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On National Western Life

Tuesday, March 25th, 2014

From respected reader:

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

From the Annual Report:

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

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

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

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

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

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

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

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

Full disclosure: long NWLI

Managing Berkshire Hathaway by Committee?

Tuesday, March 25th, 2014

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

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

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

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

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

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

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

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

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

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

Full Disclosure: Long BRK/B for myself and clients

 

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

Friday, March 14th, 2014

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

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

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

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

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

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

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

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

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

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

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

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

Year

2001

2002

2003

2004

2005

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

25.77%

18.33%

10.45%

15.36%

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

 

Year

2006

2007

2008

2009

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

16.56%

29.56%

7.78%

7.39%

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

2010

2011

2012

2013

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

9.60%

6.45%

6.59%

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

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

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

YearActionTickerSharesValueConsiderationCapital Gain (loss)

2003

InMTB         927,760              3,655,241

2003

InWFC     6,138,800         127,795,056

2003

InAXP     5,308,500         101,902,002

2003

InMCO   16,140,300         340,631,841

2003

PoofLVLT   32,691,065         100,000,000

2004

InTMK         872,200           20,268,837

2004

InHRB   14,350,600         222,546,836

2004

InCDO     1,195,274                              1

2004

InCOST     5,254,000         146,595,428

2004

InGCI     3,447,600           81,873,173

2004

InMLI     1,361,900           30,408,193

2004

InSEE     1,113,300           32,102,292

2004

InUSG     6,500,000           37,180,000

2005

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

2005

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

2005

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

2005

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

2005

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

2005

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

2005

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

2005

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

2008

InUSB   20,768,728         657,202,698

2008

InWFC   52,372,788     1,819,017,267

2008

InCOP   71,896,273     5,878,643,401

2008

InCOST     5,264,000         146,595,428

2008

InKFT   89,222,400     2,957,096,963

2008

InPG   17,200,318     1,026,726,674

2008

InUSG   10,102,918         202,419,056

2008

InWMT   18,998,300         901,731,797

2008

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

2009

InCOP   29,711,330     1,163,495,683

2009

InMTB             6,300                 447,467

2009

InPG   14,328,093         855,276,936

2009

InTMK     1,656,900           60,572,017

2009

InWMT   14,892,842         746,046,432

2009

InWFC   21,030,680         473,941,080

2009

InGSK     1,510,500           78,918,016

2009

InPKX     1,087,000           44,260,228

2009

InSNY     2,896,133         119,233,280

2009

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

2009

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

2009

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

2010

InJNJ   13,274,736         851,173,066

2010

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

2010

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

2010

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

2010

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

2011

InCOP   21,109,637         826,653,385

2011

InGCI     1,740,231           13,921,848

2011

InIBM   63,905,931   10,856,339,550

2011

InMTB     4,671,245           38,003,193

2011

InPG   12,669,252         756,256,889

2011

InWFC   28,446,437         718,140,133

2011

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

2012

InWFC   32,872,641     1,090,916,624

2012

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

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

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

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

Summary

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

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

Full disclosure: long BRK/B for clients and me

On the Structure of Berkshire Hathaway

Wednesday, March 12th, 2014

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

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

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

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

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

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

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

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

Full disclosure: long BRK/B for clients and me

On the “770” Account

Thursday, March 6th, 2014

A letter from a reader:

Dave,

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

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

Dear Friend,

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

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

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

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

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

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

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

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

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

Final Note

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

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

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

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

Thoughts on the Berkshire Hathaway Annual Letter & Report

Saturday, March 1st, 2014

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

On Acquisitions

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

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

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

And he might want to buy more utilities:

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

The Powerhouse Five

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

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

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

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

Debt

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

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

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

Derivatives

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

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

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

Insurance

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

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

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

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

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

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

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

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

The Structure of Berkshire Hathaway [BRK]

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

 

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

 

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

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

Notes

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

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

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

Other Notes

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

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

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

Full disclosure: Long BRK/B for myself and clients

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.

Disclaimer


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


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


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

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