Insurance – Page 14 – The Aleph Blog

On Insurance Investing, Part 4

Posted on 26 February 2013 by David Merkel

This will be a short but important part in this series on insurance investing.? It deals with the accounting, and applies to all areas of insurance.? Insurance accounting is complex. When an insurance policy is written, the insurer does not know the true cost of the liability that it has incurred; that will only be known over time.

Now the actuaries inside the firm most of the time have a better idea than outsiders as to where reserve should be set to pay future claims from existing business, but even they don’t know for sure.? Some lines of insurance do not have a strong method of calculating reserves.? This was/is true of most financial insurance, title insurance, etc., and as such, many such insurers got wiped out in the collapse of the housing bubble, because they did not realize that they were taking one big nondiversifiable risk.? The law of large numbers did not apply, because the results were highly correlated with housing prices, financial asset prices, etc.

Even with a long-tailed P&C insurance coverage, setting the reserves can be more of an art than science.? That is why I try to underwrite insurance management teams to understand whether they are conservative or not.? I would rather get a string of positive surprises than negative surprises, and you tend to one or the other.

There are a couple ways to analyze this:

1) This had more punch when interest rates were higher, because insurance managements were more tempted to compromise underwriting, because they had compelling investment opportunities, but asking the anti-question, “How are you planning on growing the top line next year?” is a good one.

An inexperienced or liberal management team will try to talk about business opportunities.? An experienced, or conservative management team will say, “We don’t target top line growth.? We aim for growth in fully converted book value per share.? We only grow the top line when the market favors that, and ability to write risks at favorable prices is easy.”

Conservative investors should be wary of any financial company that is growing aggressively; finance is a mature industry, and sustainable competitive advantages are few.

2) What is the company’s attitude on reserving?? How often do they report significant additional claims incurred from business written more than a year ago?? Good companies establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.

So get out the 10K, and look for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years.”? That value should be consistently negative.? That is a sign that he management team does not care about maximizing current period profits but is conservative in its reserving practices.

One final note: point 2 does not work with life insurers.? They don’t have to give that disclosure.? My concern with life insurers is different at present because I don’t trust the reserving of secondary guarantees, which are promises made where the liability cannot easily be calculated, and where the regulators are behind the curve.

As such, I am leery of life insurers that write a lot of variable business, among other hard-to-value practices.? Simplicity of product design is a plus to investors.

In all things as investors, aim for a margin of safety.? That is the hallmark of value investing.

A Note on the Purchase of Heinz

Posted on 19 February 2013 by David Merkel

I participate in an online group of Johns Hopkins students and Alumni, mainly discussing company analysis and valuation.? This is what I posted on the Heinz acquisition by 3G and Buffett:

There are two ways to look at this: like Buffett or like 3G. Let’s look at both:

(1) 3G will be the active partner. Their stake is equity only, and own 70%. They very well may have cost savings or product or marketing synergies. They are businessmen, not speculators. They will use Heinz to create a better & more global company.

(2) Buffett gets 30% of the equity for $4B, and $8B of preferred stock paying a 9% coupon. It doesn’t matter much where he places the equity in his holding company, but the preferred will go into some of the insurance companies, where it will be financed by cost-free float, require minuscule amounts of capital, and be taxed at preferential rates.

Over a long enough period of time (~20 years), the preferred pays for the whole deal, and any value of owning 30% of Heinz is gravy. (They sell gravy too.)

After the Burlington Northern acquisition, I wrote this post to justify the price paid: The Forever Fund. Regarding Heinz, ask the same questions — what would take to create a company like Heinz from scratch, i.e. replacement cost, including all of the regulatory hurdles.

Between Buffett and 3G, you likely have the financing and the savvy for a significant joint venture that will be mutually profitable. Nothing is a slam-dunk, but this looks good.

Full disclosure: long BRK/B

To sum this up: Buffett gets focused talent; he doesn’t have to concern himself with managing Heinz. He gets a stable asset that he can cheaply finance that will throw off a minimum of 6% on average (assuming 3G performs adequately; they have done better than adequate in the past).

3G gets patient capital.? They can take short and long-term steps to maximize the value of Heinz without a lot of interference or second guessing.? And if they do it very well, their upside is levered by Buffett’s preferred financing.

If they blow it… that’s another thing, but Buffett would hold the option of restructuring Heinz with a new partner, or finding talent to run it internally at BRK.? After all, it”s not like he doesn’t have the liquidity to do it.

Full disclosure: long BRK/B

Advice to Two Readers

Posted on 16 February 201317 February 2013 by David Merkel

I have great readers.? Two questions tonight on very different topics:

I’ve really enjoyed reading your blog ever since I came across it (via Simoleon Sense, I think?). I think your perspective as a bond manager is especially neat. When I was doing some research on Sears I?saw something odd in the most recent 10-Q and I was curious to see what you thought about it. It seems like the company sold $250M in bonds to its own pension plan back in 2010:

Senior Secured Notes

In October 2010, we sold $1 billion aggregate principal amount of senior secured notes (the ?Notes?), which bear interest at 6 5/8% per annum and mature on October 15, 2018. Concurrent with the closing of the sale of the Notes, the Company sold $250 million aggregate principal amount of Notes to the Company?s domestic pension plan in a private placement. The Notes are guaranteed by certain subsidiaries of the Company and are secured by a security interest in certain assets consisting primarily of domestic inventory and credit card receivables (the ?Collateral?). The lien that secures the Notes is junior in priority to the lien on such assets that secures obligations under the Domestic Credit Agreement, as well as certain other first priority lien obligations. The Company used the net proceeds of this offering to repay borrowings outstanding under a previous domestic credit agreement on the settlement date and to fund the working capital requirements of our retail businesses, capital expenditures and for general corporate purposes. The indenture under which the Notes were issued contains restrictive covenants that, among other things, (1) limit the ability of the Company and certain of its domestic subsidiaries to create liens and enter into sale and leaseback transactions and (2) limit the ability of the Company to consolidate with or merge into, or sell other than for cash or lease all or substantially all of its assets to, another person. The indenture also provides for certain events of default, which, if any were to occur, would permit or require the principal and accrued and unpaid interest on all the then outstanding notes to be due and payable immediately. Generally, the Company is required to offer to repurchase all outstanding Notes at a purchase price equal to 101% of the principal amount if the borrowing base (as calculated pursuant to the indenture) falls below the principal value of the notes plus any other indebtedness for borrowed money that is secured by liens on the Collateral for two consecutive quarters or upon the occurrence of certain change of control triggering events. The Company may call the Notes at a premium based on the ?Treasury Rate? as defined in the indenture, plus 50 basis points. On September 6, 2011, we completed our offer to exchange the Notes held by nonaffiliates for a new issue of substantially identical notes registered under the Securities Act of 1933, as amended.

I feel like that’s a bit odd, but I couldn’t find much about it either way. I assume you’ve pretty much seen it all with bond placement, so I figured you’d be a good person to ask – is that normal? Or is that something you see when a company has a hard time finding buyers for its debt? My gut says the latter since you’re basically jacking up your pension fund’s exposure to the company’s health and creating some agency issues, but maybe that’s just naivete on my part…

Anyway, love your blog, you’re putting something great out there (and not too many folks can say the same).

Aye, Miguel Barbosa, I know him.? We had dinner together in Chicago 1.5 years ago.? A great guy.

As for the odd Sears bonds, often companies with liquidity difficulties take the desperate step of issuing company securities to the pension plan.? You will note that most of the demand for the bonds came from external parties, and then they used that price to issue another $250 million to the pension plan.? To be perfectly above board, if I had been doing it, I would have done the deal for $1.25B, with a protected $250M order from the pension plan.? External investors should know the total size of the deal.

I’m not a pension actuary, but I do know that there are limits on what can be bought by pension plans of affiliated securities.? It is not considered to be a good practice — it is a form of leverage, and good companies don’t do it.? It would make me more skittish on Sears from a credit perspective.? Doing this is a red flag.

Aside from that, Eddie Lampert has harmed the interests of bondholders before, when he bought KMart.? Why should you be docile for someone who does not respect bondholders?

Here’s email #2:

I know you’re a big fan of RGA. How do you get comfortable with the tail risk potential from pandemics? What would downside be for the stock in the event of a pandemic?

I look forward to hearing your input.

That’s a good question.? In late 2004, I attended the Casualty Actuarial Society Annual Meeting in Montreal.? That was the first time I heard about H1N1, and the threat it might pose.? I owned for clients two pure-play life reinsurers at the time, RGA and (spit, spit) Scottish Re, so the potential problem concerned me.? After a lot of research, I held onto my reinsurers, here’s why:

Positives:

People are a lot healthier now than in 1918
We are better at screening visitors from areas where avian flu exists.
The 1918 virus was unusual in terms of its ability to spread to humans and its virulence
Fewer people sleep on the ground with the birds that they shepherd.
Chickens and pigs are usually more separated now than previously.
Also humans don’t have as much contact with pigs.? Confinement raising may be cruel to animals, but it protects human health, in addition to being economic.

Negatives

No one alive has any immunities to the avian flu.
Flu shots and Tamiflu are worthless with respect to the avian flu.? Don’t get vaccinated.? It is close to useless.? I have never gotten vaccinated.? They can’t predict what strains will be virulent six months in advance.

Now, nothing is impossible.? There is risk here, just as there is risk of large meteorites hitting earth every 100 years or so.? Those are risks I have to live with, unless I have special information, which I don’t.

More disasters don’t happen than do happen.? As Ecclesiastes 11:3-6 says:

If the clouds are full of rain, They empty themselves upon the earth;
And if a tree falls to the south or the north, In the place where the tree falls, there it shall lie.
He who observes the wind will not sow, And he who regards the clouds will not reap.

As you do not know what is the way of the wind, Or how the bones grow in the womb of her who is with child,
So you do not know the works of God who makes everything.

In the morning sow your seed, And in the evening do not withhold your hand; For you do not know which will prosper, Either this or that, Or whether both alike will be good.

Worrying about large disasters is fruitless.? Far better to try to be productive, than to try to time disasters.? Productivity is something we can control under ordinary circumstances.? Disasters are something we are subject to, and are very hard to avoid, so unless you are one of the favored ones with inside knowledge, aim to be productive? — it is the far better choice.

Full disclosure: Long RGA (double-weight)

Questions from Readers

Posted on 15 February 2013 by David Merkel

From a reader:

I have enjoyed reading your blog for the past few years. I started researching some insurance companies and went to some of your posts to help me get a better understanding of their financials. In one of your posts you talk about RGA trading below TBV and TBV ex AOCI. Why do you exclude AOCI from TBV?? Do insurance companies trade on ex AOCI multiples or regular BV and TBV multiples?

BV -> Book Value
TBV -> Tangible Book Value
RGA -> One great life reinsurer, Reinusurance Group of America.
AOCI -> Accumulated Other Comprehensive Income

We typically exclude AOCI from book value, because AOCI stems from one time events, or things that may revert.? That said, insurance stocks they tend to react to book value prior to any adjustments.? Maybe the answer is this: unless we think the AOCI should revert, the AOCI should be credited to the value of the firm, though ignored by its operating income.

In this low interest rate environment, many bonds trade above the prices at which they were purchased.? Unrealized Capital Gains are usually one of the biggest items in AOCI.? Sadly, only the asset values rise when rates fall, because liabilities aren’t publicly traded, and as such have no price to mark to market.? With life companies, because of the longer tail of obligations, and the capitalizing of deferred acquisition costs (DAC, which is a discounted measure) the unrealized capital gains are applied to reduce the DAC.? DAC, though intangible, is a hard intangible, because there are are cash flows behind it, and if those cash flows are insufficient to repay the DAC asset, the asset gets written down.

Most insurance analysts as a result exclude AOCI from book value for valuation purposes; they think it will disappear when rates rise.? Now that said, I have read research that indicates that insurance stocks track unadjusted book value more than BV less AOCI.? If true, I think that works better for short-tail insurers, because discounting of liabilities does not have so much impact.

I look at it all and kind of shrug.? After that, I do some digging to analyze whether some components of AOCI might be more permanent than otherwise considered.

Insurance stocks mostly trade in line with their book value.? I have been around long enough to see the average multiple move in the range of 0.5x to 2.0x.? Be aware of where we are in the range, and whether pricing power is rising of falling.

From another reader:

I stumbled upon your blog post regarding generating ideas. I too use google alerts to fill the inbox. Unfortunately, I have been unhappy with the results so far. I have attached my alerts (with some culling of personal ones), which can be generated from the bottom of the manage alerts page.?

?I was hoping that you would do likewise and send me your fruitful query strings.?

It would be greatly appreciated.

My Googlebots use the following phrases:

CEO resigned
CEO “Steps down”
CEO fired

Now, creating good Googlebots takes time and effort, trial and error.? I typically create them for a specific task, and when that task is complete, I retire them.? My biggest success with Googlebots occurred in 2005, when they detected the peak in the housing market.? I had about 10 Googlebots working to pick up market chatter.? In October 2005, they went through a dramatic change, where the chatter was confused, and the speed of the closing for housing sales dropped dramatically. ?After that, the chatter was subdued.? I posted my result at RealMoney?s Columnist Conversation sometime in October, and told my boss that though credit conditions were still loose, the wind was now at our back on housing prices.? We were ?too early? bears on housing, and I was the one skeptic in the shop on the timing of that.

That’s all for now.

Berkshire Hathaway & Variable Annuities

Posted on 14 February 201314 February 2013 by David Merkel

Sometimes I miss stuff in the news… last week Berkshire Hathaway reinsured the remainder of the variable annuity business that Cigna reinsured in the 1990s.? Four articles:

It was the last that attracted my attention, and led me to the rest of the articles cited.? To that article I commented:

This is very similar to the reinsurance deals that Buffett has done regarding asbestos.? Long-tail, upfront premium, with capped downside to Buffett.? He can invest the $2.2B of proceeds as he likes, and make additional money.? My guess is this leads to a profit of $500 million or so for Berkshire, plus any incremental from reinvestment of the $2.2B.

CIGNA was the patsy of the poker game of variable annuity reinsurance in the ’90s — this ends that ugly performance.??

Full disclosure: long BRK.B

In the past, CIGNA gave disclosures on its variable annuity liabilities.? From the most recent 10-K (pages 58-59):

Future policy benefits ? Guaranteed minimum death benefits (?GMDB? also known as ?VADBe?)

These liabilities are estimates of the present value of net amounts expected to be paid, less the present value of net future premiums expected to be received. The amounts to be paid represent the excess of the guaranteed death benefit over the values of contractholders? accounts. The death benefit coverage in force at December?31,?2011 (representing the amount payable if all of approximately 480,000 contractholders had submitted death claims as of that date) was approximately $5.4?billion.

Liabilities for future policy benefits for these contracts as of December?31 were as follows (in?millions):

?2011 ? $1,170

?2010 ? $1,138

Current assumptions and methods used to estimate these liabilities are detailed in Note?6 to the Consolidated Financial Statements.

And…

Accounts payable, accrued expenses and other liabilities, and Other assets, including other intangibles – Guaranteed minimum income benefits

These net liabilities are calculated with an internal model using many scenarios to determine the fair value of amounts estimated to be paid, less the fair value of net future premiums estimated to be received, adjusted for risk and profit charges that the Company anticipates a hypothetical market participant would require to assume this business. The amounts estimated to be paid represent the excess of the anticipated value of the income benefit over the value of the annuitants? accounts at the time of annuitization.

The assets associated with these contracts represent receivables in connection with reinsurance that the Company has purchased from two external reinsurers, which covers 55% of the exposures on these contracts.

Liabilities related to these contracts as of December?31, were as follows (in?millions):

? 2011 ? $1,333

? 2010 ? $ 903

As of December?31, estimated amounts receivable related to these contracts from two external reinsurers, were as follows (in?millions):

? 2011 ? $712

? 2010 ? $480

Current assumptions and methods used to estimate these liabilities are detailed in Note?10 to the Consolidated Financial Statements.

At 2010, the net liability was less than $1.6B.? 2011, near $1.8B.? Buffett gets a $2.2B premium, and from what was said on the conference call, the net liability declined in 2012.? Thus I estimate Berkshire Hathaway as being $500M to the good on this transaction, subject to future market conditions.

Okay, so assume the duration on these liabilities is 10 years on average.? At the limit of $4 billion in claims, Berkshire Hathaway would have to earn somewhat less than 7%/yr in order to fund payments.? That’s more than achievable for Buffett.

From Roddy Boyd’s work on AIG, by the late 80s, Hank Greenberg was running out of places to expand in P&C insurance.? As such, he began to expand with life insurance and financial services.? Greenberg liked the fact that it diversified his risk exposures, and while it was small enough, did not threaten the solvency of the whole.

Buffett has always had a wider field to play on than AIG.? In some ways, life & annuity reinsurance does diversify BRK.? It is a little more complex for Buffett, because he has a decent number of bets against the equity markets & credit falling dramatically.? This deal is similar, in that the liabilities decrease as the equity market rises, and increase as the market falls.

Buffett does not have to maintain the hedges that Cigna currently does, but if it doesn’t Buffett might have to make some promises to the regulators like a BRK parental guarantee of the subsidiary reinsuring the variable annuities.

Buffett tends to think more in book value terms — he will try to over accumulate the implied returns in reinsuring the variable annuities.? From my angle, odds are he will succeed.? The only real concern is if he does not continue the hedge, and the markets fall for a considerable period, like 1973- 1982, or 2000-2008.? That would drive up the cost of the liability considerably, if left unhedged.? That said, Buffett, of all investors tends to do well after market declines, often finding compelling investments while others are afraid to commit.

Of itself, this deal is not large enough to materially materially harm BRK if the markets do badly.? It does add on to the “long bias” of BRK if left unhedged.

A note to those who get to question Buffett at his annual meeting: Ask him about this deal.? Cigna wrote a lot about this, held a teleconference, etc.? It was a big deal for them.? BRK said nothing.? Ask Buffett if he decided to continue hedging, or whether his investing in portfolio companies or wholly owned companies constitutes an internal pseudo-hedge that he thinks will outcompete hedging.

Personally, I expect that he does not hedge.? After all, he didn’t on his equity and credit index wagers.? Buffett is a bull on the US an the world; it would not be like his past behavior to hedge.? Besides, that’s why he keeps cash around, and hey, this gave him $2.2B more cash.

Full disclosure: long BRK.B

PS — one more article about variable annuity guarantees — they give me the willies.? Much as I like insurers, I avoid insurer that offer a lot of variable annuities.? I believe they are mis-reserved.? When I listened to Cigna’s conference call and their reserving off of “thousands of scenarios” I could not help thinking of how such methods could be tweaked or abused.? There is no good underlying theory for long dated options with uncertain payoff patterns.

The Education of a Mortgage Bond Manager, Part IX

Posted on 13 February 2013 by David Merkel

The Negative Convexity Project

Me: We can’t buy the majority of Residential Mortgage Backed Securities [RMBS] anymore.

Boss: What! That is a staple asset class of ours.? There’s nothing illegal about life companies owning RMBS.

Me: nothing illegal, yes, but because of new cash flow testing rules which our client is subject to, the negative convexity of RMBS will force our client to put up more risk-based capital than they would otherwise have to.? Most RMBS will require so much additional capital that the additional yield is uneconomic, and that assumes we get the yield when we want it, ignoring prepayment and extension risks.

Boss: I can’t believe that we can’t buy any RMBS… are there any exceptions?

Me: There are a few.? You know about the odd RMBS classes that have positive convexity, but little yield?

Boss: Yes, Yes… but why would we want to buy that?? Our client needs yield!

Me: I know that.? Would that they could do something other than need yield to sell yield.? There is one type of RMBS that still fits, and it is the NAS bond [Non-accelerating security], last cash flow structure.? Also, some of the credit-sensitive RMBS bonds rated less than AAA don’t affect the convexity issue, but we might not want to buy them, because the additional yield per unit risk is not compelling.

Boss: So what do we do?

Me: Buy NAS bonds when they are attractive, and buy CMBS that is attractive, after that look to corporates that our analysts like.

Boss: You are right, but I hate to lose a staple asset class.

=–=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-==–=-=-=-==-=-=–=-=-=-=-=-=-=

What I wrote there took longer than a single conversation, and involved contact with the client as well.? The client was very conservative with capital, because they levered up more than most life insurers.? The results of detailed cash flow testing would affect large annuity writers like my client, and negative convexity would make them put up more capital, constraining the amount of business they could write.

Wait: negative convexity simply means your bond portfolio hates interest rate volatility — it does better when things are calm.? That is certainly true with residential mortgages, where people refinance easily when rates fall, and in that era, no one faced falling property prices.

It took some effort, but I made my case to the client and my boss, and we stopped buying most RMBS.? As an aside, it made asset-liability management tighter.

Alternative Investments

I was not totally hidebound with respect to derivatives.? I bought our first asset-swapped convertibles, and synthetic corporates.? If the risks associated with getting additional yield were small, I would take those risks.? In both cases, they converted other asset into straight corporate debt (plus counterparty risk).

But I wouldn’t do anything.? I grew to hate CDOs, as I saw how perverse the structure was. I remember one weird CMBS deal structure that added a note that combined the AAA, BBB & BB CMBS of the deal.? What a nice yield, but the riskiness was greater than my models would allow for the incremental yield.

Finally, for this piece, the “piece of work” broker that I have previously described pitched me a private placement debt deal for a power producer affiliated with his firm.? After hearing the initial spiel, I said, “Okay, soft-circle me for $25 million, subject to due diligence; send me all of the hard data via email and paper.”

My request should not have obligated me to buy the deal.? Indeed, when I got the hard data, and began estimating the counterparty risks, I thought the deal was a loser, so I contacted the “piece of work,” and said, “Sorry, but we are dropping out of the deal — it just doesn’t offer enough value for the yield.”? After some arguing, he eventually said, “Look, stay in the deal, and I promise you that I will get you out at par at minimum on deal day.? Okay?”

Sigh, even though he was number eight with us, he served an important firm that could potentially do a lot for us, so I agreed.? The day of the deal came, and indeed, he got us out at a teensy premium (I would have accepted par, maybe even a slight scrape).? The deal did horribly, at least initially, though I have no idea of what the eventual credit result was.

As my boss who taught me bonds would say, “On Wall Street, if you want a friend, get a dog.”? There are some honorable people on Wall Street, but the economics of Wall Street often leads to suboptimal results for clients, and indeed, the salesmen may be sweet enough, but they live to distribute paper; they don’t live to be your friend in any true sense.? Professional duty to company trumps friendship.

The Education of a Mortgage Bond Manager, Part VIII

Posted on 12 February 2013 by David Merkel

I sat down this evening, thinking that I would finish the series this evening, and realized that I had left out some significant things.? As such, I expect this series to have two more parts after this one.

Traveling to Annapolis

When you are an actuary, and a good one, you have elements of being a jack-of-all-trades.? Knowing the math is not enough, you have to understand the business processes that the math summarizes.? That also requires some knowledge of the law.? From early in my career, I realized that the insurance company lawyers would not help me with reserving, investing, contract provisions, and other legal questions, so I had to go to the law library and answer the questions myself.? Not fun, but I ended up learning a lot.

While working on another project one day, I made a copy of the Maryland life insurance investment code.? I took it back with me, saying to myself: “It’s only eight pages, written in 1955.? Don’t you think you should know the details of what your local regulator allows?”

Dangerous question, and it led to the following: under a strict interpretation of the law, we were in violation of the law.? Here is the key question: are asset-backed securities bonds?? They trade like bonds, but by the old Maryland statute, they are not bonds — they don’t fit any categories of permitted investments, and as such could only be held if we had sufficient surplus, which we did not, and probably most life insurers in Maryland did not.

Thus the problem.? I discussed it with my boss, and we had a conference call with the legal department, who confirmed my view of things.? A few days later we had a chat with the Maryland regulators.? That was a tough call, because at minimum we wanted them to accept asset-backed securities as bonds, which the the law did not admit.? We suggested, “Why don’t we adopt the NAIC [National Association of Insurance Commissioners] Model Investment law?”? The response was curt, “Oh, you mean the Illinois Investment Law?”

True, Illinois was the only state that adopted it verbatim, but several other major states had adopted >90% of it.? I said, “Tell me what you’d like to take out of the Model Investment Law.”? The main thing the Maryland department wanted was to avoid speculation through derivatives.? So I happily cut that out of my proposed law; I thought that was a good idea.? There were a few other minor things that they wanted, and I trimmed/added those as well.

After a lot of work between the lawyers and me, we sent the proposed bill to the Department of Insurance.? Then the conference call — would they go for it?? As it was they went for it.? They found it reasonable, and it codified what insurers were doing, and provided structure, such that present practices were approved, but bad extensions beyond that were forbidden.

But then we asked, “Are you not opposing us, or are you supporting us?”? They replied, “We are supporting you.? We know we need to modernize, but this statute meets our needs and yours.? Well done.”

(Note: all quotes here are summaries of what was said.? Most of it was not exactly the way I wrote it here.)

So, we hired an expert attorney who was skilled in getting bills through Annapolis.? He told us what we would need to do to get the bill passed.

So, a few weeks later, we were there in Annapolis, before the Assembly Finance Committee.? I can’t remember why, but I was not at the table before the Assembly Committee.? I sat a few feet behind my boss, our internal lawyer and our expert attorney.

The Assembly Finance Committee had a hard time with the bill.? Part of it was that there was no one to oppose the bill.? Opposition sharpens the minds of legislators.? As a result, the Committee remanded the bill to a study session, so that they could better understand the implications of the bill.

A week or so later, we appeared before the Senate Finance Committee, and I was on the panel this time.? Instead of the disorganized questions of the assembly, they asked three “simple” questions:

How will this law prevent Procter & Gamble?
How will this law prevent Orange County?
How will this law prevent Long Term Capital Management?

This was the reverse of the Assembly, because I answered all of the questions, and my partners were silent.? I could not have expected that.

As it was, I explained that P&G could not happen because the statute forbids using derivatives for speculation.? With Orange County, I explained that existing law required cash flow testing, so that we can’t invest in volatile mortgage derivatives or else we will fail our asset-liability management tests.

As for LTCM, I explained that the risk-based capital regulations would never allow us to take on that degree of leverage, and that the forbade speculation through derivatives.

And then, after a mercifully brief session, they let us go.? (Note: I had to sit through a couple sessions where we might be called, but weren’t.? Dull, but I brought work to do.? Also, I learned that Johns Hopkins, my Alma Mater, owns the state of Maryland.? Anything they ask for, they get.)

That left one more hurdle.? So on one early morning we met with the Assembly Finance Committee.? It was just my boss and I, because they were trying to understand what the bill meant.? (Technical subjects are tough for many state legislators.)? We met with them for two hours, and finally we convinced the Chairman of the committee that this was a good and honest deal.? (We both did good work here,? and the absence of the lawyers was a plus.)

That left the final voting, which was unanimous in both chambers.? And then, two months later, the signing ceremony with the governor, dressed like a Mafia Don, with a dark suit, and black shirt with thin white stripes.

So what did I accomplish here?? I reshaped Maryland’s Life insurance investment laws to be among the best in the nation.? I did it while working with many parties that had different goals.? I calmed and instructed many legislators that it was a good bill.? Finally, I set the company that I served on firm legal ground.? What could be better?

The Education of a Mortgage Bond Manager, Part V

Posted on 8 February 2013 by David Merkel

Sometimes you have to do odd stuff for your client.? My boss and I were asked to come to a client meeting where there would be games (and a dopey speaker, I will leave that out).? As it was I found myself in a game where the one who moves his feet amid pushing loses.? I came in 4th (amid 60), I eventually lost to the tax guy… a very clever guy who should never be underestimated.? I ended up beating him in a game where we were all blindfolded, and those that were touched were out (we were the last two).

But the best part of the contest? was the square game.? We were blindfolded, and rope was around us, and they told us we had five minutes to form a square.? When the official said, “Go!” a marketing guy shouted out, “I know there has to be an actuary in our group.? What do we do?”

I shouted out, “I’m an actuary!”? “To the right of me, counterclockwise, count off, I am number one!” And so I heard, “two, three, four… fifteen.”

Fifteen? Uh-oh, that does not divide by four, so I shouted, “Okay, listen to me!? Five, Nine, and Thirteen, put your arms at right angles, and pull out.? You are the corners of the square.? Everyone else, put no pressure on the ropes.? Fourteen and Fifteen, make sure that you are not touching.”

After that, I shouted, “Has everyone complied with what I said!”? After agreement, I shouted to the judges, “Okay, we’re done!”

When we took off our blindfolds, behold, a square!? Way ahead of the other teams, who looked like blobs.

All actuaries are bright, but many lack courage.? I have courage, and a desire to learn more in areas where I am not an expert.

I needed all of my skills and my courage working for that difficult client. Here’s an example: I did not invest in a hedge fund structured note, with a guarantee from the AA insurer who was pushing it.? I said to them, “most hedge funds are short liquidity.? Why should I invest there?”? He disputed that hedge funds were short liquidity, but he dropped the case and we did not buy.

Here’s another example: A guy called me, asking me to let him pay at par a premium mortgage that we needed to fulfill our liabilities.? I said to him, “I can’t do that, we need the payment over time so that our shareholders are not badly affected.”? Then I said, “Why not get a second mortgage if you need to take money out?”? He said, “A second mortgage? Those guys wear ‘panky rangs.'”

I had the same experience on the most prominent building in Baltimore — the TransAmerica Building, which was the Legg Mason building when I was dealing with it.? Toward he end of my tenure at Dwight, they called me, asking to buy out the second mortgage, which was now the first mortgage.? They offered a slight premium to par, and I said no.? I told them that we needed 125% of par to make us whole, and we would be done.? They offered 110%, and I told them to go away; I would not counteroffer.

I had a strong position, and so I did not have to move.? Sadly, when I left, the company made a bad deal with the borrower, and lost a lot of money.

What can I say? I did my best, and they lost due to their stupidity.? They got more interest due to my intransigence at minimum.

The Product that Never saw the Light of Day, Redux

Posted on 1 February 2013 by David Merkel

I love my readers.? How many Variable Annuity [VA] products got mentioned to me as a result of yesterday’s article? Four, out of 2 emails, 3 comments, and one clever guy who figured out my phone number (no, I don’t keep it secret).

In my opinion these are some of the better VA options out there.? It’s not quite what I proposed in my article, where every major mutual fund would offer T-shares, but they are close.

My main differences with these products is that:

the expense charges going from taxable to annuity should be smaller.
there should be more choices, aside from Jefferson National.
it would be better if the mutual fund companies took the lead in these matters.

As an aside, I pushed for products like this from 1996-2006.? By the time I gave up, I concluded that there was no one willing to offer variable annuity products that were truly cost-efficient.? Now we have at least four contenders, though I think my product idea would be better still.

But incremental improvement is a good thing.? Thanks to those who commented, emailed, and called.

The Product that Never saw the Light of Day

Posted on 31 January 2013 by David Merkel

I have never particularly liked individual variable life and annuity products.? But one day, I came up with an individual variable annuity product idea.? I don’t think it has ever been done.? If it has been done, please note it in the comments below.

Most individual variable annuity products offer some hard to price guarantee:

Guaranteed Minimum Death Benefit
Guaranteed Minimum Accumulation Benefit
Guaranteed Minimum Income Benefit
Guaranteed Minimum Withdrawal Benefit

This product would have no such guarantees.? It would also be sold by agents inside the mutual fund companies, and carry no commission.? I call it T-shares, for deferred TAX shares.? The insurance company offering this would go to mutual fund companies, and offer to train mutual fund company representatives to be insurance agents.? The T-shares would have the same annual fee as the “no load” C-shares, plus 0.2%/year for the insurance company.? The T-share buyer gets the option of having a tax-deferred mutual fund for the price of 0.2% extra per year.

Considering the ease of not having to track your cost basis on a mutual fund, and the additional growth from compounding what is not taxed, this could be a very attractive proposition.? It would be interesting to have contractual provisions that allow the annuitant to be changed during the deferral period, even after death, so that the tax savings could continue.

There has to be a loser here, but who?

The obvious one is the taxman.? Much of the mutual fund industry could end up issuing T-shares, instead of C-shares.

But the other one is not so obvious.? I pitched this idea to a number of insurers.? One said, “Great idea, but why should we cannibalize our existing block of variable annuity policies to make less?”? That told me I needed to approach large life companies that had no variable products.? So I spoke to one of the few that was like that, and the CEO was interested, but nothing came of it, because he left soon afterward.

As a buy-side analyst of insurers, I tossed the idea out to most of the life insurance CEOs I met that I knew had no individual variable annuity block of policies.? No one bit.? Maybe it would be the complexity of making the policy work across a large number of mutual fund companies.? The IT expertise needed would be considerable.? So would the legal documents.

But no one grabbed the idea and ran with it.? Personally, I think a lot of people would like this product, but it never saw the light of day.? Mmmm… I never talked to Assurant about this one….

On the other hand, maybe the place to start is with the mutual fund companies… they might have the greater interest.

PS — to those who are receiving buyout offers some life insurers on variable annuities with guarantees, turn them down.? They are not offering you what the guarantees are truly worth.? Unless you know something critical that they don’t, don’t take the buyout offer.

Full Disclosure: long AIZ, and many other insurers