Insurance – Page 4 – The Aleph Blog

On Negative Interest Rates

Posted on 21 April 201521 April 2015 by David Merkel

Photo Credit: Alcino || What is the sound of negative one hand clapping?

As with many of my articles, this one starts with a personal story from my insurance business career (skip down four paragraphs to the end of the story if you want):

25 years ago, when it was still uncommon, I wanted?to go to an executive course at the Wharton School for actuaries that wanted to better understand investment math and markets. ?I went to my boss at AIG (a notably tight-fisted firm on expenses) and asked if the company would pay for me to go… it was an exclusive course, and very expensive compared to any other conference that I would ever go to again in my life. ?I tried not to get my hopes up.

Lo, and behold! ?AIG went for it!

A month later, I was with a bunch of bright actuaries at the Wharton School. ?The first thing I noticed was aside from the compound interest math, and maybe some bond knowledge, the actuaries were rather light on investment knowledge, and I would bet that all of them had passed the Society of Actuaries investment course. ?The second thing I noticed were some of the odd investments described in the syllabus: it was probably my first taste of derivative instruments. ?At the ripe old age of 29, I was learning a lot, and possibly more than the rest of my classmates, because I had spent a lot of time studying investments already, both on an academic and practical basis.

I had already studied the pricing of stock options in school, so I was familiar with Black-Scholes. ?(Trivia note: an actuary developed the same formula for valuing optionally terminable reinsurance treaties six years ahead of Black, Scholes and Merton. ?That doesn’t even take into account Bachelier, who derived it 73 years earlier, but no one knew about it, because it was written in French.) ?At this point, the professor left, and a grad student came in to teach us about the pricing of bond options. ?At the end of his lesson, it was time for the class to have a break. ?I went down to make a comment, and it went like this:

Me: You said that we have to adjust for the fact that interest rates can’t go negative.

Grad student: Of course.

Me: But interest rates could go negative.

GS: That’s ridiculous! ?Why would you ever lend money and accept back less than you gave them, and lose the time value of money?!

Me: Almost of the time, you wouldn’t. ?But imagine a scenario where the demand for loanable funds leaves interest rates near zero, but the times are insecure and violent, leaving you uncertain that if you stored your cash privately, you would run too large of a risk of having it stolen. ?You need your cash in the future for a given project. ?In this case, you would pay the bank to store your money.

GS: That’s an absurd scenario! ?That could never happen!

Me: It’s unlikely, I admit, but I wouldn’t say that you can never have negative interest rates.

GS: I will say it again: You can NEVER have negative interest rates.

Me: Thanks, I guess.

Well, so much for the distant past. ?Here is why I am writing this: yesterday, a friend of mine wrote me the following note:

Good evening.? I trust you had a blessed Lord’s Day in the new building.?

Talking bonds today with my Econ class.? Here’s our question. Other than playing a currency angle why would anyone buy European debt with a negative yield?? The Swiss and at least one other county sold 10 year notes with a negative yield.? Can you explain that?? No interest and less principle [sic] at the end.

Now, I didn’t quite get it perfectly right with the grad student at Wharton, but most of it comes down to:

Low demand for loanable funds,?with low measured inflation, and
Security and illiquidity of the funds invested

The first one everyone gets — inflation is low, and few want to borrow, so interest rates are very low. ?But that doesn’t explain how it can go negative.

Things are different for middle class individuals and large financial institutions. ?Someone in the middle class facing negative interest rates from a checking or savings account could say: “Forget it. ?I’m taking most of my money out of the bank, and storing it at home.” ?Leaving aside the inconvenience of currency transaction reports if the amount is over $10,000, and worries over theft, he could take his money home and store it. ?Note that he does have to run a risk of theft, though, so bringing the money home is not costless.

The bank has the same problem, but far larger. ?If you don’t invest the money, where would you store it? ?Could you even get enough currency delivered to do it? ?if you had a vault large enough to store it, could you trust the guards? ?Why make yourself a target? ?If you don’t have a vault large enough to store it, you’re in the same set of problems that exist for those that warehouse precious metals, but with a far more liquid commodity.

Thus in a weak economic environment like this, with low inflation, banks and other financial institutions that want certainty of payment in the future are willing to pay interest to get their money back later.

Part of the problem here is that the fiat currencies of the world exist only to be?units of account, and not stores of value. ?Thus in this unusual environment, they behave like any other commodity, where the prices for futures are often higher than the current spot price, which is known as backwardation. ?(Corrected from initial posting — i.e. it costs more to receive a given cash flow in the future than today, thus backwardation, not contango.) ?The rates can’t get too negative, though, or some institutions will bite the bullet and store as much cash as they can, just as other commodities get stored.

To use another analogy, a while ago, some market observers couldn’t get why anyone would accept a negative yield on Treasury Inflation Protected Securities [TIPS]. ?They did so because they had few other choices for transferring money to the future while still having inflation protection. ?Some people argued that they were locking in a loss. ?My comment at the time was, “They’re trying to avoid a larger loss.”

Thus the difficulty of managing cash outside of the bond/loan markets in a depressed economy leads to negative interest rates. ?The financial institutions may lose money in the process, but they are losing less money than if they tried to store and protect the money, if that could even be done.

One Potential Weakness of Berkshire Hathaway

Posted on 4 March 2015 by David Merkel

As I mentioned yesterday, there wasn’t anything that amazing and new in the annual letter of Berkshire Hathaway. ?Lots of people found things to comment on, and there is always something true to be reminded of by Buffett, but there was little that was new. ?Tonight, I want to focus on a few new things, most of which was buried in the insurance section of the annual report.

Before I get to that, I do want to point out that Buffett historically has favored businesses that don’t require a lot of capital investment. ?That way the earnings are free to be reinvested as he see fit. ?He also appreciates having moats, because of the added pricing power it avails his businesses. ?Most of his older moats depend on?intellectual property, few competitors, established brand, etc. ?Burlington Northern definitely has little direct competition, but it does face national regulation, and dissatisfaction of clients if services can’t be provided in a timely and safe manner.

Thus the newer challenge of BRK: having to fund significant capital projects that don’t add a new subsidiary, may increase capacity a little, but are really just the price you have to pay to stay in the game. ?From page 4 of the Annual Letter (page 6 of the Annual Report PDF):

Our bad news from 2014 comes from our group of five as well and is unrelated to earnings. During the?year, BNSF disappointed many of its customers. These shippers depend on us, and service failures can?badly hurt their businesses.

BNSF is, by far, Berkshire?s most important non-insurance subsidiary and, to improve its performance, we?will spend $6 billion on plant and equipment in 2015. That sum is nearly 50% more than any other railroad?has spent in a single year and is a truly extraordinary amount, whether compared to revenues, earnings or?depreciation charges.

There’s more said about it on pages 94-95 of the annual report, but it is reflective of BRK becoming a more asset-heavy company that requires significant maintenance capital investment. ?Not that Buffett is short of cash by any means, but less will be available for the “elephant gun.”

Insurance Notes

Now for more arcane stuff. ?There are lots of people who write about Buffett and BRK, but I think I am one of the few that goes after the insurance issues. ?I asked Alice Schroeder (no slouch on insurance) once if she thought there was a book to be written on Buffett the insurance CEO. ?Her comment to me was “Maybe one good long-form article, but not a book.” ?She’s probably right, though I think I have at least 10,000 words on the topic so far.

Here are two articles of mine for background on some of the issues involved here:

Here’s the main upshot: reserving is probably getting less conservative at BRK. ?Incurred losses recorded during the year from?prior accident years is rising. ?Over the last three years it would be -$2.1B, -$1.8B, and now for 2014 -$1.4B. ?(See page 69 of the annual report.) ?Over the last three years, the amount of reserves from prior years deemed to be in excess of what was needed has fallen, even as gross reserves have risen. ?In 2012, the amount of prior year reserves released as a proportion of gross reserves was greater than 3%. ?In 2014, it was less than 2%.

In addition to that, in general, the reserves that were released were mostly shorter-tailed reserves, while longer-tailed reserves like asbestos were strengthened. ?In general, when longer-tailed lines of business are strengthened in one year, there is a tendency for them to be strengthened in future years. ?It is very difficult to get ahead of the curve. ?Buffett and BRK could surprise me here, but delays in informing about shifts in claim exposure are a part of longer-tailed lines of insurance, and difficult to estimate. ?As I have said before, reserving for these lines of business is a “dark art.”

From page 91 of the annual report:

In 2014, we increased estimated ultimate liabilities for contracts written in prior years by?approximately $825 million, substantially all of which was recorded in the fourth quarter. In the fourth quarter of 2014, we?increased ultimate liability estimates on remaining asbestos claims and re-estimated the timing of future payments of such?liabilities as a result of actuarial analysis. The increase in ultimate liabilities, net of related deferred charge adjustments,?produced incremental pre-tax underwriting losses in the fourth quarter of approximately $500 million.

This was the only significant area of reserve strengthening for BRK. ?Other lines released prior year reserves, though many released less than last year.

There were a few comments on insurance profitability. ?In addition to asbestos, workers’ compensation lost money. ?Property-catastrophe made a lot of money because there were no significant catastrophes in 2014, but rates are presently inadequate there, and BRK is likely to write less of it in 2015.

My concern for BRK is that they are slowly running out of profitable places to write insurance, which reduces BRK’s profitability, and reduces the float that can be used to finance other businesses.

Maybe BRK can find other squishy liabilities to use to create float cheaply. ?They certainly have a lot of deferred tax liabilities (page 71). ?Maybe Buffett could find a clever way to fund pensions or structured settlements inexpensively. ?Time to have Ajit Jain put on his thinking cap, and think outside the box.

Or maybe not. ?Buffett is not quite to the end of his “low cost of informal borrowing” gambit yet, but?he is getting close. ?Maybe it is time to borrow at the holding company while long-term rates are low. ?Oh wait, he already does that for the finance subsidiary.

Final Notes

From an earnings growth standpoint, there was nothing that amazing about the earnings in 2014. ?A few new subsidiaries like NV Energy added earnings, but existing subsidiaries’ earnings were flattish. ?Comprehensive income was considerably lower because of the lesser degree of unrealized appreciation on portfolio holdings.

On net, it was a subpar year for Berkshire Hathaway. ?The annual letter provided a lot of flash and dazzle, but 2014 was not a lot to write home about, and limits to the BRK business model with respect to float are becoming more visible.

Full disclosure: long BRK/B for myself and clients, for now

The “Secret” of Berkshire Hathaway

Posted on 3 March 20153 March 2015 by David Merkel

Photo Credit: Chuck Coker || Another Dynamic Duo and their secret Batcave

This piece has kind of a long personal introduction to illustrate my point. ?If you don’t want to be bored with my personal history, just skip down to the next division marker after this one.

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

There will always be a soft spot in my heart for people who toil in lower level areas of insurance companies, doing their work faithfully in the unsexy areas of the business. ?I’ve been there, and I worked with many competent people who will forever be obscure.

One day at Provident Mutual’s Pension Division [PMPD], my friend Roy came to me and said, “You know what the big secret is of the Pension Division?” ?I shook my head to say?no. ?He said, ” The big secret is — there is no secret,” and then he smiled and nodded his head. ?I nodded my head too.

The thing was, we were ultra-profitable,?growing fast, and our financials and strategies were simple. ?Other areas of the company were less profitable, growing more slowly, and had accrual items that were rather complex and subject to differing interpretations. ?But since the 30 of us?(out of a company of 800) were located in a corner of the building, away from everyone else, we felt misunderstood.

So one day, I was invited by an industry group of actuaries leading pension lines of business to give a presentation to the group. ?I decided to present on the business model of the PMPD, and give away most?of our secrets. ?After preparing the presentation, I went home and told my wife that I would be away in Portland, Oregon for two days, when she informed me we had an important schedule conflict.

I was stuck. ?I tried to cancel, but the leader of the group was so angry at me for trying to cancel late, when I hung up the phone, I just put my head on my desk in sorrow.

Then it hit me. ?What if I videotaped my presentation and sent that in my place? ?I called the leader of the group back, and he loooved the idea. ?I was off and running.

One afternoon of taping and $600 later, I had the taped presentation. ?It detailed marketing, sales, product design, risk control, computer systems design, and more. ?If you wanted to duplicate what we did, you would have had a road map.

But the presentation ended with a hook of sorts, where I explained why I was so free with what we were doing. ?We were the smallest player in the sub-industry, though the fastest growing, and with one of the highest profit margins. ?I said, “The reason I can share all of this with you is that if you wanted to copy us, you would have to?change an incredible amount of what you do, and kill off areas where you have invested a lot already. ?I know you can’t do that. ?But maybe you can imitate a few of our ideas and improve your current business model.”

So my colleague took the tape to the meeting, and when he returned, he handed me a baseball cap that had the word “Portland” on it. ?He said, “You did it, Dave. ?You won the best presentation of the conference award. ?Everyone sent their thanks.”

Sadly, that was one of the last things I did in the Pension Division, as corporate management chose me to clean up another division of the company. ?That is another story, but one I got few thanks for.

Today I call that hat “the $600 hat,” and I wear it to my kids baseball and softball games as I keep score.

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

The secret of Berkshire Hathaway is the same as my story above. ?There is no secret.?Buffett’s methods have been written about by legions; his methods are well known. ?The same applies to Charlie Munger. ?That’s why in my opinion, there were?no significant surprises in their 50th anniversary annual letter. (There were some small surprises in the annual report, but they’re kinda obscure, and I’ll write about those tomorrow.) ?All of the significant building blocks have been written about by too many people to name.

Originally, this evening, I was going to write about the annual report, but then I?bumped across this piece of Jim Cramer’s on Buffett. ?Let me quote the most significant part:

…Cramer couldn’t help but wonder if things in the business world could be different if we approached other CEOs the way that Buffett is approached.

Perhaps, if the good CEOs were allowed to stay on longer like Buffett has or if people treated them as if they were their companies the way that Buffett is treated in relation to Berkshire, things could be different?

“Clearly something’s gone awry in the business world if we can praise this one man for everything he does, and yet every other chief executive feels shackled into being nothing like him,” Cramer said.

Cramer is very close to the following insight: the reason why more companies don’t imitate Berkshire Hathaway is that they would have to destroy too much of their existing corporations to make it worth their while. ?As such, the “secrets” of Berkshire Hathaway can be hidden in plain view of all, because the only way to create something like it would be to start from scratch. ?Yes, you can imitate pieces of it, but it’s not the same thing.

Creating a?very profitable diversified?industrial conglomerate financed by insurance liabilities is a very unique strategy, and one that few would have the capability of replicating. ?It required intelligent investing, conservative underwriting, shrewd analysis of management teams so that they would act independently and ethically, and more.

Indeed, an amazing plan in hindsight. ?Kudos to Buffett and Munger for their?clever business sense. ?It will be difficult for anyone to pursue the same strategy as well as they did.

But in my next piece, I will explain why one element of the strategy may be weakening. ?Until then.

Full disclosure: long BRK/B for myself and clients

Choose Your Weatherman With Care

Posted on 28 January 2015 by David Merkel

This should be a short post. Weather forecasters deserve to be double-checked, as there has been a tendency among weather broadcasters to sacrifice accuracy for ratings, which can be goosed in the short run by offering a good scare.

I offer the most recent snowstorm as a partial exhibit. There is a real cost to misforecasting, as this article from USA Today points out:

The lost wages and tax revenue from stores and others businesses that shut down early Monday and kept employees home Tuesday, in anticipation of something far more … dramatic.

The vacations, business trips and job interviews disrupted by the pre-emptive cancellation of thousands of airline flights across the Northeast. The extra aggravation caused Monday by those two words that every working parent of school-age children dreads: early dismissal.

All the overkill adds up, in ways that may be impossible to tease out precisely.

Now, many actions are due to a need for caution, but caution needs to be kept in bounds, lest the costs of?businesses and government grow without any value gained. ?Maybe my bias comes from growing up in Wisconsin, because we were always ready for bad weather, and at least in that era, rarely canceled anything in the winter.

My second observation stems from hurricane forecasting. ?Both the overall estimates of the number and severity of storms for the season and the individual estimates of likely severity seem to be biased high. ?Again, I blame the need for high ratings.

Yes, we get occasional monster years with hurricanes, like 2004 and 2005. ?We also get freak storms like Katrina and Sandy that cause a lot of damage from the degree of flooding that accompanies some severe storms.

As an analyst of insurance companies that insure against many of the losses that come from these storms, it has taken an iron constitution to keep from trading out of loss-exposed insurers when I think the forecast is overly pessimistic.

On a personal level, it is good to be prepared for the kinds of catastrophes common to the area in which you live, regardless of the current predictions. ?But where weather affects your business or your investing, I would encourage you to double-check?severe weather forecasts to see if they make sense before taking actions as a result. ?There are costs to being wrong on each side, so be careful.

Out and About with The Aleph Blog

Posted on 20 December 201421 December 2014 by David Merkel

1. Recently I appeared on RT Boom/Bust again. ?The interview lasts 6+ minutes. ?Erin Ade and I discussed:

Who benefits from lower energy prices.
The No-Lose Line for owning bonds,
Whether you are compensated for inflation risks in long bonds
How much an average person should invest in stocks with any assets that they have after buying their own house.
The value of economics, or lack thereof, to investors today.

2. Also, I did an “expert interview” for Mint.com. ?I answered the following questions:

What is your most basic advice on investing?
What can you tell young people to help them stay financially secure in their futures?
How can a potential investor go about finding the best investment professional to work with for his or her individual needs?
Please explain how being a good investor and a good businessman go hand in hand.
What is your favorite part of your job?
You clearly do a lot of reading, as seen from your book reviews. What other genres of books do you enjoy?

3. Finally, Aleph Blog was featured in a list of the Top 100 Insurance Blogs at number 29. ?I find it interesting because my blog has maybe 18% of?posts on insurance topics. ?That said, I have a distinctive voice on insurance, because I will talk about consumer issues, and what are companies that might be worth owning.

Enjoy the overly long infographic.

An infographic by the team at Rebates zone

On Financial Risk Statements, Part 1

Posted on 13 December 2014 by David Merkel

Most formal statements on financial risk are useless to their users. Why?

They are written in a language that average people and many regulators don’t speak.
They often don’t define what they are trying to avoid in any significant way.
They don’t give the time horizon(s) associated with their assessments.
They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
They don’t consider whether history might be a poor guide for their estimates.
They don’t consider the conflicting interests and incentives of the parties that?direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
Occasionally, approximations are used where better calculations could be used. ?It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
Where complex math is used, there is no simple language to explain the economic sense of it.
They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story. ?I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did. ?The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into. ?It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them. ?The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual. ?You can’t believe how many people came to us saying, “I get it.” ?Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known. ?Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not. ?It combined the best of both rules and principles, going well beyond the minimum of what was required. ?Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

Investment prospectuses and reports, and all investment and insurance marketing literature
Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
The reports that sell-side analysts write
The analyses that those that provide asset allocation advice put out
Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned?for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

AIG Was Broke

Posted on 30 September 201430 September 2014 by David Merkel

138524447_df928490da_o — Photo Credit: Ron

There’s a significant problem when you are a supremely?big and connected financial institution: your failure will have an impact on the financial system as a whole. ?Further, there is no one big enough to rescue you unless we drag out the public credit via the US Treasury, or its dedicated commercial paper financing facility, the Federal Reserve. ?You are Too Big To Fail [TBTF].

Thus, even if you don’t fit into ordinary categories of systematic risk, like a bank, the government is not going to sit around and let you “gum up” the financial system while everyone else waits for you to disburse funds that others need to pay their liabilities. ?They will take action; they may not take the best action of letting the holding company fail while bailing out only the connected and/or regulated subsidiaries, but they will take action and do a bailout.

In such a time, it does no good to say, “Just give us time. ?This is a liquidity problem; this is not a solvency problem.” ?Sorry, when you are big during a systemic crisis, liquidity problems are solvency problems, because there is no one willing to take on a large “grab bag” of illiquid asset and liquid liabilities without the Federal Government being willing to backstop the deal, at least implicitly. ?The cost of capital in a financial crisis is exceptionally high as a result — if the taxpayers are seeing their credit be used for semi-private purposes, they had better receive a very high penalty rate for the financing.

That’s why I don’t have much sympathy for M. R. Greenberg’s lawsuit regarding the bailout of AIG. ?If anything, the terms of the bailout were too soft, getting revised down once, and allowing tax breaks that other companies were not allowed. ?Without the tax breaks and with the unamended bailout terms, the bailout was not profitable, given the high cost of capital during the crisis. ?Further, though AIG Financial products was the main reason for the bailout, AIG’s domestic life subsidiaries were all insolvent, as were their mortgage insurers, and perhaps a few other smaller subsidiaries as well. ?This was no small mess, and Greenberg is dreaming if he thought he could put together financing adequate to keep AIG afloat in the midst of the crisis.

Buffett was asked to bail out AIG, and he wouldn’t touch it. ?Running a large insurer, he knew the complexity of AIG. ?Having run off much of the book of Gen Re Financial Products, he knew what a mess could be lurking in AIG Financial Products. ?He also likely knew that AIG’s P&C reserves were understated.

For more on this, look at my book review of?The AIG Story, the?book that tells Greenberg’s side of the story.

To close: it’s easy to discount the crisis after it has passed, and look at the now-solvent AIG as if it were a simple thing for them to be solvent through the crisis. ?It was no simple thing, because only the government could have provided the credit, amid a cascade of failures. ?(That the failures were in turn partially caused by bad government policies was another issue, but worthy to remember as well.)

The FSOC is Full of Hot Air

Posted on 6 September 2014 by David Merkel

I’ve written about this before, but if the FSOC wants to prove that they don’t know what they are doing, they should define a large life insurer to be a systemic threat.

It is rich, really rich, to look at the rantings of a bunch of bureaucrats and banking regulators who could not properly regulate banks for solvency from 2003-2008, and have them suggest solvency regulation for a class of businesses that they understand even less.

And, this is regarding an industry that posed little?systemic threat during the financial crisis. ?Yes, there were the life subsidiaries of AIG that were rescued by the Fed, and a few medium-large life insurers like Hartford and Lincoln National that took TARP money that they didn’t need. ?Even if all of these companies failed, it would have had little impact on the industry as a whole, much less the financial sector of the US.

Life insurance companies have much longer liability structures than banks. ?They don’t have to refresh their financing frequently to stay solvent. ?It is difficult to have a “run on the company” during a time of financial weakness. ?Existing solvency regulation done by actuaries and filed with the state regulators considers risks that the banks often do not do in their asset-liability analyses.

Systemic risk comes from short-dated financing of long-dated assets, which is often done by banks, but rarely by life insurers. ?I’ve written about this many times, and here are two of the better ones:

MetLife and other insurers should not have to live with the folly of “Big == Systemic Risk.” ?Rather, let the FSOC focus on all lending financials that borrow short and lend long, particularly those that use the repurchase markets, or fund their asset inventories via short-term lending agreements. ?That is the threat — let them regulate banks and pseudo-banks right before they dare to regulate something they clearly do not understand.

The Art of Extracting Large Commissions From Investors

Posted on 28 August 2014 by David Merkel

The dirty truth is that some investments in this life are sold, and not bought. ?The prime reason for this is that many people are not willing to learn enough to save and invest on their own. ?Instead, they rely on others to corral them and say, “You ought to be saving and investing. ?Hey, I’ve got just the thing for you!”

That thing could be:

Life Insurance
Annuities
Front-end loaded mutual funds
Illiquid securities like Private REITs, LPs, some Structured Notes
Etc.

Perhaps the minimal effort necessary to avoid this is to seek out a fee-only financial planner, and ask him to set up a plan for you. ?Problem solved, unless…

Unless the amount you have is so small that when look at the size of the financial planner’s fee, you say, “That doesn’t work for me.”

But if you won’t do it yourself, and you can’t find something affordable, then the only one that will help you (in his own way) is a commissioned salesman.

Now, to generate any significant commission off of a financial product, there have to be two factors in place: 1) the product must be long duration, and 2) it must be illiquid. ?By illiquid, I mean that either you can’t easily trade it, or there is some surrender charge that gets taken out if the contract is cashed out early.

The long duration of the contract allows the issuer of the contract the ability to take a portion of its gross margins over life of the contract, and pay a large one-time commission to the salesman. ?The issuer takes no loss as it pays the commission, because they spread the acquisition cost over the life of the contract. ?The issuer can do it because it has set up ways of recovering the acquisition cost in almost all circumstances.

Now in some cases, the statements that the investor will get will?explicitly reveal the commission, but that is rare. ?Nonetheless, to the extent that it is required, the first statement will?reveal how much the contractholder would lose if he tries to cash out early. ?(I think this happens most of the time now, but it would not surprise me to find some contract where that does not apply.)

Now the product may or may not be what the person buying it needed, but that’s what he?gets for not taking control of his?own finances. ?I don’t begrudge the salesman his commission, but I do want to encourage readers to put their own best interests first and either:

Learn enough so that you can take care of your own finances, or
Hire a fee-only planner to build a financial plan for you.

That will immunize you from financial salesmen, unless you eventually become rich enough to use life insurance, trusts, and other instruments to limit your taxation in life and death.

Now, I left out one thing — there are still brokers out there that make their money through lots of smallish commissions by trading a brokerage account of yours aggressively, or try to sell you some of the above products. ?Avoid them, and?let your fee-only planner set up a portfolio of low cost ETFs for you. ?It’s not sexy, but it will do better than aggressive trading. ?After all, you don’t make money while you trade; you make it while you wait.

If you don’t have a fee only planner and still want to index — use half SPY and half AGG, and add funds periodically to keep the positions equal sized. ?It will never be the best portfolio, but over time it will do better than the average account.

One final note before I go: with insurance, if you want to keep your costs down, keep your products simple — use term insurance for protection, and simple deferred annuities for saving (though I would buy a bond ETF rather than insurance in most cases). ?Commissions go up with product complexity, and so do expenses. ?Simple products are easy to compare, so that you know that you are getting the best deal. ?Unless you are wealthy, and are trying to achieve tax savings via the complexity, opt for simple insurance products that will cover basic needs. ?(Also avoid product riders — they are really expensive, even though the additional premiums are low, the likely benefits paid are lower still.)

Ranking P&C Reserving Conservatism

Posted on 20 August 2014 by David Merkel

About 1 1/2 years ago, I wrote a seven-part series on investing in insurance stocks. ?It is still a good series, and worthy of your time, because there aren’t *that* many writers freely available on the topic.

This particular article deals expands on part 4 of that series, which deals with insurance reserving. ?I wanted to do this at the time, but I was short on time, and wrote out the general theory there, while not actually doing the time-consuming job of ranking the conservativeness of P&C insurers reserving practices.

Let me quote the two most important sections from part 4:

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.

and

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.

Today’s post analyzes Property & Casualty Insurers, and looks at their history of whether they consistently reserve conservatively each year. ? Repeating from above, management teams that reserve conservatively?establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves. ?This should give greater confidence that the accounting is fair, if not conservative.

So, I went and got the figures for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years,” for?67 companies over the past 12 years from the EDGAR database. ?Today I share that with you.

When you look at the column “Reserving by Year,” that tells you how the reserving for business in prior years went over time. ?A company that was consistently conservative of the past twelve?years would have “12N’ written there for twelve negative adjustments to reserves. ?Using Allstate as an example, the text is “5N, 1P. 3N, 3P” which means for the last 5 years [2013-2009], Allstate had negative adjustments to prior year reserves. ?In 2008, it had to strengthen prior year reserves. ?2007-2005, negative adjustments. ?2004-3,?it had to strengthen prior year reserves.

Now, in reserving, current results are more important than results in the past. ?Thus, in order to come up with a score, I discounted each successive year by 25%. ?That is, 2013 was worth 100 points, 2012 was worth 75, 2011 was worth 56, 2010 was worth 42 points, etc. ?Since not all of the companies were around for the full 12 years, I normalized their scores by dividing by the score of a hypothetical company that was around as long as they were that had a perfect score.

Now, is this the only measure for evaluating an insurance company? ?Of course not. ?All this measures?in a rough way is the willingness of a management team to reduce income in the short-run in order to be more certain about the accounting. ?Consult my 7-part series for more ways to analyze insurance companies.

As an example, imagine an insurance company that consistently writes insurance business at an 80% combined ratio. ?[I.e. 20% of the premium emerges as profit.] ?I wouldn’t care much about minor reserve understatement. ?Trouble is, few companies are regularly that profitable, and companies that understate reserves tend to get into trouble more frequently.

Comments and Surprises

1) Now, it is possible for a company to game this measure in the short run, where the management aims to always release some reserves from prior year business whether it is warranted or not. ?That may have happened with Tower Group. ?Very aggressive in growth, after their initial periods, they consistently released reserves for eight years, before delivering huge reserve increases for two years.

Now, someone watching carefully might have noticed a reserve strengthening for their non-reciprocal business in 2011, and then strengthenings in mid-2012, before the whole world realized the trouble they were in.

2) Notice in the red zone (scores of 40% and lower) the number of companies that did subprime auto insurance — Infinity, Kingsway, and Affirmative. ?That business is very hard to underwrite. ?In the short run, it is hard to not want to be aggressive with reserves.

3) Also notice the red zone is loaded with companies with much recent strengthening of reserves. ?Many of these companies are smaller, with a few exceptions — the law of large numbers doesn’t apply so well with smaller companies, so they mis-estimate more frequently. ?I won’t put companies with less than $1 billion of market cap into the Hall of Shame. ?It’s hard to get reserving right as a smaller company.

4) As for larger companies, they can be admitted to the Hall of Shame, and here they are:

Hall of Shame

AIG
The Hartford
AmTrust Financial Services
Mercury General, and?
National General Holdings

AIG is no surprise. ?I am a little surprised at the Hartford and Mercury General. ?National General Holdings and Amtrust are controlled by the Karfunkels, who are aggressive in managing their companies. ?Maiden Holdings, another of their companies is in the yellow zone.

Final Notes

I would encourage insurance investors to stick to the green zone for their investing, and maybe the yellow zone if the company has compensating strengths. ?Stay out of the red zone.

This analysis could be improved by using prior year reserve releases as a fraction of beginning of year reserves, and then discounting by 25% each year. ?Next time I run the analysis, that is how I will update it. ?Until then!

Full disclosure: long TRV, ENH, BRK/B, ALL