When it comes to business books, I occasionally get skittish.? It’s just the same old stuff over and over, so I often refuse to review such books.? This book was a rare gem for me; it even made me wish that I had worked for the author.
There are two classic models for maximizing value in enterprises: 1) low cost, high volume, and 2) high quality, reasonable cost.? My Dad ran a business that was the latter, and on a far larger level, so did Morton Mandel.
Customer service was what he focused on, and listened to customers in order to see what problems they might have that his firm might solve.? More, he created a culture that would focus on the customer.? That required hiring good businessmen — men who could run almost any business, once they understood the industry.
Such men could do people management, project management, financial management, and have a strong ethical slant.? You are managing for the long-run, not the short run.? You do not want management that cuts corners.
When I was 17-18 years old, I was the student representative to the School Board from my high school for two years.? In the meeting room,? there was a prominent painting by some student that had the bold title “What’s best for the Kids?”? So it was for managers in Mandel’s company — “What’s best for our Customers?”? Such an attitude, inculcated through the organization created extreme customer loyalty, employee loyalty, and significant profits.
From my own work in the insurance industry, I have experienced many cultures.? I can smell a bad management team and culture a mile away.? I invest in the best cultures that I can find in the insurance industry.? In any industry, when I find companies that I think do it right, treating all stakeholders well, I am quick to buy the stock, and slow to let it go.
To give an example, in 1994, I did a deep study of the trucking industry, and I came away with one firm that did it all right — a strong focus on safety, good incentives for drivers and terminals.? I bought, the stock doubled in a year, and was bought out by a private equity group.? Ethics in business pay off.? Good service to others will receive its reward.? And so it was for Morton Mandel.? Superior customer service led to loyalty of customers and good margins.
Mandel was also smart about acquisitions.? He would buy small companies with desirable characteristics, and then improve their management team and grow them organically.? He never bet the company.
Did he ever make mistakes?? Yes, and he made a big one when he mis-estimated a guy to whom he sold his firm.? He thought the guy would preserve the culture of the firm, and it was anything but that.? Within a year, the combined firm was suffering, there was a boardroom coup, and Morton Mandel, far from retiring, was back as CEO repairing the damaged firm.
He was big on standardizing best practices, so that everyone in the firm would know the best way to serve customers.? Also, he was big with charitable enterprises, and realized that most of the principles that applied to for-profit companies applied to non-profits.
The main idea is this: if you focus on doing quality work for your customers, and charging an appropriate price for it, you will prosper.? Would that more companies would do it.
Quibbles
None
Postscript
I forgot one thing — his close relationship with Peter Drucker, my favorite expert on management.? The two were close to a degree where Drucker would give Mandel advice he would not give others, but only because Mandel was capable of receiving it.? Drucker thought Mandel was one of the top managers in America.? That in its own right should recommend this book to you.
Full disclosure: I received a free copy from the publisher.
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.
What does it take to create a global or national financial crisis?? Not just a few defaults here and there, but a real crisis, where you wonder whether the system is going to hold together or not.
I will tell you what it takes.? It takes a significant minority of financial players that have financed long-dated risky assets (which are typically illiquid), with short-dated financing.
The short-dated financing needs to be rolled over frequently, and during a time of financial stress, that financing disappears, particularly when creditors distrust the value of the assets.? It typically happens to all of the firms with weak liability structures at the same time.
During good times financing short is cheap.? Locking in long funding is costly, but safe.? That is why many financial firms accept the asset-liability mismatch — they want to make more money in the short-run in the bull phase of the market.? But when many parties have financed long risky assets with loans that need to be renewed in the short-term, the effect on the markets is multiplied.? The value of the risky assets falls more because many of the holders have a weak ability to hold the assets.? Where will the new buyers with sound finances come from?
Areas of Short-dated Financing
Short-dated financing is epitomized by bank deposits prior? to the Great Depression.? If doubt grew about the ability of a bank to pay off its depositors, depositors would run to get their cash out of the bank.? Deposits are supposed to be available with little delay.? After creation of the FDIC, deposits under the insurance limit are sticky, because people believe the government stands behind them.
But there are other areas where short-dated financing plays a significant role:
Margin accounts, whether for derivatives, securities, securities lending, etc.? If a financial company is required to put up more capital during a time of financial stress, they may find that they can’t do it, and declare bankruptcy.? This can also apply to some securities lending agreements if unusual collateral is used, as happened to AIG’s domestic life subsidiaries.
Putable financing, particularly that which is putable on credit downgrade.? This has happened in the last 25 years with life insurers [GICs used for money market funds], P&C reinsurers, and utilities.? Now this is similar to margin agreements on credit downgrades because more capital must be posted.? Anytime a credit rating affects cash flows, it is a dangerous thing.? The downgrade exacerbates the credit stress.? Then again, why were you dancing near the cliff that you created?
Repo financing was a large part of the crisis.? The weakest large investment banks relied on short-term finance for their assets in inventory.? So did many mortgage REITs.? As repo haircuts rose, undercapitalized players had to sell, lowering asset prices, leading to a new round of selling, and higher repo haircuts.? It was the equivalent of a bank run and only the strongest survived.
Auction-rate preferreds — a stable business for so long, but when creditworthiness became a question, the whole thing fell apart.
Finance companies — GE Finance and other finance companies rely on a certain amount of short-term finance via commercial paper.? It is difficult to be significantly profitable without that.
All other short-term interbank lending.
Crises happen when there is a call for cash, and it cannot be paid because there are not enough liquid assets to make payment, and illiquid assets are under stress, such that one would not want to sell them.? This has to happen to a lot of companies at the same time, such that the creditworthiness of some moderately-well capitalized institutions, that were thought to have adequate liquidity are called into question.
The Value of a Long Liability Structure
Let me give a counterexample to show what would be a hard sort of company to kill.? In the mid-1980s, a number of long-tailed P&C reinsurers found their claims experience in a number of their lines to be ticking up dramatically.? But the claims take a long time to settle, so there was no immediate call for cash.? Later analysis showed that for many of the companies, if the full value of the claims that eventually developed were charged in the year the business was written, many of them would have had negative net worth.? As it was, most of them suffered sub-par profitability, losing money on the insurance, and making a little more than that on their investments.
But they survived.? Other insurers cut some corners in the ’90s & ’00s and wrote policies that were putable if their credit was downgraded.? This would supposedly give more protection to those buying insurance or GICs [Guaranteed Investment Contracts] from them.? Instead, the reverse would happen when the downgrade came — there would be an immediate call on cash that could not be met, and the company would be insolvent.? Even if the majority of the liability structure is long, if a significant part of it was short, or could move from long to short, that’s enough to set the company up for a liquidity crisis of its own design.
Credit cycles come and go.? The financial companies in the greatest danger are the ones that have to renew a significant amount of their financing during a crisis.? It’s not as if firms with long liabilities don’t face credit risk; they face credit risk, and sometimes they go insolvent.? But they have the virtue of time, which can heal many wounds, even financial wounds.? If they die, it will be long and drawn out, and they will hold options to influence the reorganization of the firm.? Creditors may be willing to cut a deal if it would accelerate the workout, or, they might be willing to extend the liability further, in exchange for another concession.
In any case, not having to refinance in a crisis makes a financial company immune from the crisis, leaving aside the regulators who may decide the regulated subsidiaries are insolvent.? But, the regulators may decide they have more pressing issues in a crisis from firms that can’t pay all their bills now.
That might be true for GE Capital.? They certainly still borrow enough enough in the commercial paper market, though not as much as they used to.? If GE Capital failed, a lot of money market funds would break the buck.
AIG?? The current CEO says he doesn’t mind being being systemically important.? Still, Financial Products is considerably smaller than it was before the crisis, they aren’t doing the same foolish things in securities lending that they were prior to the crisis, and they don’t have much short-term debt at all.? The liabilities of AIG as a whole are relatively long.? And even if AIG were to go down, we shouldn’t care that much, because the regulated subsidiaries would still be solvent.? Financial holding companies are by their nature risky, and regulators should not care if they go bust.
But Prudential?? There’s little short term debt, and future maturities are piddling on long term debt.? If the holding company failed, I can’t imagine that the creditors would lose much on the $27B of debt, nor would it cause a chain reaction among other financial companies.
I feel the same way about Metlife; both companies have long liabilities, and would have little difficulty with financing their way through a crisis.? Just slow down business, and free cash appears in the subsidiaries.
I can make a case that of these four, only GE Capital poses any systemic risk, though I would have to do more work on AIG Financial Products to be sure.? But what the selection of companies says to me was it was mostly a function of size, and maybe complexity.? Crises occur because a large number of financial companies finance long-dated assets with short-dated borrowings.? I think the FSOC would have done better to look at all of the ways short-term finance makes its way into financial companies, and then stress test the ability to withstand a liquidity shock.
My belief is that if you did that, almost no insurers would be on such a list; the levels of stress testing already required by the states exceed what FSOC is doing.
The usually good Felix Salmon wrote a piece that I disagreed with called: Don?t worry about cov-lite loans.? This is what I wrote as a response:
Ask a loanholder, ?All other things equal, would you rather have a cov-lite loan or a normal one?? The answer will always be ?Normal, of course. Why are you asking such a dumb question??
Loanholders would prefer more defaults with lesser severity than fewer with higher severity. What is flexibility to the borrower is a higher degree of expected credit costs to the lenders.
To make this general, I have to explain to you the four phases of competition in uncertain outcomes. I know I?ve written about this before, but I can?t remember where. It applies to a wide number of phenomena, including insurance underwriting and fixed income investing.
Phase 1: the market is offering a bargain in yields relative to normal default costs, and terms & conditions are firm. More competition causes prices to rise & yields to fall.
Phase 2: the market is fully priced in yields relative to normal default costs, and terms & conditions [covenants] are firm. More competition causes terms & conditions to erode. Conservative firms end new purchases. Assets with good terms get premium pricing.
Phase 3: the market is fully priced in yields relative to normal default costs, and terms & conditions [covenants] are soggy. More competition causes some to speculate that ?maybe things won?t be so bad, besides, we have money to put to work.? Conservative firms sell existing positions.
Phase 4: Market crashes, defaults are realized. Lower quality assets lose more money. Conservative firms buy assets at a discount from posers who thought they knew what they were doing, some of which are now broke.
So, no Felix, the presence of cov-lite loans indicates that we are in phase 2 at minimum. I think we are in phase 3. I have sold my loan funds for clients last year ? we are on borrowed time now.
The same sort of thing happens with insurance underwriting, and I even think bull markets in stocks.? After a disaster, insurance surplus levels are low, and pricing is generous, with terms & conditions tight.? Additional competition lowers profitability to levels that justify the cost of capital employed.? After that, pricing stays at that level, and terms and conditions deteriorate, until they can decline no more. After that, pricing deteriorates further until the next disaster uncovers their folly.? Conservative insurers drop out before the disaster, and return capital to shareholders rather than writing bad business.
With bull markets in stocks the first phase is disbelief, the next phase is belief.? During that phase, parties lessen risk controls and buy what is hot.? In the last phase, valuation plays little role for the marginal decision-makers, until the bull market peaks.
Maybe I am overgeneralizing here, but to me there seems to be an inflection point in bull markets where in order for equity managers to compete, they toss away risk discipline.? After that, managers stretch their willingness on valuations.
Both of these articles make me think we are in the last phase of a bull market.? Valuation is getting ignored.? Be wary, and play some defense, but avoid the idea that traditional defensive stock types will be defensive, particularly with low volatility and dividend paying stocks.
Maybe I should call this article “the product that saw the light of day, after a long sleep.”? Barron’s had an article last week, “Top 50 Annuities.”? Guess what? Almost all of the annuities they featured were stripped down and low cost.? That’s the way things should be.? If you have time and interest, read the article; it’s a good thing.? Also note at the end the skepticism of investment managers, particularly hedge funds running insurers.? The skepticism is deserved.
You might recall my letter to Warren Buffett, and his response to me.? A number of my readers made some very nice offers to help me on this project.? Many thanks to you all, but I found a way to shrink the size of the project.? Look at this table:
NAIC #
Assets
Liabs
Surplus
Name
Group
Notes
Pct
38865
443
199
244
CALIFORNIA INSURANCE COMPANY
AU
0.2%
28258
92
49
43
CONTINENTAL NATIONAL INDEMNITY CO
AU
0.0%
14144
347
322
25
APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.
AU
(2)
0.0%
35246
23
8
15
Illinois Insurance Company
AU
0.0%
21962
11
–
11
Pennsylvania Insurance Company
AU
0.0%
20044
1,083
346
737
BERKSHIRE HATHAWAY HOMESTATE INSURANCE COMPANY
BHH
0.6%
11673
762
336
426
REDWOOD FIRE & CASUALTY INSURANCE CO
BHH
0.3%
10855
1,065
858
207
CYPRESS INSURANCE COMPANY
BHH
0.2%
34630
459
321
138
OAK RIVER INSURANCE COMPANY
BHH
0.1%
11014
11
4
7
BROOKWOOD INS CO
BHH
0.0%
35939
9
2
7
CONTINENTAL DIVIDE INSURANCE CO
BHH
0.0%
34274
335
50
285
CENTRAL STATES INDEMNITY CO OF OMAHA
CSI
0.2%
82880
18
4
14
CSI LIFE INSURANCE COMPANY
CSI
0.0%
22063
19,090
11,072
8,018
GOVERNMENT EMPLOYEES INSURANCE CO
GEICO
6.3%
22055
6,444
3,695
2,749
GEICO INDEMNITY COMPANY
GEICO
2.1%
41491
1,713
1,051
662
GEICO CASUALTY COMPANY
GEICO
0.5%
14137
239
19
220
GEICO SECURE INSURANCE COMPANY
GEICO
0.2%
14139
249
36
213
GEICO CHOICE INSURANCE COMPANY
GEICO
0.2%
14138
249
41
208
GEICO ADVANTAGE INSURANCE COMPANY
GEICO
0.2%
35882
184
70
114
GEICO GENERAL INS CO
GEICO
0.1%
22039
15,533
4,840
10,693
GENERAL REINSURANCE CORP
GenRe
8.4%
27812
15,069
4,637
10,432
COLUMBIA INSURANCE COMPANY
GenRe
8.2%
86258
3,101
2,513
588
GENERAL REINSURANCE LIFE CORPORATION
GenRe
0.5%
37362
748
182
566
GENERAL STAR INDEMNITY CO
GenRe
0.4%
11967
251
69
182
GENERAL STAR NATIONAL INS CO
GenRe
0.1%
38962
190
55
135
GENESIS INSURANCE COMPANY
GenRe
0.1%
12319
176
76
100
PHILADELPHIA REINSURANCE CORP
GenRe
0.1%
32280
130
61
69
Commercial Casualty Insurance Company
GenRe
0.1%
20931
48
26
22
Atlanta International
GenRe
Runoff
0.0%
97764
20
5
15
IDEALIFE INSURANCE COMPANY
GenRe
0.0%
31470
512
363
149
NORGUARD INSURANCE COMPANY
Guard
0.1%
42390
416
316
100
AMGUARD INSURANCE COMPANY
Guard
0.1%
14702
104
71
33
EASTGUARD INSURANCE COMPANY
Guard
0.0%
11981
42
29
13
WestGUARD
Guard
0.0%
11843
3,013
1,938
1,075
MEDICAL PROTECTIVE CO
MedPro
0.8%
42226
586
173
413
Princeton Ins Co
MedPro
0.3%
13589
14
11
3
MedPro RRG Risk Retention Group
MedPro
0.0%
20087
127,340
48,479
78,861
NATIONAL INDEMNITY COMPANY
NI
61.7%
20079
5,597
1,739
3,858
NATIONAL FIRE & MARINE INSURANCE CO
NI
3.0%
62345
10,938
8,700
2,238
BERKSHIRE HATHAWAY LIFE INSURANCE COMPANY OF NEBRASKA
NI
1.8%
13070
1,841
692
1,149
BERKSHIRE HATHAWAY ASSURANCE CORPORATION
NI
0.9%
39136
1,203
487
716
Finial Reinsurance Company
NI
Runoff
0.6%
20052
1,419
705
714
NATIONAL LIABILITY & FIRE INS CO
NI
0.6%
42137
212
70
142
NATIONAL INDEMNITY CO OF THE SOUTH
NI
0.1%
20060
173
49
124
NATIONAL INDEMNITY CO OF MID-AMERICA
NI
0.1%
22276
90
19
71
STONEWALL INSURANCE COMPANY
NI
0.1%
37923
100
55
45
SEAWORTHY INSURANCE CO
NI
0.0%
36048
74
42
32
UNIONE ITALIANA REINS CO OF AMERICA
NI
Runoff
0.0%
11591
63
51
12
FIRST BERKSHIRE HATHAWAY LIFE INSURANCE COMPANY
NI
0.0%
10391
43
32
11
AMERICAN CENTENNIAL INSURANCE CO
NI
0.0%
13795
2
–
2
AttPro RRG Reciprocal Risk Retention Grp
NI
0.0%
25895
675
234
441
UNITED STATES LIABILITY INS CO
USLI
0.3%
26522
434
160
274
MOUNT VERNON FIRE INSURANCE CO
USLI
0.2%
35416
161
59
102
US UNDERWRITERS INSURANCE CO
USLI
0.1%
15962
171
23
148
KANSAS BANKERS SURETY CO
Wesco
0.1%
Total
223,315
95,444
127,871
106,000
From 10K
This table lists all of Berkshire Hathaway’s domestically domiciled insurance subsidiaries, all 55-56 of them, maybe minus a few intermediate holding companies that are just shells.? The NAIC # uniquely identifies each company for the National Association of Insurance Commissioners.? Then comes the assets, liabilities, and surplus for regulatory purposes.? Then there are the groups that each subsidiary belongs to, and what percentage? of the total statutory surplus each one represents.
The table is sorted by the major subsidiary groups, and then in declining order of surplus.?? Here is the key to the groups:
AU = Applied Underwriters
BHH = Berkshire Hathaway Homestate
CSI = Central States Indemnity
GEICO (what else?)
GenRe = General Reinsurance
Guard = AmGuard
MedPro = Medical Protective
NI = National Indemnity
USLI = United States Liability Insurance
Wesco = Wesco Financial
A number of the companies are not writing new business; they are in what is called “runoff.”? Two companies may have the same name “APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.” but are domiciled in different states.
So, back to my challenge to understand the structure of Berkshire Hathaway.? The above table makes my life easy.? Really, I only need to get the reports of the following companies:
Berkshire Hathaway Homestate
General Reinsurance
GEICO
National Indemnity (really, the one most needed)
Medical Protective
Those five companies cover ~94% of the statutory surplus of? all of Berkshire’s insurance companies.? I can afford to get that data.? But how should I do it?
I could write Warren another letter asking for his approval to ask each company for their statutory statements.
I could ask each subsidiary for their statements, and see how they react.
I could troll the web, and see if they aren’t hiding out there.? One reader suggested that the Statements are out there on some state insurance department websites, but that would surprise me. That hasn’t been true in the past.
I am thinking of doing #2, but am open to advice.
As an aside, note that the sum of $128 billion of statutory surplus is far more than the $106 billion listed in the latest 10-K.? That is because of capital stacking, which is a form of double counting.? Lower lever subsidiaries surplus gets counted in their intermediate parent companies.? But if I eliminate all of the lower level companies, I only end up with $100 billion.
This is a different approach to Berkshire Hathaway, approaching it as a group of? insurance companies that owns businesses.? It is very different, yet successful.? When I get the data, I hope we all learn a lot.
During a panic, it is useful to reflect on the degree to which the real economy has been driven by the financial economy.? In the Great Depression, the degree was heavy; in the seventies, it was light.? Today, my guess is that it is in-between, which makes it difficult to figure out the right strategy.
Again, this was written in 2002 or so.? As I posted last night, the banks were in relatively good shape then.? I made a lot of money for my clients buying bank floating rate trust preferred securities at ~$80.? There was no security that we did not clear at least $10 on, and most cleared $20 within a year.? One even went from $68 to $100, plus a healthy coupon.? In bond terms those were a series of home runs.? As an aside, as a bond investor, I focused more on net capital gains than most, and that helped us in a rocky era.? I often gave up current income to gain the potential for capital gains, which was the opposite of most of my competitors.
So in 2002 it was reasonable to buy banks as the willingness to supply of credit grew.? But there are limits to how much credit you can have in an economy without things getting screwy.? An economy with too many promises to pay becomes inflexible; far better to finance more of the economy with equity, but that requires a Fed that works properly, like it was under Eccles, Martin and Volcker.? Under men of less courage, like Bernanke, Greenspan, Burns, Miller, Crissinger, and Young, it simply paves the way for asset bubbles and price inflation.
In 1929 and 2008, though, it was relatively easy to know that the financial economy had grown too large for the real economy.? Total debt to GDP levels were at records.
Or think of it from this angle: in 2004, I was recruited by another financial hedge fund to be their insurance analyst.? I talked with them, but ultimately I refused, because I felt the boss was probably less competent than my current boss.? A major part of his presentation was how amazing the outperformance of financial stocks had been over the prior 10 years, implying that it would be the same over the next 10.? That outperformance was not repeatable because the capital of the banking and shadow banking industries had gotten so large that there was no longer any way that they could extract a high return out of the rest of the economy.? As it was, the effort to do so made them take on asset risks that killed many companies, and should have killed many, many more, had economic policy been handled properly.
This is one reason why my long only portfolio was so light on financials, excluding insurers, going into 2008.? I sold the last of my banks in 2007, realizing Europe would be no safe haven.? I retained one mortgage REIT that cratered as repo fell apart, teaching me a valuable lesson that I had bought something cheap, but not safe.? That was my only significant loss during the crisis starting in 2007-2008.? Repo funding is not a safe funding source during crises, and this is something that is not fixed from the last crisis, along with portfolio margining, and a few other weak liability structures.
With respect to the eras starting in 1929 and 2008, the key concept is debt deflation?? When there are too many debts, there will be too many bad debts.? That is the time to only only companies with strong balance sheets that will not need to refinance under any conditions.? That eliminates all banks and shadow banks.
I can’t guarantee that we are past the crisis, because we haven’t seen what will happen to the economy when the Fed starts to lessen policy accommodation, much less tighten.? As it is, for the most part, I not only own companies that are cheap, but primarily companies that are safe.? Value investing is “safe and cheap,” not just cheap.? This applies to financials as well, but many value investors lost a lot of money on financials because they ignored credit quality near the end of a credit boom.? Many credit-sensitive companies looked cheap near the end of the 2007, but they were cheap for a reason — they were about to get pelted by a ton of losses.
As an aside, do you know how hard it is to get a value manager to short something trading at 50% of book value?
I know how tough that is.? I’ve been through it.? He would not bite.
The company had asset risks as well as liability risks.? I extrapolated the liability cash flows to realize the long-term care? policies the company had written would likely bankrupt them.? But when the boss came to me pitching it as a long because one his buddies thought it was dirt-cheap, I uttered, “Gun to the head boss, I would tell you to short it.”? Reply: “But it’s trading at half of book value.” Me: “Book value is misstates true economic value.? Can’t say for certain, but I think this one goes out at zero.”
As it was, we did nothing, and the stock, Penn Treaty, did go out at zero. (There was one small positive out of this, I did convince the private equity arm not to fund a competitor in long-term care.)
Back to the main point.? Have a sense as to the financial economy.? This will probably only happen once in your life, but that time is crucial.? If there is a financial mania going on, move to safety, and reduce exposure to credit-sensitive financials.? It’s that simple, but to most value investors who invest in seemingly cheap financials that is a hard move.? Remember, safe comes before cheap in value investing, and that means questioning asset accrual items.? Financial companies have that in spades.
I have a saying that when there is no news, the market reveals its true direction.? That applies to individual securities as well as the market as a whole.? Why?
Think of institutional traders, who drive much of the market.? They are so big that they have to spread out their orders over time, or they would move the market against their positions.? On days when there is no news, volume tends to be light, displaying the actions of the big traders.
Valero recently spun off CST Brands, which was their retailing arm, selling gasoline, and things you find at convenience stores.? Seems cheap to me.? Over the last few days it has been rising on no news.? To me that means some institutional investors are buying.
I’ve seen the same thing happen when a stock falls on no news.? That’s usually a bad sign if you are long, because it means someone is selling for a reason you are not aware of.? Now, if you have done your homework, and know more than the seller, a lower price is to you advantage if you want to buy more.? The trouble is, you don’t know how much the seller has to unload.? To use CST Brands as an example again, I received some shares as a result of holding Valero for clients (and me, I get what my clients get), but I estimated how much index related selling had to happen as a result.? I bought a full stake for my clients at the point where the total volume from the prior “when issued” trading, plus actual trading on the first day hit my estimates.? It was close to the low for the day, though someone more enterprising could have picked up shares cheaper during the “when issued” trading, if he was clever.
But sometimes when there is news, you need to try to gauge whether something is an over- or under-reaction.? My favorite example here is RGA, the prominent well-run life reinsurer.? Once every eight quarters or so, they report a lousy quarter.? Why?? Because of the law of small numbers.? The large claims inside a life reinsurer are few, but make a considerable difference to the earnings when a bunch of large policy deaths happen at the same time.? The general public does not get this, so when RGA has a bad quarter, it is usually a good time to be a buyer.
The same applies to P&C reinsurers during crises.? I added to my reinsurance holdings post-Sandy, because I knew that the reinsurers would take relatively few claims because they don’t cover flood for residential, though they might have commercial-related claims.? As it was, none of my insurance holdings had any significant claims from Sandy, and the portfolio did well.
Toss out another example, but Endurance Specialty is one of the leading underwriters of crop insurance.? Crop insurance was a horrible place to be last year, and that put pressure on ENH as a stock.? But that neglected all of the other lines of business of Endurance that were performing well, as well as the risk controls that Endurance placed on its crop insurance business.
Perhaps the broad message here is to know your stocks well, so well that you can gauge whether a? market reaction to news is overdone, underdone, or meh, normal.
Analyzing the reaction to news (or no news) bonds and other assets as well.? When I was an institutional bond manager, I would watch the results of trading on the slow days, because it would give a clue to what the “big guys” were doing.? Also, when an event that has been anticipated occurs, like a ratings downgrade on the bonds of a troubled company, the market reaction says a lot, because often there are many who were waiting to buy once the downgrade happened, so price rises a lot at the downgrade.? (Think of the USA downgrade by S&P.)? The reverse is true for downgrades that are more of a surprise.
In summary, all news is not equal.? The reactions to news, and the lack thereof, can tell us a lot about the intentions of large market actors.? Do your homework well, and prosper off of the knowledge that it gives you regarding reactions, over-reactions, and under-reactions.
I wrote this piece once, and lost it, 1000 words.? Going to try again.
1) The first thing to realize is that diversification across insurance subindustries usually does not work.
Do not mix:
Life & P&C
Financial & Anything
Health & Anything
Maybe you can mix P&C, Mortgage & Title, after all Old Republic survived.? The main point is this.? Insurance is not uniform.? Coverages are sold and underwritten differently.? Generally, higher valuations will be obtained on “pure play” companies? Diversification is swamped by management inability.? These are reasons for AIG and Allstate to spin off their life operations.
2) Middle-sized companies tend to do best from a valuation standpoint: the large have nowhere to grow, and the small are always questionable on their viability.? With a few exceptions, I like sticking with focused mid-cap companies with my insurance names.
3) Be aware of total subindustry capital relative to need.? After a big disaster, those that underwrote well will have capital to deploy into a stronger underwriting environment, where capital is scarce.? But don’t make too much of it because capital has become very fluid in insurance; the barriers to entry and exit are low.? Still, it is best to be an investor after a disaster, when everyone is running scared.? When total capital is high, and companies are fat, dumb, and happy, it is time to leave.
4) It’s good to look through the Statutory statements [regulatory statements filed with state insurance regulators] of their operating insurance subsidiaries to look for odd entries.? Occasionally, you will run into problems that do not have to be reported under GAAP accounting.? (Note: they should be reported under the spirit of GAAP, but not the letter of GAAP.? I have a saying, “It is okay to violate GAAP to be more honest, but not to be less honest.”)
Here’s an example: I ran across a life company that had to post an extra statutory reserve because they would lose money if interest rates rose.? That’s a significant admission, and the company was invested far more aggressively than almost all the other life companies we were tracking.? We shorted it, and got ripped as the credit markets surged 2003-2005.? We got out with a small gain when their earnings proved inadequate as interest rates rose, and credit losses rose.? But it took a long time.
At this point, I would be looking for special reserves established for secondary guarantees established for Term and Universal Life, and Variable Life & Annuity policies.? There is no specific requirement to hold those reserves on a GAAP basis, even though there may be general principles that would encourage additional reserves or disclosures.
5) There are ways of multiplying capital across subsidiaries — Subsidiary A reinsures liabilities of subsidiary B, while Subsidiary B reinsures liabilities of subsidiary A.? This is a way to create hidden leverage, so be aware of what is being done at the subsidiary level.? Doing these sorts of things is dumb, though legal.
Reviewing leverage is a good idea as well, where it is located, and what conditions it has.? The practice of insurance subsidiaries issuing surplus notes to parent companies has become all too common, which allows subsidiaries to write more business at the risk that when a subsidiary becomes impaired, the domiciliary state takes it over, and the parent company gets little to nothing.? (Payments on surplus notes can only be made with the approval of the insurance commissioner. In insolvency surplus notes typically receive nothing.)
The thing is, it is a lot harder to produce return on assets than return on equity. Though part 6 focused on ROE, in the short run, insurance companies can improve their ROE through substituting debt for equity.? The same applies to insurance companies that write GIC Medium Term Notes.? It’s just a cheap way of making a little extra income arbitraging your subsidiary’s high claims paying ability rating.? It fascinates me that regulators have allowed the insurance industry such latitude with deposit contracts that are called annuities, but have never once been annuitized.
Another hidden source of leverage are financial reinsurance agreements.? Down in the insurance subsidiaries, companies trade away a portion of future profits for surplus today.? These are usually bad deals to enter into, but because some insurance companies have a sales culture that requires continual growth, even if the sales that don’t justify the cost of capital required to back the policies.
6) Free cash flow is difficult to determine for financials, this applies to insurers as well.? Each regulator has rules on how much can be paid in dividends to their holding company.? Typically, subsidiaries can dividend away surplus so long as they are still strongly capitalized after the dividend.? (If it is large, they may have to petition their regulator for approval)? So if you want to approximate free cash flow for an insurer, try the following:? (Income or loss outside your insurance companies for the current period) + (Distributable Income from insurance companies for the current period).? The latter figure is statutory income +/- any decrease/(increase) in capital required to maintain the remaining business with adequate financial strength, calculated separately for each subsidiary.
7) Last note: on DAC/VOBA [deferred acquisition costs, value of business acquired; they? are similar, so I will just talk about DAC].? Once I had to convince a boss that though it is an intangible, like goodwill, it is not like goodwill in that it is more rigorously tested for recoverability.? If DAC gets written down (as opposed to amortized) that means that the future sum of profits on some of the insurance business is expected to be less than the acquisition costs deferred for the business.
Now, DAC can be done conservatively, by product and class year.? The more disaggregated it is, the more conservative, generally.? A few cells getting written down is no big thing.? But DAC can be as liberal as having one cell, which means if DAC is written down, the total value of future profits from existing business has been reduced — the company is worth a lot less.? The change in value is even more than the reduction in the DAC, because in the writedown process, the discount rate on the DAC went from a positive number to zero.? All other things equal, a DAC asset is worth more the higher its discount rate.
S0 pay attention: if DAC amortization is high relative to net income before tax, it means there isn’t that much margin for adverse deviation in the DAC.? Also, all other things equal, lower levels of DAC as a fraction of net worth are better.
Close with a story: before Mony Group was bought by AXA, it was doing DAC for the company as a whole.? A value investor, seeing the discount to book value, and sensing opportunity bought a lot of Mony.? Profitability was so bad, they had to write down DAC.? Book value declined & price to book value declined as well.? The value investor agitated for a sale, and AXA stepped in, buying it for moderate premium to where it was trading.? The group I was with went long for an arbitrage trade on a cash deal.
But the value investor thought the premium wasn’t high enough and agitated for more.? Because the takeout price was 70% of book, the idea seemed plausible.? But when you factored in the DAC earning 0% and a few other items, it looked generous enough to me.? So when the price got several percent above the deal terms we sold our stake and went short as much as we could find without having to pay much interest on the borrow.? Bit-by-bit the stock price moved down until a few days before the deal would close, when the price collapsed below the deal price, and we covered.? We even arbed a little more on the long side, but the trade was over.
And the point is this: it may look cheap, but test your assumptions on the values of assets and liabilities before committing a lot of capital to a any insurance stock.? GAAP, Tax and adjusted Statutory income validate book value, so a cheap stock with a low return on equity or assets is often not cheap.
David, I am curious if you have thoughts about insurance companies (especially P&C) hedging political risk ? the answer to this question obviously will carry over to healthcare quickly.
Recently, my state (Corrupticut) was hit by hurricane Sandy. Many municipalities (but not all) still had extensive flood control, hurricane gates, levies, etc from the 1970s ? the last time we had really active hurricanes.
In an effort to bump up property tax revenue, several municipalities allowed developers to build McMansions right on top of, or in place of, sand dunes that had existed for centuries. The dunes blocked the view or some such nonsense. Quite predictably, these municipalities had much higher damage than those who maintained dunes and other protection.
Our idiot governor decided to keep his heel on the throats of insurance companies to make them pay ? and the insurance companies called his bluff. ?Fine Mr Malloy, we will stop selling home owners insurance in your state ? good luck getting a mortgage without any insurance. Gee whiz, the lack of mortgages probably will devastate home prices. You should have thought of that before you chased us out.?
All up and down the coast line, insurance companies are telling state and local governments that sand dunes, levies and sea walls must be restored and maintained ? or insurance will not cover anything.
States along the gulf of Mexico (ie hurricane Katrina et al) enacted laws prohibiting developers from taking down mangrove fields.
I heard rumors (not sure if they are true) that re-insurance companies have told underwriters that they will not accept pools that contain policies in states that allow destruction of natural flood barriers.
Perhaps most recently, New Jersey?s governor told his MTV ?J Wow? constituents that they were going to restore sand dunes regardless of whether it looked good.
I seriously doubt that corrupt populist politicians (like the governor of my state) will stop promising to seize private property to buy votes ? but it also seems they have pushed the P&C insurance industry too far. Hard to imagine that anyone will knowingly operate at a loss.
And Hugo Chavez not withstanding, most national governments won?t jeopardize their own regime to subsidize a practice that also threatens their regime.
The US government doesn?t have the trillions needed to allow FEMA to insure McMansions built where sand dunes once stood.
Whether the US ends up with ?universal healthcare? or not ? the federal government does not have the money to keep the current healthcare system growing 8-10% per year while the economy grows less than half as fast.
The end result is obvious ? stupid government policies will fail long term. Maybe common sense will prevail again. Maybe the government will bankrupt itself and become irrelevant. Hard to guess which.
But in the short term ? how can the insurance companies hedge political risk?
One of the reasons for high storm damages over the past ten years has been the pressure from developers to develop land that is beautiful, but subject to flooding risk? from storms.? In the present time, that has led insurers to raise prices on such developments, and/or refuse to insure, allowing state-sponsored captive insurers to absorb the risk on behalf of the taxpayers.
Insurers have gotten smarter, in my opinion, and most have learned to resist the actions of the states, sacrificing business volume for profitability.? They understand that there is a “Knot at the Bottom of the Rope,” below which you can’t go any lower.? So if a state is making certain classes of business unprofitable, stop underwriting those classes of business.
Contract law favors the insurers.? They can’t be compelled to take losses against their will, except by contract.
Eventually politicians have to face reality, lest they go the way of Argentina, or worse, Zimbabwe.? Insurers, though they may not be loved, reflect a fair estimation of risk.? Politicians in the short-run may try to bend the view of risk to voters, but if contract law is observed, no change will happen.
Look, we would all like Santa Claus behind us bailing out our every mistake and trouble, but in the real world, where resources are limited, claim payments flow according to contract.
Yes, the reinsurers push on the insurers, and that leads to reductions in coverage.? They have economic incentives as well, and they are all the more sharp, because they really get hit when things get bad.
Finally, you are correct that the US can’t maintain its current approach to healthcare.? If we were smart, we would eliminate the corporate tax deduction for healthcare, and return the system to the free market.? If you want health insurance, let it be done outside of the tax code.? That could help balance the budget.? As I listen to many screaming, I would add, “And let’s eliminate the interest deduction on mortgages, and the charitable donation deductions.”
We have to clean up the tax code such that most tax preferences disappear, so that the budget can balance.? Balanced budgets promote growth, because people do not fear higher future taxes.
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 ten 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, buying up a restaurant chain last year.
Third, health insurers face an uncertain future.? Obamacare may disappear, or Obamacare could slowly eliminate insurers.? It?s a mess.? Insurers debate to what degree they should compete in insurance exchanges.
But beyond all of that, valuations are fair-to-cheap 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 2011-2012, 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 Renaissance Re [RNR]. Possibly undervalued: Tower Group [TWGP] and Endurance Specialty [ENH].
Now, this simple model can fail if you have an intelligent management team that has a better model.? Arch Capital and Renaissance Re may be that.? But with an expected ROE of less than 20%, it is hard to justify their valuation, when the average stock in this group needs an expected 11% 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.? Endurance and Arch have been good at that.
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 tight fit.? The insurers that are seemingly undervalued are equity-sensitive ones: Phoenix Companies [PNX], Aegon [AEG], and ING [ING].? Those that are overvalued are Citizens [CIA], Eastern Insurance Holdings [EIHI], and Atlantic American [AAME].? For the undervalued companies, I am unlikely to buy because I am skeptical of the accounting.? I would look further down the list and consider buying some companies that are more reliable, like Assurant [AIZ], National Western [NWLI], and Fortegra Financial Corp [FRF].
One more note: to get book value in Life Insurance, you need a 9.8% 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 First Acceptance [FAC], Employers Holdings [EIG], and Erie Indemnity [ERIE].? Below the line: Hartford Financial Services [HIG], Hilltop Holdings [HTH] Hartford Financial [HIG], and United Insurance Holdings [USIH].
Again, these are only screening tools.? Before buying or selling, understanding management and reserving quality, and riskiness of the lines of business makes a considerable difference.? Erie Indemnity has an ?asset light? model where it manages insurers, but does not bear underwriting risk.? Hartford has a significant life insurance and annuity exposure.? Models are models, and we have to understand their limitations.
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 an okay fit, with the idea that the following companies might be undervalued: Wellpoint [WLP] and Humana [HUM].? And the following overvalued: ?Molina Healthcare [MOH].
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 1.8%.
Financial Insurers
This group comprises the surviving mortgage, title and financial insurers, and two companies in the ghoulish business of buying life insurance policies from sick people.? Here?s the PB-ROE graph:
This graph is weird, because it slopes down, and does not have a good fit.? That?s because we?ve been through a rough period financially, and in many cases GAAP accounting does not do a good job with these companies that take a lot of credit risk.
We can still look for companies that have high price-to-book, and low ROEs ? note Life Partners [LPHI] and Radian [RDN] as possible sell candidates. We can also look for companies that have low price-to-book, and high ROEs ? note Assured Guaranty [AGO] and MBIA [MBI] as possible buy candidates.
This subsector is more difficult than most, because credit is not an underwritable risk.? It is feast and famine.? We are in a period of feast now, so in some ways what is bad is good.? The more risk, the more return.? But winter may come soon ? who knows what the Fed may do?? In general, I avoid this subsector for longs.
Insurance-Related Companies
This is a group that is a non-group.? It?comprises brokers and insurance service providers.? Here?s the PB-ROE graph:
It doesn?t look like much of a group.
As it is the potential outperformers include?Brown & Brown [BRO], and Aon [AON], two leading insurance brokers.? A potential underperformer Willis Group [WSH], another leading insurance broker.
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 a decent amount 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.
In the final part of this series, I will go over some nuances of insurance accounting ? I leave it to the end because it is kind of dull, but can make a lot of difference, because some companies look cheap and aren?t really cheap.
Full disclosure: long AIZ, ENH, NWLI for clients and myself
