWII financial repression, recurs as a current investing meme $$ Feb 22, 2012
• The Intelligent Investor: Are Index Funds Messing Up the Markets? http://t.co/VAoFtksw May also be traders following each other $$ Feb 21, 2012
• If history is any indication, high dividend stock outperformance should continue http://t.co/C5GaWmW8 Uses 40s & 50s as analogy $$ Feb 20, 2012
• Breakout or consolidation? http://t.co/GTSkBjIT Many market seem to be at inflection points. Which way will they go? Wildcards: EZone, China Feb 20, 2012
• RE: @alea_ Interesting analysis.  I would be wary of teasing too much out of the cluster analysis of sector correlati… http://t.co/zirdOJ8v Feb 18, 2012
• MORGAN STANLEY: January Exhibited This Tell-Tale Sign Of A Market Top http://t.co/IQqidpUE When everything rises at once, look out! $$ Feb 18, 2012
• Apple Stock May Not Be as Cheap as It Looks http://t.co/2dgfjfPq Earnings quality has declined, and so has the PE multiple $$ Feb 18, 2012
• @ampressman Common summary stat 4 acctg quality 4 $AAPL Net Operating Accruals / Assets, has been deteriorating 4 last 7 years + Feb 18, 2012
• @ampressman $AAPL acctg used to be very conservative, now modestly liberal by that statistic. It’s a bad direction, not a bad position, yet Feb 18, 2012
• Should the Rich Invest Like Colleges? http://t.co/M9OaPEPA Better question: what are your goals? Do you have an infinite horizon? $$ Feb 18, 2012
• High Yield Bonds as Equity Indicator | The Reformed Broker http://t.co/OXUtZrWG Meet my friends & former colleagues Ed Meigs & Sean Slein $$ Feb 17, 2012
• When Earnings Slow, Focus on Big Cap, Quality http://t.co/zjD3RPKA High quality is the place to be at present, credit cycle shifting some $$ Feb 16, 2012
• A Lesser Known Indicator http://t.co/8oivTJFl Cash enters market through IPOs, employee grants, & exits through cash buyouts, buybacks $$ Feb 16, 2012
• Parabolas have 2 end somewhere $$ RT @ReformedBroker: $AAPL sold off because people were getting impatient with how slowly it was moving up. Feb 15, 2012
• FPA Capital’s Bryan Beats Peers Embracing Oil Volatility http://t.co/7ebuGmrb A clever focus on absolute retruns, w/a long horizon $$ Feb 15, 2012
• Paulson Gives Activism a Go http://t.co/dkHb3cht Not as easy as it looks w/ $HIG. Acctg may not fairly capture variable liabilities $$ Feb 15, 2012
• RE: @SoberLook DB hedges its bets.  Average years rarely happen in high yield, they are either good or bad. http://t.co/0C51uulu Feb 14, 2012
• THE 1987 MYTH…. http://t.co/mHSU4nM3 “Illusion of stability within disequilibrium” Very well said, in one short phrase. $$ Feb 14, 2012
• America Inc. Faces Margin Stall http://t.co/RbqvqbT9 US companies have begun to see rising costs eat into the bottom line. Finally. $$ Feb 13, 2012
• Hulbert: Insiders Selling at Heavy Pace http://t.co/qOPk2cbY Just another straw blowing in the wind, but insiders usually have good sense $$ Feb 10, 2012

Greece

• Greek PSI outcomes tree: credit event probability at 93% http://t.co/jcLBc04c Clever grraphic shows high likelihood of Gk CDS triggering. $$ Feb 23, 2012
• The market is now pricing in Greek sovereign CDS trigger http://t.co/w5vJ42Fa Upfront prices for Greek CDS moving up $$ Feb 22, 2012
• Despite Pact, Unease Lingers for Greece http://t.co/Urp7mmag “Many Problems Remain Even Under Best-Case Scenarios” Shrink, shrink… $$ Feb 22, 2012
• Greek Rescue Is Not the End of the Story http://t.co/IOCVcCTb Won’t save Greece on its own & there r other fringe nations 2 deal with $$ Feb 20, 2012
• ECB Greek Plan May Hurt Bondholders While Triggering Debt Swaps http://t.co/Aya9urfV ECB may get better treaqtment than private holders $$ Feb 20, 2012
• So, what would your plan for Greece be? http://t.co/SAd2f28O Play the game, and let Keynes sneer @ u as u attempt 2 solve the impossible $$ Feb 18, 2012
• Greek Economy Shrinking Rapidly http://t.co/VzXi375M And it may shrink more rapidly depending on what the rest of Europe does $$ Feb 14, 2012

Eurozone

• ECB’s Mario Draghi magic corrupts bond markets http://t.co/r0ZCmYpb Banks become dependent on ECB, bank bondholders more subordinated $$ Feb 24, 2012
• European Banks May Tap ECB for $629 Billion Cash http://t.co/Re5TjLR5 “There is a ‘lose-lose’ air around the ECB’s auction next week,” $$ Feb 24, 2012
• The Eurozone should be prepared for a new government in France http://t.co/qGFPC20S And that govt will be more hostile to current actions $$ Feb 22, 2012
• Spain Sinks Deeper Into Periphery on Debt Rise http://t.co/wkuef6tS As debts grow higher, the probability of escape gets lower. $$ Feb 22, 2012
• Iron Lady Merkel Bucks German Street on Greek Aid http://t.co/Wc95xI47 Strategy working 4 now, but what if colleagues lose their seats? $$ Feb 20, 2012
• Moody’s Cuts European Sovereigns http://t.co/GvJuES7t Spain, Italy, Portugal, Slovakia, Slovenia & Malta all cut. France & UK -> neg outlook Feb 15, 2012
• Unlisted in euroland http://t.co/AQQrJMUf Didn’t catch this in Jan. Private bonds can offered 2 ECB as collateral; helps French banks $$ Feb 13, 2012

The Well-off Fringe Nations

• Icelandic Anger Brings Debt Forgiveness http://t.co/P4BH8HKN If the debt problem is not severe, austerity. If it is severe (Iceland) default Feb 22, 2012
• Nordic Currencies Stung in Crisis http://t.co/teorxG1P Much of the world, looking for a store of value, drive fringe currencies up $$ Feb 21, 2012
• Canada housing market: poised 4 ‘severe correction,’ George Athanassakos says http://t.co/05kaVIAD Canada is used to the boom/bust cycle $$ Feb 21, 2012
• @joshuademasi You’re right, but most of the fringe currencies are facing the same dilemma; who to favor, consumers vs exporters, etc… $$ Feb 21, 2012
• Israel Safest as Investors Discount War Threat http://t.co/3oXTlILj Well-capitalized banks & balanced economy w/much high tech $$ #warrisk Feb 20, 2012
• A hedge fund bets big on a Canadian mega quarry http://t.co/k7OZBC9u Property rights r tough here. What if an existing farmer tried this? $$ Feb 18, 2012
• Australia’s Gillard Urged to Increase Mortgage Purchases http://t.co/ylsCuvq4 A mistake, far better to let the market fail. $$ Feb 17, 2012
• You’re right, reminds me of an old piece I wrote: http://t.co/XkgO7z7A Thanks $$ RT @joshuademasi: The 5 stages of USD grieving ! Feb 15, 2012
• Norway’s Rate Policy Dilemma Pits Household Debt Against Krone ‘Headache’ http://t.co/Ud4FCOsI Cut rates, asset bubble grows, Krone weakens Feb 15, 2012

China

• Plan B for China’s Wealthy: Moving to the U.S., Europe http://t.co/X9jRPy6q Wealthy Chinese know their govt, thus the need for flight $$ Feb 22, 2012
• China’s FDI and Trade Outlook Horrible Says Commerce Spokesperson http://t.co/LIlvmxIL Hard 4 Comm Party 2command domestic consumption up $$ Feb 18, 2012
• ‘Mother of all bubbles’ will pop China stocks: GMO http://t.co/OMENKZOI Low prob: China successfully navigating soft landing out of a bubble Feb 18, 2012
• China’s excess exports turn negative http://t.co/CiLgTKqC Key Q: how will China grow its economy by stimulating domestic consumption? $$ #uh Feb 18, 2012
• Too many bearish on China, but I’m bearish also.  What to do? Seek out China bulls.  If their arguments sound dumb, d… http://t.co/vrhUIdsh Feb 17, 2012
• The Silent Victims of the U.S.-China Currency War http://t.co/6DXAnE3m Smaller nations get caught in crossfire of competitive devaluation $$ Feb 17, 2012
• China’s Military Spending to Double by 2015 http://t.co/5Va8kiLr I think it take some losses before DC takes this seriously. $$ Feb 17, 2012
• China’s Tenuous Hold on Peace http://t.co/dOFr68tL Tibet is restive, China blames its problems on the economic mismanagement of foreigners Feb 14, 2012
• Glimpses of a Chinese Town Under Lockdown http://t.co/AFoW0zsM some reporters managed to get there to document the heavy security presence Feb 14, 2012
• Liu Mingkang Outlines the Reforms China needs to Undertake http://t.co/L0cXMoIf Will the communist party willingly reduce its power in China Feb 13, 2012

Japan

• Japanese Equities Herald Return to Inflation http://t.co/rxlt5OhI If Japan bond market breaks, ructions will be felt the world over. $$ Feb 23, 2012
• Energy imports will pressure Japan’s trade deficit http://t.co/lieDm3T4 But, Japan has a current account surplus from its net foreign assets Feb 23, 2012
• Japan Suggests No Quick G-20 Deal on IMF Funding http://t.co/RZYF5EB2 non-European members of the IMF waiting on the Europeans to act $$ Feb 22, 2012
• Tokyo Small-Caps Set for Longest Win Streak http://t.co/mD3ySrzh Unnoticed but true, look @ this CEF: http://t.co/VcdMQDxL FD: long $JOF Feb 22, 2012
• Yen Slumps After Japan Expands Bond Buying http://t.co/L6yImwzC Competitive currency devaluations driving Forex $$ #beggarthyneighbor Feb 15, 2012

Iran

• Japan Refiners Said to Stall on Iran Deals http://t.co/uEq1DYtb Life is harder on those that need Iranian oil, like India, China, Japan $$ Feb 21, 2012
• Iran Says It Loaded Locally Made Fuel to Nuke http://t.co/6HkMaEFj Not sure I believe this, but if it’s true, the Israelis will know $$ Feb 15, 2012
• Iran presses ahead with dollar attack http://t.co/Hd4Qtnvz Unlikely to work, but it’s all they can do w/oil transport shut down $$ Feb 14, 2012
• Letter Writers Break Iranian Taboo http://t.co/M3NMfmk1 They are so desperate that they write the Ayatollah and criticize conditions. $$ Feb 14, 2012
• Iran Sanctions Tighten as Shippers Stop Loading http://t.co/ubEtI6om Risk goes up, shipping insurance premiums rise, shipping stops $$ Feb 13, 2012

Rest of the World

• Record Redemptions Loom Amid Akbank $1.3 Billion Loan Talks http://t.co/x5iDTSwE Never knew Turkish firms financed w/so much Short debt $$ Feb 18, 2012
• Chavez Missing $10 Billion a Month by Curbing State Oil Investment http://t.co/uTG1Z8d8 PDVSA falls behind Pemex? How low can you go? $$ Feb 15, 2012
• Chávez Opposition Faces Hard Election http://t.co/YBWi9PaW Chavez controls media & oil wealth; tough for Capriles, but he can still win. Feb 14, 2012
• Gunfights in Saudi Arabia Show Spread of Tensions http://t.co/dNxhg2ij Shia in Saudi Arabia fight the govt. Biggest split in Mideast $$ Feb 14, 2012
• The Real Reasons the Rich Are Moving Cash to the Caymans http://t.co/gh7d85ZA Litigation risk, and US political risk; diversify yr govts Feb 13, 2012

Federal Reserve / Monetary Policy / Fiscal Policy

• Those believing the Fed is on hold for the next 3 years will be in for a rude awakening http://t.co/VYggm431 FF futures & TIPS betray mkt $$ Feb 24, 2012
• Exported Inflation to Return Home, but When and in What Form http://t.co/UHT61w4Y The Fed will find it hard to shrink its balance sheet $$ Feb 24, 2012
• Healthcare expenses will overwhelm the US federal budget http://t.co/lLUABMYy Suspect a deal will b driven 2 reduce benefits somehow $$ Feb 23, 2012
• “Fiat Money and Collective Corruption” http://t.co/lRAa2xnG Hard money would help, the bigger problem is light regulation of banks/credit $$ Feb 23, 2012
• Fed Writes Sweeping Rules From Behind Closed Doors http://t.co/UtozNgly Q: Why? 2 avoid bank influence, or 2 hide bank influence? $$ Feb 21, 2012
• The Race To Debase In All Its Glory http://t.co/rPtS9EqD Balance sheets of major central banks expand rapidly $$ #racetothebottom Feb 21, 2012
• Wealthy Enriched by Double-Dipping U.S. Plan http://t.co/YtGTfakC Long article describing unethical use of SBA $$ . #eliminatetheSBA Feb 21, 2012
• Over-regulated America http://t.co/uMKtg2W0 The home of laissez-faire is being suffocated by excessive and badly written regulation $$ Feb 18, 2012
• Geithner: GOP Walked Away From Tax Overhaul – Bloomberg http://t.co/yupPqVeO Articles like this indicate another stalemate in the making $$ Feb 17, 2012
• Potomac Divide Shows Foreclosures Thru Courts Slow Home-Price Recovery http://t.co/kilW75GM MD has slow foreclosures, housing mkt lags VA Feb 16, 2012
• Sober Look: Regulate it all, ask questions later http://t.co/qnpfakfJ New regulations reduce the liquidity of the corporate bond market $$ Feb 16, 2012
• FHA is almost broke. What will DC do when it goes critical? RT @HousingWire: FHA defaults up for ninth straight month http://t.co/TSZFHCeD Feb 15, 2012
• Pentagon May Oust Troops Involuntarily to Meet Reductions in Budget Plan http://t.co/VnY4At7J Tough time 2b let go if you r a veteran $$ Feb 14, 2012
• What a surprise! $$ RT @pdacosta: Bernanke’s big housing speech makes no mention of the Fed’s regulatory laxity in run-up to the crisis. Feb 10, 2012

Bonds

• Contra: Should Mortgage Rates Even Be Lower? http://t.co/lODEFb1P Mortgages do not price off of Tsys, but swaps and bank bond yields $$ Feb 22, 2012
• Wall Street Crowds Into Trader Joe’s http://t.co/dHZT83VK CMBS mkt getting heated; loans linked 2 retail rose to 45% 4 bonds sold in 2011 Feb 22, 2012
•  Have a lot of friends who have lost a lot of money waiting for $TLT to break. FD: long TLT http://t.co/Lw6Rqn02 Feb 21, 2012
• A $360 trillion confidence trick http://t.co/Kar0f3Cz I have argued that LIBOR should be based off of binding offers to borrow/lend $$ Feb 14, 2012
• http://t.co/VOIG2gUk W/TIPS NY Fed concentrates on the long on-the-run & nearby, w/nominals opposite. Makes implied inflation look higher $$ Feb 10, 2012

Muni Bonds

• Stockton, CA, to Weigh First Steps Toward Bankruptcy http://t.co/d2lsCmx8 Start of negotiations to reduce emplyee pensions & healthcare $$ Feb 24, 2012
• Good piece, thx RT @munilass: Evaluating Chapter 9 Bankruptcy for City of Detroit: Reality Check or Turnaround Option? http://t.co/PxWo5qHA Feb 21, 2012
• Yes. http://t.co/4DUVVTKi $$ RT @BarbarianCap: @munilass isn’t this the muni book that @AlephBlog reviewed very favorably a few days ago? Feb 20, 2012

Pensions

• New Rules Wreak Havoc forRetirement-Plan Sponsors http://t.co/HzHWTTtL I would expect rules to be modified, else headaches 4 DC plans $$ Feb 24, 2012
• @BarbarianCap Looking at the RFP, that is one of the few things *not* under consideration, pity too, because it is more important. #DumbOCPP Feb 23, 2012
• @BarbarianCap The audit is a test of methods and data, not assumptions. That’s actually pretty normal unless you an assumptions outlier $$ Feb 23, 2012
• @BarbarianCap I’ve said it many times b4, if life insurers have 2b conservative in accounting, DB plans s/b more so, but they r less so $$ Feb 23, 2012
• @BarbarianCap Some cases, deals will be driven to reduce benefits, depends on state/muni laws, Ch 9 allowable; not protected by ERISA/PBGC Feb 23, 2012

Stocks

• The Capabilities Premium in M&A http://t.co/9CdZIugk Long piece that explains why some mergers work; they aid organic growth & r small $$ Feb 22, 2012
• Elemental to Raise $1.7 Billion Next Year to Mine Potash http://t.co/w7GNsA2H Potash pricing has been volatile lately, cross-currents $$ Feb 22, 2012
• Gamestop to J.C. Penney Shut Facebook Stores: Retail http://t.co/zSui0fCf $FB may have a more difficult time w/retail than some expect $$ Feb 20, 2012
• Hewlett-Packard’s Message: We’ve Been Here All Along http://t.co/vU8piGMt Note: long $HPQ . HPQ definitely sounds more certain now. $$ Feb 16, 2012
• Icahn Pushing CVR’s Sale Means $1 Billion Gain for Shareholders http://t.co/TfBKGErf What refiner wants more capacity now & fertilizer? $$ Feb 16, 2012
• Hedge Funds Switch Positions, While Paulson Switches Investing Style http://t.co/MznmLhci Issue w/ $HIG is value of Variable product biz $$ Feb 15, 2012

Miscellaneous

• The Control Revolution And Its Discontents http://t.co/FY4XgPde There is a “sweet spot” for market efficiency, too much & things get chaotic Feb 24, 2012
• The Decline In Inventory Right Now is NOT a Good Sign http://t.co/Ra1Iz65H Fall in seller confidence & decline in new distressed inventory Feb 23, 2012
• Spring Lambing in UK Turns Deadly as New Virus Kills Young http://t.co/PrO4neT1 Infects pregnant sheep, cows and goats, 5% infection rate Feb 22, 2012
• Midwest Farmland Prices Update for the Year 2011 http://t.co/se9DbEgB Good discussion after a good article; things r getting a little bubbly Feb 22, 2012
• Finding Treasures Among Insurer’s Wreckage http://t.co/jiFZiydE Never bot Atl Mutual’s Surplus Notes, but historical curiosities, wow $$ Feb 18, 2012
• @StockTwits Insurance is boring, but antiquities at the oldest companies are fascinating. Wonder what Nationwide did w/Provident Mutuals? $$ Feb 18, 2012
• @StockTwits I would hold meetings every now and then in Provident Mutual’s underused antiquities room; would start good conversations $$ Feb 18, 2012
• Why Is Violent Crime Declining in US Cities? http://t.co/SLgD8bEL & http://t.co/RRRI2m8X Smarter law enforcement makes DC safer. Wow! $$ Feb 18, 2012
• Thanks, liked it. RT @onwrdnupwrd: you will like this one from this weeks economist http://t.co/DMqhgXBB Feb 18, 2012
• Interracial Marriages in US Reach a Record http://t.co/RJjWnTso Interesting that it is more prevalent with college educated people. $$ Feb 18, 2012
• Harvard Mapping My DNA Turns Scary http://t.co/m5stl0d2 Journalist learns hard things about his DNA. Would he be better off not knowing? $$ Feb 18, 2012
• Groupthink: The brainstorming myth http://t.co/7VBlhzKC People do better solving problems on their own, and sharing ideas w/the group $$ Feb 18, 2012
• Fear, Submission, and Authoritarianism; a Disturbing Trend http://t.co/0lb32tOw Negative social mood leads to loss of liberties $$ Feb 16, 2012
• Santorum’s Electability Pitch Undermined by 2006 Senate Re-Election Loss – Bloomberg http://t.co/8xglQQPJ Shouldn’t be an issue, here’s why: Feb 15, 2012
• As the late Bob Casey said, “You can’t lose if you are a pro-life Democrat.” This is true, and it is why Santorum lost to his son. $$ Feb 15, 2012
• Cracking the Long-Jump Code http://t.co/MN9d9EdJ Fascinating science applied; the key seems 2b2 jump higher, not just longer $$ Feb 15, 2012
• The Best Foods for Thought, Literally http://t.co/tMyLW9E2 Perhaps the Mediterranean diet can aid brain function, or a lowcal diet $$ Feb 14, 2012
• Contra: Almost Half the Price of Oil is Speculative Premium http://t.co/z8t51JOl It should be impossible to so overprice such a large mkt $$ Feb 14, 2012
• The Hunt Brothers thought they could corner a much smaller silver market, and were not able to do it.  The oil compan… http://t.co/MLYVH5w3 Feb 14, 2012
• So, What’s Your Algorithm? http://t.co/lC4voWCI Being able 2 crunch large amounts of data can lead to more objective decisions $$ #ornot Feb 13, 2012

Do you want to read an entertaining book about risk and insurance?  Right, I know that it is not likely that anyone could do that, but this book succeeds at the the task.  How does it do that?

1) It approaches the topic without using a lot of math.

2) It introduces you to the practical problems that anyone would face in trying to insure against any catastrophe.

3) It offers an entertaining story at the end of each chapter, some of which build off of prior stories.  The stories have farfetched elements to them, but they illustrate the main points that the chapter has made, while making you laugh.

The author gives no hints to his views on religion, but uses the concept of “acts of God,” to describe events which are out of our control, and thus need risk pooling (insurance), to contrast with “acts of man,” which potentially are controllable, though often not practical to do so.  Insurance may still have a role there, but there will be many more terms and conditions in the insurance contract.

One dominant theme of the book is how one estimates likelihood in the absence of a large amount of data.  Do you:

a) take what little data you have, and calculate an estimate? or,

b) get expert opinion on the matter, and let the small amount of data modify the experts?

The book takes the second position.  I lean toward the first position, but am not dogmatic about it.

When you are done reading this book, you will likely have skepticism toward much economic, sociological, and biometric research, because their foundations are very weak.  Estimates made are not from repeatable processes.

This is a good book.  It takes some effort to read, because the concepts are dense, but the structure of the book lightens things up.

Quibbles

Math error on page 89 — 1.5 should be 1.25.

Who would benefit from this book: Those who want to understand insurance, probability, or research better would benefit from this book.  If you want to, you can buy it here: Acts of God and Man: Ruminations on Risk and Insurance (Columbia Business School Publishing).

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

I appreciate Steve Randy Waldman, who writes the excellent blog Interfluidity.  Even before I started blogging, while I was at RealMoney, we interacted over CPDOs, along with Alea, and several others that were onto the scam.  That was a fun time, because aside from the Canadian rating agency Dominion, there was no one else questioning the idiocy of the AAA ratings aside from a few bloggers — we are the conscience of Wall Street, but that doesn’t mean that we get any pay as a result.  We write these things as a public service.

Recently, he wrote two  articles on financial intermediation.  Now I’d like to try my own thoughts on the topic.

Financial intermediation has two purposes: transactions and safety.  People want to buy and sell, but don’t want to have a currency where its value shifts radically day-to-day, which would complicate their decisions considerably.  They want a stable unit of account, and don’t want the possibility that they lose a lot of money as a result.  (Yes, during conditions of hyperinflation that boundary disappears, but that’s because they are already losing value already each day from holding the formerly “safe” transactional asset.  They get more careless on the intermediary, because of the risks of holding the safe asset.)

The second goal is safety/preservation/growth of purchasing power.  Can I park money or a short to long amount of time and be assured that when the term is up, I will:

• Receive receive back as much or more in purchasing power terms.
• Reduce my risks or the risks of those I care for from death and other calamities.

Financial intermediation leaves money on the table.  It does not seek the best investment outcome, but takes a lesser return, so that goals can be achieved with greater certainty.

Now, that provides an advantage to the financial intermediaries.  It means that they get cheap funding under most conditions.  Now, can they invest it over the likely lifetime of the funding and not lose money?  That’s a lot of what solvency regulation is about in banks and insurers.   Because financial promises made can’t be easily analyzed for quality by those that offer money, there are two responses by the government:

• Capital rules (which vary by liability and investments)
• Insurance, so that users don’t have to worry about loss.

And, for what it is worth, 12 years ago I played a large role in setting the rules for Maryland life insurers in place, both writing the law, and explaining to the legislators how it protected the public interest.  (Hey! Passed unanimously on the first try, and with the d-word! (Derivatives)  My bill allowed risk mitigation but not risk taking with derivatives.)  The then-governor dressed like a mafia don at the bill signing, for what it is worth… My boss and I and our external and internal legal counsels spent a lot of time on this, but I was the prime mover on getting it done.

As an aside, sitting around in hearings in Annapolis, not knowing when your bill will come up is a chore.  If you know me well, you know I brought work to do, and if that wore out, good books to read.  I was never sitting there with nothing, bored. In the process I learned that Johns Hopkins owns Maryland, but declines from making that public, except when they care. When they spoke up, the legislature rolls over and asks for a scratch on the tummy. Arf!

Sorry, got lost in reminiscing.  Can I say that it was weird?  (I will leave out my dealings with the Department of Insurance, which were surreal.)  I’m not political for the most part, but in the end, the Maryland life insurance investment code is one of the best of the 50 states.  Kind of sad that we don’t have more life insurers here.

The last three paragraphs were quite a detour.  Let me take a different tack.  Yes, intermediation is opaque; that is true by necessity.  Depositors and insureds do not know how their money is invested.  I am here to tell you that that is a feature and not a bug, because the regulators know you can’t analyze the safety of your deposited assets.

In most things, I am a libertarian, but in areas where average people can’t ascertain truth or or falsehood, I support some form of regulation.  Financial promises fall under that rubric, because they are hard to discern.

To close this off, my main point is this: people want financial intermediation, particularly during the bear phases of the financial cycle.  They want to be protected, and transact, and save.  It is reasonable that the government regulates this, because the ability to make future promises that people rely on is valuable to society as a whole.

A reader wrote to me:

I periodically read your blog and it seems like you have a strong grasp of the insurance industry.  As well, given your background as a life actuary I imagine you might have some valuable insights on whole-life products.  I am having a baby in the late spring and have been considering the right composition of my life insurance coverage (term vs. whole life), and have thus far had a lot of trouble making sense of the whole life math and why it is a compelling option for me.  I have received quite a lot of data from an insurance broker with the IRR’s, cash surrender values at different periods, etc., but unfortunately can only get this data in PDF form without really understanding the assumptions behind how the cash surrender value grows, or how the dividends get calculated.  In short, I have been unable to come to a more developed thesis than the idea that whole life is just a way to lock yourself in to a middling return while the insurance company benefits from your float and makes a spread off you, while taking insurance company credit risk for decades, with some benefit in the ability to pass down a decent amount of money tax free to one’s kids when they die.  

How do you view whole life, do you own any yourself?  If so, I’d love to understand your logic.  I recently re-read part of Buffett’s 94 letter in which he states how he buys whole life policies from people about to stop paying premiums for more than the cash surrender value and can only surmise that somehow at the point he is buying them there is probably a higher IRR than in the beginning of the policy (which makes sense given the math I have seen.)   

I am skeptical because I can’t figure out the answer, which makes me not inclined to lock myself in to a life-long financial commitment with an institution that might not be around in 70 years.

For most of my life, I have had term insurance.  It was cheap, and protected my wife against an untimely death of me when we were less-than-well-off.  At present, we are uninsured on my life because my wife has enough assets that if I die, she can fund the educations of the remaining kids, and live thereafter, with perhaps some work on her part.  She’s really bright, but who would be smart enough to hire her?

In general, I think it is smart for young people to buy 20 or 30-year term insurance.  It takes care of the period where your family is most vulnerable.  You get coverage when you are young and healthy, because you don’t know what tomorrow will bring.  Then save and invest to build up assets to meet the needs you may have when the term policy runs out.  If you still need insurance at that point, and are healthy, get underwritten again for a new policy.

There is one place where a whole life policy can make sense. Sometimes mutual insurers use a portfolio method for interest rate crediting. In an environment like this, where interest rates have fallen so much, that means they are crediting to new money the same rate that they are getting old money. That is quite a bonus, so if you can find that, it may prove to be cheaper than getting a long term insurance policy.

As for the second reason to buy life insurance, it is one of the most enduring ways to scam the taxman.  Death benefits are not taxed by the states or the federal government, and unless the person dying was the policy’s owner it is immune from estate tax.

This creates a wide number of vehicles that wealthy people use together with annuities and trusts to transfer wealth out of their estate, and into death benefit proceeds that will pass to their heirs outside their estate.

This is one reason why I believe the estate tax has to go. It does not accomplish its stated ends. The wealthy find all manner of clever ways to escape it. It would be far better to eliminate the ability to shelter income from taxation while they are living. Besides, the government needs the money now.

Closing Points

 First, don’t worry about the credit risk, within limits, the state guarantee funds stand behind the insurance companies. For most people that should be enough.

Second, as for Buffett buying life policies, this is done only when an investor buys a policy from someone who is expected to live less long than the actuarial tables would’ve predicted at the time of policy issuance. The policy is more valuable than the cash surrender value; the investor attempts to make money off the difference.

This is a controversial area, and I am generally against the practice. It should not be legal; it endangers the tax favored status of life insurance, because it allows people without an insurable interest to benefit from the proceeds of life policy. That said, the market would go away if insurers were willing to deal more favorably with those who have impaired lives, and want to cash out their insurance policy.

Third, I have run into really advanced methods for scamming the taxman that involve asset-backed securities, trusts, and what else? Life insurance. In general, I think the U.S. Treasury should use their anti-abuse rules in order to invalidate these transactions, because they lack true economic purpose. That is, even if they are structured in such a way as to give the appearance of economic purpose, there is no reason that a businessman in his right mind would structure the business in that way, except to avoid taxes.

Finally, remember that the agent has a different motive than you. He wants to earn a commission. Commissions are low, and prices are easily comparable on term policies. There are services that will even do the comparison for you. The only way that an insurance agent will earn high commission is by selling a policy that is complex, not comparable to other policies, and builds up assets. The insurance company pays a high commission on such policies because they can earn investment returns off of the excess premiums that you pay in relative to a term policy.

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology names here, some energy some healthcare-related names, P&C Insurance and Reinsurance, particularly those that are strongly capitalized.  I’m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

A word on banks and REITs: the credit cycle has not been repealed, and there are still issues unresolved from the last cycle — I am not interested there even at present levels.  The modest unwind currently happening in the credit markets, if it expands, would imply significant issues for banks and their “regulators.”

I’m looking for undervalued and stable industries.  I’m not saying that there is always a bull market out there, and I will find it for you.  But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.  I don’t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.  The red zone is pretty cyclical at present.  I will be very happy hanging out in dull stocks for a while.

P&C Insurers and Reinsurers Look Cheap

After the heavy disaster year of 2011, P&C insurers and reinsurers look cheap.  Many trade below tangible book, and at single-digit P/Es, which has always been a strong area for me, if the companies are well-capitalized, which they are.

I already own a spread of well-run, inexpensive P&C insurers & reinsurers.  Would I increase the overweight here?  Yes, I might, because I view the group as absolutely cheap; it could make me money even in a down market.  Now, I would do my series of analyses such that I would be happy with the reserving and the investing policies of each insurer, but after that, I would be willing to add to my holdings.

Do your own due diligence on this, because I am often wrong.  One more note, I am still not tempted by banks or real estate related stocks.  I am beginning to wonder when the right time to buy them as a sector is.  As for that, I am open to advice.

I’m still toying with the idea of starting an insurance-only hedge fund.  I own a lot of insurers, and I think that I get the better of that market.

Where I have a harder time is with what to short. Shorting is tactical not structural, and I am less good at the tactical vs structural.  Having a tradable benchmark to short against would be useful, but what exists there?

There is one ETF focused on insurance that has any significant volume — KIE.  In the past, it was capitalization-weighted, but now it is equal-weighted.  That stems from a change in the index that the ETF follows, from one set by KBW to one set by S&P.

Personally, I don’t get the change, but here are my statistics on the change:

The “Old KBW” column comes from segmentation done by KBW.  The other columns are done by me.  There are some matters for judgment:

Do you include Berkshire Hathaway?  I think you should.  Do you include foreign life insurers traded on US exchanges?  I think you should.

I am also more willing to place a company in the “Conglomerate” category because of companies that are in multiple lines of insurance, without a dominant area of insurance that they are in, or, they have significant non-insurance ventures.

Anyway, the new KIE overstates the insurers in Bermuda and the Brokers.  It understates life insurers and conglomerates.

Aside from that, the new S&P index, being equal-weighted, is more mid-cap than a whole market index would be.  Also, if I put more effort into this, I would segment companies into their proportions, and there we be no conglomerates.

These may be trivial concerns to some, but if you are thinking of running a portfolio that might be shorting KIE against other insurance longs, it makes a considerable difference.

The market takes action against firms that carry positions bigger than their funding base can handle.  Temporarily, things may look good as the position is established, because the price rises as the position shifts from being a marginal part of the market to a structural part of the market.  After that happens, valuation-motivated sellers appear to offer more at those prices.  The price falls, leading to one of two actions: selling into a falling market (recognizing a true loss), or buying more at the “cheap” prices, exacerbating the illiquidity of the position.

When an asset management firm is growing, it has the wind at its back.  As assets flow in, they buy more of their favored ideas, pushing their prices up, sometimes above where the equilibrium prices should be.

As Ben Graham said, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”  The short-term proclivities of investors usually have no effect on the long run value of companies.  Rather, their productivity drives their long-term value.

There have been two issues with asset managers following a “value” discipline that have “flamed out” during the current crisis.  One, they attracted hot money from those who chase trends during the times where lending policies were easier, and the markets were booming.  And often, they invested in financials that looked cheap, but took too much credit risk.  Second, they invested in companies that were seemingly cheap, rather than those with a margin of safety.

My poster child this time is Fairholme Fund.  Now, I’ve never talked with Bruce Berkowitz; don’t know the guy at all.  Every time I read something by him or see a video with him, I think, “Bright guy.”  But when I look at what he owns, I often think, “Huh. These are the stocks you own if you are really bullish on financial conditions.”

Yesterday, I saw a statistic that said that his fund was 76% invested in financial stocks as of 8/31.  Now I believe in concentrated portfolios, and even concentrated by sector and industry, but this is way beyond my willingness to take risk.  From Fairholme’s 5/31/2011 semi-annual report to shareholders, here are the top 10 holdings and industries:

Aside from Sears, all of the top 10 holdings are financials.  And, of those financials that I have some knowledge of, they are all what I would call “complex financials.”

In general, unless you are a heavy hitter, I discourage investment in complex financials because it is hard to tell what you are getting.  Are the assets and liabilities properly stated?  Financial companies are just a gaggle of accruals, and the certainty of having the accounting right on an accrual entry decreases with:

• Company size (the ability of management to make sure values are accurate or conservative declines with size)
• Rapidity of the company’s growth
• Length of the asset or liability
• Uncertainty over when the asset will pay out, or when the liability will require cash
• Uncertainty over how much the asset will pay out, or when how much cash the liability will require

It’s not just a question of whether the assets will eventually be “money good.”  It is also a question of whether the company will have adequate financing to hold those assets in all environments.  For financials, that’s a large part of “margin of safety,” and the main aspect of what failed for many financials in the last five years.

Another aspect of “margin of safety” for financials is whether you are truly “buying it cheap.”  All financial asset values are relative to the financing environment that they are in.  Imagine not only what the assets will be worth if things “normalize,” or conditions continue as at present, but also what they would be worth if liquidity dries up, a la mid-2002, or worse yet, late 2008.

Also remember that financials are regulated, and the regulators tend to react to crises, often making a marginal financial institution do something to clean up at exactly the wrong time, which puts in the bottom for some set of asset classes.  Now, I’m not blaming the regulators (or rating agencies) too much; no one forced the financial company to play near the cliff.  Occasionally, for the protection of the system as a whole, the regulator shoves a financial off the cliff.  (or, a rating agency downgrades them, creating a demand for liquidity because of lending agreements that accelerate on downgrades.)

Finally, think about management quality.  Do they try to grow rapidly?  That’s a danger sign.  There is always the tradeoff between quality, quantity, and price.  In a good environment, you can get 2 out of 3, and in a bad environment, 1 out of 3.  Managements that sacrifice asset quality for growth are not good long run investments, they may occasionally be interesting speculations at the beginning of a new boom phase.

Do they use odd accounting metrics to demonstrate performance?  How much do they explain away one-time events?  Are they raising leverage to boost ROE, or are they trying to improve operations?  Do they try to grow through scale acquisitions?

Are they willing to let bad results show or not?  Even with good financial companies there are disappointments.  With bad ones, the disappointments are papered over until they have to take a “big bath,” which temporarily sets the accounting conservative again.

The above is margin of safety for financials — not just seeming cheapness, but management quality and financing/accounting quality.  They often go together.

Fairholme’s annual report should come out somewhere around the end of January 2012.  What I am interested in seeing is how much of his shareholder base has left given his recent disappointments with AIG, Sears Holdings, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Brookfield, and Regions Financial.  Even the others of his top 10 have not done well, and the fund as  a whole has suffered.  Mutual fund shareholders can be patient, but a mutual fund balance sheet is inherently weak for holding assets when underperformance is pronounced.

(the above are estimates, I may have made some errors, but the data derives from their SEC filings)

Now, we eat dollar-weighted returns. Only the happy few that bought and held get time-weighted returns.  And, give Fairholme credit on two points (though I suspect it will look worse when the annual report comes out):

• A 9.9% return from inception to 5/31/2011 is hot stuff, and,
• A 6.0% dollar-weighted return is very good as well.  Only losing 3.9% to mutual fund shareholder behavior is not great, but I’ve seen worse.

This is the problem of buying the “hot fund.”  Once a fund becomes the “Ya gotta own this fund” fund, future returns on capital employed get worse because:

• It gets harder to deploy increasingly large amounts of capital, and certainly not as well as in the past.
• Management attention gets divided, because of the desire to start new funds, and the complexity of running a larger organization.
• When relative underperformance does come, it is really hard to right the ship, because assets leave when you can least handle them doing so.  The manager has to think: “Which of my positions that I think are cheap will I liquidate, and what will happen to market prices when it is discovered that I, one of the major holders, is selling?”

That is a tough box to be in, and I sympathize with any manager that finds himself stuck there.  It can be a negative self-reinforcing cycle for some time.  My one bit of advice would be: focus on margin of safety.  If you do, eventually the withdrawals will moderate, and then you can work to rebuild.