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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.


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.


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.


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.


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; Becky Quick, of CNBC, at; and Andrew Ross Sorkin, of The New York Times, at

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

Letter from a Reader

Thursday, February 27th, 2014

Here’s a letter from a reader on insurance topics:

Hi David. I’ve been following your blog. Just want to say thank you for willing to share your knowledge in the public domain.

I have a question for you – as you know, “climate change” is happening… whether human caused or not, it certainly feels like we are seeing more extreme weathers of late.

How do you see this affecting P&C insurers? Does this give them the chance to start rising prices?  

Lastly, just wondering if you have an opinion about Markel and Lancashire and Allied world. I owned allied for a long time. Made some gains. But the recent blow up at tower and short attack at Am Trust prompted me to really stick with firms that have a much longer record. Which lead me to Markel and Lancashire. Not that this verifies these guys are clean. I’m not an accountant and nor do I think accountants can catch anything. Nonetheless, their long term record offers me a better sense of security in my mind. 

First, I *don’t* know that climate change is happening, except that it always happens.  Evidence for climate science is weak, like that for economics.  We don’t have a good model yet.  If we had a good model, we would have better predictions on hurricanes, which have been uniformly lousy for the last ten years.  And as for warm climates, the Earth has been warmer than now in the past, and far colder, if the history books are correct.

As to how it affects P&C insurers and reinsurers, for that we do have a simple and reliable model.  Look at industry surplus relative to the past — when it is high, as it is now, premium rates will be lower than the risk demands.  Most P&C pricing is weak now — I have been decreasing exposure to P&C insurers.

Markel and Allied World I know and respect.  Good companies both, though I own neither of them.  I’ve heard of Lancashire, but I do not know them in any detail.  To analyze, look in my On Insurance Investing series.

Thanks for writing.

On HCI Group

Friday, January 31st, 2014

It is not often that I get asked to opine on a domestic insurer that I have never heard of.  Thus tonight’s article on HCI Group.  Here’s the request:

I am a longtime and frequent reader.  I appreciate your value-oriented approach and your genuine desire to help your readers.  (A vast difference from much market commentary!) 

I would be interested in your thoughts on the P&C insurer HCI Group  (HCI).  The fundamentals look pretty good to me, and the company is growing well, but the stock has gotten beaten down in recent weeks, the PE is 8, and there is huge short interest. 

The only news of interest seems to be that they have started writing flood insurance in Florida.  I suppose that is a big hurricane risk.

What are your thoughts?

Florida has had many good years recently of no significant hurricane damage.  This company has a lot of coastal hurricane exposure.

Moving into flood insurance, and undercutting the National Flood Insurance Program is highly unusual, and I would be skeptical.  There is a reason why most of the P&C Insurance industry does not offer Flood cover.  Severity of claims is very high when it happens.

I don’t like owning insurance companies at over 2x book, and this one is over 3x book.  Reserving seems a little weak, with a large reserve strengthening done in 2012.

Also, the share count is growing, which is a bad sign ordinarily, and particularly when capital is flush in the insurance industry, as it is today.  Asset growth is also a bad sign, from a quantitative standpoint.

If conditions are normalizing in Florida, the big guys will start to move back in, and HCI will lose a lot of its past advantages.

Taking concentrated risks is great for an insurance company, so long as no claim events occur.  But if there are severe claims from hurricanes, this company could be in a lot of trouble.  That’s why it has a high short interest.

And so my judgment is no interest.  Gun to the head, I would short it, but I don’t short, by and large.  This is another company with a limited strategy that could be washed up by a few major hurricanes in Florida.  We’re due.

On Position Sizing in Equity Long-Short Hedge Funds

Tuesday, January 28th, 2014

This article is prompted by the following article by John Hempton of Bronte Capital.  This is not meant as a criticism of him; I have nothing but respect for him.  The article triggered memories of my own experiences with position sizing at a hedge fund.

The hedge fund I once worked for had great expertise with financial companies, and I worked for them in the boom years of the 2000s.  Our leader was bearish on depositary financials, a view that would eventually be right.  Of course “eventually right” is another way to say “wrong in the short run.”

Let me describe the problem from another angle.  When I was a corporate bond manager, I would mentally set three levels with the bonds that I held.

  • Spread necessary for an ordinary-sized position.
  • Spread necessary for a big position.
  • Spread necessary for a maximum position.

These spreads I would adjust for premium vs discount, optionality, and a bunch of other things.  The point is that I would always have a schedule for where I would be willing to buy more, or lighten up (sell some).  I often dealt in some of the least liquid corporate bonds, and I was patient, and even willing to break rules by holding more than 20% of a given issue.  My analysts almost always did good work, and I trusted them.

When markets are illiquid, they “trade by appointment.”  If you have a balance sheet behind you that is not worried about liquidity, you can do interesting things by buying assets that most ordinary managers won’t touch, because the issue is too small.

I came to the hedge fund after I managed corporate bonds.  In one sense, I had managed a far more complex long-only portfolio.  But being able to short creates complexities of its own.

I can’t tell you how many times at meetings at the hedge fund we had tough discussion on position sizing, more frequently on short positions. We were perpetually long quality, short market capitalization, long insurers, short banks, and long value.  Great idea, if too early. This would be an extreme example:

Boss: “This short position is killing us, it is up 50% from where we shorted it, and now we have a 6% short position, what do we do?”

Others answered in front of me, essentially suggesting no change.  He asked me personally and I said:

David: “If you had no position, and you were approaching this company today, what would you do?”

Boss: “I would short the maximum — 4%.”

David: “Then buy in 2%.”

Boss: “But that locks in the loss.”

David: “Do you want to risk locking in a bigger loss?”

The boss once said to me that I was the only one on his team that was natively a portfolio manager rather than an analyst.  (That said, I remained an analyst, while an analyst was made an assistant portfolio manager.  I think it would have been too difficult to have the insurance guy to manage the portfolio of what was a banking shop.  That said, as a corporate bond manager, I managed the financials, which were mostly banks.)

Setting position sizes on shorts is always harder than longs.  When your thesis goes wrong on a short, your risk increases, as the position size gets larger.  When it goes wrong on a long position your risk decreases, as the position size gets smaller.

As I have often said, being short is not the opposite of being long, it is the opposite of being leveraged long.  When you are short, or leveraged long, you do not fully control your trade.  The margin desk can take you out of your trade if the equity in the account gets small enough.  They are ruthless in doing so, because the margin desks at brokerages do not want to take losses.

That makes it all the more important to set a schedule of sizes on short positions.  The first question should be: at what price would I put my maximum position on?  That would help in sizing introductory and normal positions.  They would be far smaller than what most hedge funds do.

Again, the same exercise is easier in a long-only format, but the protocol is the same.  Establish introductory, normal and maximum position sizes, and hold to them.  Also put into effect the idea that analysts must give greater scrutiny to large positions.

All That Said

This is a reason I am not a fan of most hedge funds.  I believe in the funds of my former employer and those of Mr. Hempton.  But the difficulties of dealing with bad decisions with a weak balance sheet kills a lot of hedge funds.  Long only — it might survive.  But when you go long and short with leverage, the risk arises of total loss.

So don’t think you are a “cool kid” because you invest in hedge funds.  Long only does better over the long haul, because it is less risky, and compounds value.


What Life Insurance to Buy?

Saturday, January 25th, 2014

Another letter from one of my readers:

Hello :)

I am reaching out to you because you are among the “Got To Guys” in your industry

I am doing an “expert” and “common man” round up on my blog and I think a lot of people including me will benefit from your expert advice

 I will publish a detailed post in about 10 days and will obviously mention your blog along with a link back to your website. I will also be adding a custom infographic related to the topic of discussion and reach out to journalists when I am ready with my post.

I just need few minutes of your time to answer TWO questions mentioned below:

 If you can tell me:

“If you had to buy life insurance at current age, which policy would you buy? and which company will be your choice?”

I appreciate your time and it will be a favor if you reply back.

There are only two reasons to buy life insurance. You can:

  • Protect your loved ones after your death.
  • You can scam the taxman.

If you are young, the first reason predominates.  In order to do that, long-dated term insurance will do the trick.  Insure yourself for 20-30 years, and over that time, build your assets so that at the end of the life insurance policy, your heirs will not need the insurance.  And neither will you, should you survive.  That is what has happened to me.  I have no life insurance — instead, I have assets.  Should I die, my family will survive without my wife having to go to work, intelligent lady that she is.

(She doesn’t have a financial bone in her body, she is a princess, as her father was well-off.  She has lived with me long enough to absorb my prejudices, and grasp that there are no easy pickings in markets, so avoid those with get rich quick ideas.)

If you are old and wealthy, the second impulse is important.  How do you send money to heirs, away from the taxman?  Life insurance in the US is outside of the estate.  A large insurance policy can take assets that would be taxable to an estate, and move them outside of the estate.

As an aside: estate taxes are stupid.  The intelligent wealthy don’t pay them, or pay little of them.  The wealthy have a phalanx of helpers who they hire to reduce their estate (and other) taxes.  It would be far better to tax everyone as traders, and capture income taxes when they are really earned.

As to your second question: what insurance company to buy from?  If your policy is small, it doesn’t matter.  If your company fails, the state guaranty association will pick up the remainder.  If your policy is large, buy from the highest quality companies, you don’t want to deal with the guaranty associations after a default.

Systemic Risk Stems from Asset-Liability Mismatches

Thursday, January 23rd, 2014

What happens when a crisis hits?  There are demands for cash payment, and the payments can’t be made because the entities have short liabilities requiring immediate payment, and long illiquid assets that no longer can be sold for a price consistent with average market conditions.  When there are many firms for which this is true, and they rely on each other’s solvency, that creates a systemic crisis.

Whether through:

  • Owning long assets, and financing short, or
  • Using the repo market to hold long assets, thus disguising it for accounting purposes as short assets
  • Taking deposits, and investing long,

it creates an imbalance.  It is almost always more profitable in the short-run to finance short and lend long.  But when there is a demand for cash, such institutions are on the ropes and might not survive.  Less than half of the major American investment banks existing in 2007 were alive in 2009 to today.

But what if you were clever as a financial institution, and had liability structures that were long, or distributed the risk of what you were doing back to clients.  You would always have adequate liquidity, and would not be in danger of default for systemic reasons.

Thus, I think the Financial Stability Oversight Commission [FSOC] is nuts to regulate insurers such as MetLife, Prudential, AIG and Berkshire Hathaway.  They do not face the risk of a run on the bank.  Look at the history of insurers: those that failed due to a run on the bank were those that:

  • Issued guaranteed investment contracts that would be immediately payable on ratings downgrade.
  • Issued P&C reinsurance contracts that would be immediately payable on ratings downgrade.

Aside from that, there were badly run companies that failed but no systemic risk.  There was also AIG, which faced a call on cash from its derivatives counterparty, but not the insurance entity.

As for investment managers, they have no systemic risk.  It does not matter if Blackrock, Pimco, Fidelity and Vanguard would all fail.  Mutual fund holders would find their funds transferred to solvent entities, and any losses  they might receive are the ordinary losses they could receive if the management  firms were still solvent.

Someone lend the FSOC a brain.  Big size does not equal systemic risk.  Systemic risk stems from a call on liquidity at financial firms that borrow short and lend long for their own accounts.  That does not include asset managers and insurers, no matter how big they are.

What this says to me is that financial reform in DC is brain-dead.  (Surprised?  Nothing new.)  They have fixated on the idea that big is bad, when the real problem is asset-liability mismatches, amplified by size and connectedness.  Big banks are a problem.  Big insurers and asset management firms are not.

Tough for Buffett to Lose this One

Wednesday, January 22nd, 2014

I have no idea what premium Buffett is receiving for insuring against one or more people having a perfect NCAA Tournament bracket, but it is unlikely that he will lose on this underwriting bet.  Those seeking insurance on unlikely events think the events are more likely than they actually are.  That said, for Quicken Loans, they don’t want to bet the company, and they do want publicity, so contracting with Buffett is worth their while.

Imagine for a moment that the average person submitting a bracket had a 78.6% chance of getting each game right, and the maximum 10 million people sent in their brackets.  What is the likely number of correct brackets?  One.

But does the average person get more than three out of four games right?  I don’t think so.  Are there some people that are better than others so that they get games right 90% of the time?  Well, if they are 1,163 out of the ten million, on average, one of them will have a perfect bracket.

Here’s a further problem.  Every tournament has significant upsets.  Someone who has a good understanding of how good the teams are will know how to pick the most likely team to win.  It is tough to pick the upsets, and tougher to pick all of the upsets.  There is no good model for upsets, or they wouldn’t be upsets.


As an aside, the prize is $500 million as a lump or $25 million for 40 years.  The breakeven yield rate on that is 4.21%.  Buffett knows he can beat 4.21%.

This contest is like the lottery.  If I had one piece of advice for lottery winners it would be to take the payments over time.  The discount rates on most lotteries are far higher than 4.21%, and really, taking them over time gives you a chance to learn how to manage more money then you know what to do with.  Taking the payments over time gives you the freedom to learn from mistakes.  We all make mistakes, but when we get all the money at once, we make more.


E-mails on Insurance

Friday, January 17th, 2014

Here we go.  E-mail #1:

You truly have one of the great blogs out there!

I was wondering, have you ever had to evaluate a company that had set up a captive insurance company to self insure? How did you get comfortable with it?

As an example, ZCL composites on the TSXV. I looked at them awhile back and disqualified it as I could not get comfortable with the environmental liability. They manufacture fuel storage tanks, so insurance is a large component of their cost of doing business.

If they did have a reputable outside insurer, you could at least count on the insurer for doing some audit work in their manufacturing and installation processes. But they have set up a captive, and self insure. 

So, how would you calculate whether they have enough reserves?

I threw the company in the too difficult pile and moved on, but it has irked me as I like them.

Good toss into the too difficult pile.  Environmental liabilities are difficult even for actuaries inside the insurance companies  to analyze.  Those of us outside have no chance.  I cannot validate reserves from outside, and particularly not on long-tail lines.  I will not invest in any insurer that has a large part of its underwriting in asbestos/environmental — it is too risky.

That aside, using a captive is a negative sign.  No one uses a captive, except to weaken reserving, taxation, or other rules.

Next e-mail:


I stumbled across Gainsco, Inc. (OTCPK:GANS), a very small nonstandard auto insurer (you may be familiar). It’s trading around 0.6x book value, seems to be well capitalized, and has had OK growth barring FY2012. It also has a pretty impressive 12.5% dividend yield.

I guess my questions are:

1) Would you expect this trade at such a discount to book because: its nonstandard insurance, it’s on the pink sheets (not regularly filing with the SEC), it’s too small, or some combination or other reason?

2) given that its nonstandard, I assume it’s riskier? What’s the best way to determine whether the company is adequately reserved/capitalized? 24.5% equity / assets seems pretty conservative, but I suppose if they’re not adequately reserved that could be meaningless.

Thanks so much, look forward to hearing from you.

I have run across Gainsco in the past, when they were bigger, and I avoided them.  Subprime insurers tend to lose money on underwriting over time.  There is a kind of cycle where a few make money for a few years, and then competition surges, and more money is lost than was previously made.  From the time I started as a buyside analyst of insurance stocks in 2003, until now, no subprime insurer has made money for a buy-and-hold investor.

Aside from that, Gainsco has gone dark.  You can see financials at their website, but do you trust them?  Aside from nonsponsored ADRs no good companies trade on the pink sheets.

Margin of safety — this does not meet my safety requirements.

Final E-mail:

Hi David,

I really enjoy your blog.  Have seen the recent news surrounding AmTrust Financial (AFSI) and short sellers?  I’d like to hear the thoughts of an actuary on the company and specifically the items that GeoInvesting points to.  To me, their financial structure appears extremely (perhaps, unnecessarily) complicated. 

Yes, and they fail my test of having conservative reserves.  They have had to strengthen reserves on prior year’s business for the past three years.  That is a bad sign, and would keep me away.  I think GeoInvesting is correct here, but this is not an endorsement of them generally.

It is very rare that an insurer should be valued near 2x book value.  Though I am rarely so bold, this one strikes me as a short sale, if you can get the borrow with confidence.


On Understanding and Valuing Financial Companies

Thursday, January 2nd, 2014

I have readers all over the world.  Here is an example:

Hi Dave

I am a 25 year old from Pretoria, South Africa. I have been reading your blog for around 2 years and I thoroughly enjoy it (especially the book reviews). I might not agree with a few things you say, but it is rare that I don’t learn something while reading your work. I love how your personality shines through in your writing…a personality based on God.

I have had this fascination with finance and investing since I ran into a popular finance magazine here in South Africa around 2008 while stile in university. Since then I have been reading everything I could on business, investing and finance. I am also about to start training with a large wealth management firm in south africa to be 1 of their financial advisors. Training I am wholeheartedly looking forward to.

In all my reading, there is something I still struggle to wrap my head around, and that’s how to value Financial companies. You are undoubtedly the most informed person on financial company investing nd financials that I read. Hence my email: I was wondering if you could suggest a few readings for me to tuck into (preferably books) as I have found most of the things I have read only scratch the surface. Reading with maths that is not too elaborate.

I hope I am not asking too much.  Thank you in advance for any suggestions you might have, and I hope you keep up the good work on your blog.

Financial companies are difficult for several reasons:

1) The cash flow statement has almost no meaning.

2) It is very hard to know how much capital is needed to keep things going.  That data gets disclosed to the regulators, and not directly to stockholders.

3) It is difficult to know the riskiness of the assets that a financial company holds.

4) With complex financials, it is difficult to tell what the “run on the bank” risk is.

I will be reviewing a book on banks this month, but I have run into few books in my life analyzing financials.  It is a real hole in the investment literature.

Financial companies are valued off of their net worth, and their expected path of earnings.  Earnings retained, rather than paid out in dividends, or used to buy back stock, adds to net worth, and is new capital that can be used for growth.

The capital of financial companies can be divided in two: that which is required by the regulators for solvency purposes, and that which is free for deployment into new business.  With banks, look at the call reports to analyze the capital needs of subsidiaries.  With insurers, get the statutory reports.

To the extent you can, analyze the quality of assets owned.  Also analyze when liabilities may require cash, particularly if assets are financed by repurchase agreements.

Now over the last seven years, I have written a lot on financials, particularly insurers.  Here are the articles at my blog that would deserve attention:

A Summary of my Writings on Analyzing Insurance Stocks

A compendium of the best articles written prior to mid-2010.

Then there was the Flavors of Insurance Series.  In 12 parts, it went through the entire insurance space, explaining what make each area different.

Thinking about the Insurance Industry

Describes the changes that have happened since the financial crisis.  Bad financial models have been destroyed.

On Life Insurance and Life Reinsurance

Explains how life insurance is saturated but reinsurance is not.

On Complexity in Financials, and Insurers Specifically

Explains why complex financials are usually a bad investment.

Investing In P&C Insurers

Once you understand the model, many are simple companies, and easy to invest in.

Evaluating Regulated Financials

An attempt to explain to college students why financials are different from other companies.

On Insurance Investing

This seven-part series explained a wide number of factors in analyzing insurance stock investing.

Penny Wise, Pound Foolish

On some of the pathologies inside badly-run insurance firms.

Two Insurance Questions

On reserving and valuation questions.

On the Designation of Systemically Important Financial Institutions

Why Insurers, no matter how large, should not be considered a threat to systemic risk.  (Please ignore AIG — no other insurer was a major party in derivatives.)  Also see: On Risk-Based Liquidity, and Financial Regulation

On Captive Insurers

Explains some of the nuances of statutory reserving/capital, and why some insurers want to fuddle it.

Classic: Financials are Different

A piece from 2006 at RealMoney, describing how financials are different from industrial stocks.

That should give you a start.  There aren’t many books dealing with the intricacies of financial companies, and of what few there are they are written by the big four auditors, or the rating agencies, for their own purposes.  I don’t own any of them.

But what I have written, from that you can benefit.

Classic: Financials are Different

Saturday, December 21st, 2013

The following was published at RealMoney in March 2006:

When you are a corporate bond manager, one of the lessons that you learn early is that financial companies (or, financials) are different from industrials or utilities.  Why?  First, the novice manager wants to buy a lot of financials, because they yield more at equivalent ratings.  Second, you have a staff of analysts, and you realize that only a few of them can do financials, whereas almost all of them can do industrials or utilities.  Again, why?  Here are a number of related reasons:

  • Tangible assets play only a small role in a financial company.  What constrains the growth of an industrial company?  The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year.  With services, workers… Finally, demand is the ultimate limiting factor, but this affects financial, industrial, and services businesses alike.  With a financial company, sometimes the limits are akin to a service business (“If only we had more trained sales reps!”), but more often, capital limits growth.
  • The cash flow statement plays a big role with industrials and utilities, but almost no role with financials.  One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow.  Free cash flow is the amount of cash that the business generates in a year that could be removed, and the business is as capable of functioning as it was at the start of the fiscal year.  Deducting maintenance capital expenditure from EBITDA often approximates free cash flow.  Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks.  Capital is released as business matures.  In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.
  • Sadly, the change in required capital is not disclosed anywhere in a typical 10K.  Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on.  Sometimes the federal or state regulators provide the most constraint; this is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers.  For entities that raise their capital in the debt markets, or do business that requires a strong claims paying ability rating, the ratings agencies could be the tightest constraint.  Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures.  Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.
  • Financial institutions are generally more highly regulated than non-financial institutions.  There are several reasons for this: the government does not want the public exposed to financial risk, systemic risk, guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.), and defaults are costly in ways that defaults of non-financials are not.  The last point deserves amplification; in a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy.  Confidence can not be allowed to fail.  Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
  • Rapid growth is typically a negative; financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality.  In normal situations, a financial institution can get only two out of three.  In bad times, it would be only one out of three.
  • Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions.  Typically, borrowing occurs at the holding company; the regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company.  This makes the common stock more volatile.  In a crisis, the regulators only want to assure the safety of the operating company; they don’t care if the holding company goes bust, and the common goes to zero.  They just want to make sure that the guaranty funds don’t take a hit, and that confidence is maintained among consumers.

All of these factors together lead to the following conclusion: financials are more complex than other types of companies, and are not correctly analyzed in the same way as non-financials.  Earnings quality is hard to discern, and growth is not always a positive thing.  Bankruptcies are rare, but when they happen, recoveries are poor for common stockholders and holding company debtholders.  Finally, management conservatism and competence are paramount, given the less certain nature of accrual accounting at financial companies, and the inability to calculate free cash flow with any precision.

In part 2 of this two-part series, I will give my approach to analyzing a sector of the insurance space in order to demonstrate some of these ideas.


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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