Insurance – Page 50 – The Aleph Blog

A Tale of Two Insurance Companies

Posted on 4 September 2007 by David Merkel

Before I start this evening, I would simply like to say that revamping the website is more complicated than I initially intended, but I want to do something that looks good, and works well.? I also want to get it right the first time, or soon enough after that to have no noticeable glitch in service.

National Atlantic — for any that bought on my words, you can see why I mentioned buying under $9.75.? I knew there was a big seller out there, and now I know who it is: Loeb Partners.? As of the filing, they still owned 7.1% of the company, and have been sellers well into the 9.70-9.80 region.? As a result, there will be pressure on the stock for a while, the same way there was pressure when Commerce Group was indiscriminately selling stock into the market after the failed takeover.

Once Loeb is done, the stock should lift, and it looks like they are somewhat price sensitive.? This could take while.? If NAHC gets driven below $9, I will be adding more.? But there is no new fundamental data driving the stock at present, just a jilted activist.

Assurant will likely be down tomorrow on the suspension of its buyback.?? I have explained the issues before on the finite reinsurance accounting, and the issues are unchanged since then.

Personally, I think the SEC is trying to make an example out of Assurant, because all of the allegations, if true, aren’t material to the economics of Assurant.? They may lose a number of key employees, but their bench is deep, and the business won’t be harmed.? The value in Assurant derives from their well-protected leading positions in niche insurance markets; that will not be changed by the SEC investigation, or any fines handed out.

If Assurant drops below $48, I will be adding.

Full disclosure: long NAHC AIZ

Tickers Mentioned: NAHC AIZ CGI

The Longer View, Part 2

Posted on 1 September 2007 by David Merkel

When the market gets wonky, I write more about current events.? I prefer to write about longer-dated topics, because the posts will have validity for a longer time, and I think there is more money to be made off of the longer trends.? Before I go there tonight, I would like to say that at present the Fed says that it is ready to act, but it hasn’t done much yet.? As for the Bush Administration, and Congress, they have done nothing so far, and the few credible promises are small in nature.? My counsel: don’t be surprised if the markets stay rough for a while.

Onto longer-dated topics:

Perhaps this should go into my “too many vultures” file, but conservative players like Annaly can take advantage of bargains produced by the crisis.? My suspicion is that they will succeed in their usual modest conservative way.
Falling rates?? Falling equity prices?? Pension funding declines.? This issue has not gone away in the UK, and here in the US, the PBGC is still struggling.? As it is, FASB is facing the issue head on (finally), and the result will likely be a diminution of shareholders’ equity for most companies with defined benefit plans.
China is a capitalist country?? Eminent domain can be quite aggressive there.? At least now they are promising compensation, but who knows whether the government really follows through.
Any strategy, like quant funds, can become overcrowded.? As a strategy goes from little known to crowded, total returns rise and then flatten.? Prospective returns only fall as more and more compete for scarce excess returns.? As the blowout occurs, total returns go negative, and more so for the most leveraged.? Prospective returns rise as capital exits the trade.? Smart quants measure prospective return, and begin liquidating as prospective returns get too low.? Not many do that for institutional imperative reasons (investor: what do you mean cash is building up?? What am I paying you for?), but it is the right strategy regardless.
This is a useful graph of sector weights in the S&P 500.? If nothing else, it is worth knowing what one is underweighting and overweighting.? I am overweight Energy, Basic Materials, Staples, Utilities, and (urk) Financials, and underweight the rest.? My portfolio, right or wrong, never looks like the market.
I’ve written about SFAS 159 before.? Well, we may have a new poster child for why I don’t like it, Wells Fargo.? Mark-to-model is impossible to escape in fixed income, but I would treat gains resulting from changes in model assumptions as very low quality.? Watch SFAS 159 disclosures closely with complex financial companies.? If we wanted to repeat the late 90s headache from gain on sale accounting, we may have created the conditions to repeat the experience in a related way.
How dishonest is the P&C insurance industry?? It varies, as in most industries.? Insurance is a bag of complex promises, which leaves it more open to abuse.? This article goes into some of that abuse, and teaches us to evaluate a company’s claims paying record.? You may have to pay more to get Chubb or Stancorp, but they almost always pay.
China’s financial system is maturing slowly; one example of that is reduced reliance on bank finance, and issuing bonds directly.
I don’t care what regulations get put into place, capitalist economies are unstable, and that’s a good thing.? There are always information asymmetries, and always crowd behavior, such that risk preferences change precipitously.? That’s the nature of the system.? The only true protection is to be aware of this reality, and adjust your behavior before things get crazy.
A firm I was with had an early opportunity to invest in LSV and we didn’t do it.? The two members of our committee that read academic research thought we ought to (I was one), but the practical men of the committee objected to investing with unproven academics.? Oh, well, win some, lose some.
Speaking of academic research, here’s a non-mathematical piece on cognitive biases.? Economists believe that man is economically rational not because of evidence, but because it simplifies the models enough to allow calculations to be made.? They would rather be precisely wrong than approximately right.
Bit by bit, the efficient markets hypothesis get chipped away.? Here we have a piece indicating persistence of excess returns of the best individual investors.? For those of us that have done well, and continue to plug away in the markets, this is an encouragement.? It’s not luck.

I have enough for two more pieces on longer dated data.? It will have to come later.

Tickers Mentioned: NLY WFC CB SFG

Cruising Across Our Speculative Markets

Posted on 29 August 2007 by David Merkel

Quants have it tough.? Few in the investment world really understand what you do, and even fewer outside that world.? To many investment managers, quants are the guys nipping at their heels, clipping their returns, and questioning the need for fundamental analysis.? There comes a kind of schadenfreude when their models blow up, where qualitative mangers get to say, “See, I knew it was too good to be true,” and in the newspapers, a kind of bewilderment at eggheads whose models failed them.

I write this as a hybrid.? I am a qualitative investor that uses quantitative models to aid my processes.? As such, I was hurt, but not badly, but recent market troubles.? Any class of models can be overused, and the factors common to most quant models indeed became overused recently.? Truth is, the models don’t vary that much from quant shop to quant shop, because the market anomalies are well known.? Many of these funds held the same stocks, as seen in hindsight.? Should it surprise us that their results were correlated?

In a situation like this, success tends to breed more success, for a time, as more money gets applied to these strategies.? The statisticians should noticed the positive autocorrelation in excess returns, rather than randomness, which should have tipped them off to to much money entering the trade.? But no.? There was another calculation that could have been done as well, estimating the prospective return from new trades, which was declining as the trades got more popular.? My view is that a quant should estimate the riskiness of his strategy, and compare the returns to those available on junk bonds.? When the return is less than that available from a single-B bond, it’s time to start collapsing the trade.? (What, they won’t pay you to hold cash?? No wonder….)

On a different topic, consider mark-to-model.? I’ve said it before, but Accrued Interest said it better when it said that mark-to-model is unavoidable.? Most bonds in the market do not have a bid at any given time.? Most bonds are bought and held; beyond that, there are multiple bonds for a given company, versus one class of common stock.? The common stock will be liquid, and the bonds merely fungible.? It is even more true for structured securities, where the classes under AAA are very thin.? The AAAs may trade, classes with lower credit ratings rarely do.

Now the same argument is true when looking at a whole investment bank.? How do you mark positions that never trade, and here there is no readily indentifiable bid or ask?? You use a model that is built from things that do trade.? Sad thing is, there isn’t just one model, and there isn’t just one set of assumptions.? It is likely that the investment banks of our world, together with those they deal with, have marked illiquid securities to their own advantage.? Assets marked high, liabilities low.? Aggregate it across all parties, and the whole is worth more than the parts, due to mismarking.

Now for a tour of unrelated items:

There is something about a spike in volume that reveals weaknesses in back offices.? For derivative trading, where there is still a lot of paper changing hands, that is no surprise.
Prime brokerage is an interesting concept.? They bring a wide variety of services to hedge funds, but also compete in a number of ways.? At my last firm, I never felt that we got much out of our prime brokerage relationships for what we paid.? They provided liquidity at times, but not often enough.? Executions were poor as well.
The market sneezes, and we worry about jobs on Wall Street.? Par for the course.? What is unusual here is that few bodies were cut 2001-2003, so pruning may be overdue.? It may be worse because the structured product markets are under stress.
Catastrophe bonds are opaque to most, and Michael Lewis did us a favor by writing this.? That said, though this article begins by suggesting that 2007 will be an above average hurricane season, I ask, “What if it is not?”? It is rare for the hurricane season to shift halfway through the season.? It may be time to buy RNR, FSR, MRH and IPCR.? But regarding cat bonds, they are issued by knowledgeable insurers.? After issue, there are dedicated hedge funds that trade them, taking advantage of less knowledgeable holder, who only originally showed up for the extra yield.
A break in the market affects obscure asset classes as well.? If wealthy hedge fund managers are the marginal buyers of art, and they are getting pinched now, the art market should follow.
Message to Mish: If Bill Gross is shilling for a PIMCO bailout, we are all in trouble.? If the prime mortgage market and the agencies are in trouble, then I can’t think of anyone in the US that will not feel the pain.? I think Bill Gross is speaking his mind here, much as I think that Fed funds rate cuts are not needed, though I also think that they will happen, and soon.
Many emerging debt markets are in better shape than the US, because their current accounts are in better order.? Now, as for this article, Brazil might be okay, but Turkey is not in a stable place here because of their current account deficits, and I would be careful.
Finally we are getting real volatility.? I like that.? It helps keep us honest, and shakes out weak holders and shorts.

See you tomorrow, DV.

Tickers mentioned: IPCR, MRH, FSR, RNR

My Newest Insurance Holding

Posted on 29 August 200729 August 2007 by David Merkel

Earlier today I wrote at Realmoney:

Good Things Come in Small Packages

8/29/2007 11:49 AM EDT

Every now and then, the market serves up a bargain that is hard to realize, because trading liquidity is poor. I was acquiring this stock for just me, and it took ten days for me to do it. (If at the end of this, you want to buy some, use limit orders. Do not use a market order, and do your own due diligence, please.) National Atlantic Holdings is a small (primarily) personal lines insurer selling almost entirely in New Jersey. No debt. 6.9x 2007 and 2008 earnings, 69% of tangible book. It has relatively defensible boundaries in its lines of business, though no one is totally immune from the dangers of over-competition in the personal lines marketplace. I have met management, and I think that they are competent.

Risks:

Up against larger companies that may be more aggressive in pricing.

Though NJ is good at present for insurance, the legal system has delivered some nasty surprises in the past.

Small insurers are subject to the “Law of Small Numbers,” which means that a small number of untoward events can knock the earnings for a loop.

They have missed earnings more frequently than many investors would like. There are a lot of burned value investors here.

There’s more, but these are the basic points that you can begin with as you do your own due diligence.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider National Atlantic Holdings to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long NAHC

Now for the rest of the story: my average cost is $9.60, and I would not recommend buying above $9.75. There has been some big player liquidating his stake at prices under $10, and I am not sure that he is done. There are significant buyers underneath $9.60, but as with many traders they don’t automatically buy when the sellers arrive there. They let the market sag, and then slowly suck in shares at the bid, while letting the bid back up.

I mentioned the law of small numbers above. Well, that can work two ways. When the small numbers result in few claims in a quarter, the stock can pop, and it gets even better if it happens a few times in a row — then a pattern gets inferred by investors, and often wrongly so, but the price runs then.

There is another risk I did not mention above. They are entering a new state, Texas, and new lines (though not in a big way) in New Jersey. I always worry when insurers do that, because they tend to underestimate the risks involved. That said, NAHC tends to be conservative here, and that ameliorates the risk. That, and the CEO own 13% of the company; he has grown it himself, and doesn’t want to spoil what he has built.

Beyond that, their asset portfolio is clean, in my opinion. Their business in NJ depends on partner agents who primarily market to the wealthy of NJ, and try to cover their full insurance needs through package policies that cover their personal insurance needs, and sometimes their business insurance needs. This allows NAHC to compete away from Progressive and GEICO.

Again, there is more to this story, but please do your own due diligence, and if you do buy, be price-sensitive, and don’t use a market order.

Full disclosure: long NAHC

Tickers mentioned: NAHC, PGR

A Baker’s Dozen on Current Issues in the Markets

Posted on 18 August 2007 by David Merkel

If I have the energy this evening, I’ll put up two posts: the first on the near-term, and the second on longer-dated issues.? Then, next week on Monday, I hope to continue addressing the balance sheets of the companies in my portfolio.? I still believe that credit quality will not in general improve, but that companies that can benefit from additional financing and obtain it will be the best off in this environment.

First a few macro pieces.? I usually don’t comment on Nouriel Roubini.? To me, he seeks too much publicity.? Is the present situation worse than LTCM?? Yes and no.? Yes, the entire housing market and housing finance areas are affected, as well as some levered areas in corporate credit — CDOs and loans to private equity.? No, at least not yet.? During LTCM, the solvency of at least one major investment bank (the rumor is Lehman) nearly went down.? That would have been worse than what we have at present by a fair margin.
This piece from Paul Kasriel is interesting.? He brings up the correlation of seemingly unrelated asset classes, and hits the nail on the head by explaining that it id the owners of many risky classes of securities that are forced to sell due to margin calls that drives the rise in correlations.? Then he makes another hit on a favorite topic of mine, Chinese inflation.? That is the greatest threat to the value of the US Dollar and the end of Chinese stimulation of the US through the recycling of the current account deficit.? (At an ISI Group lunch late in 2006, I suggested that Chinese inflation was the greatest threat to the global economy.? Jason Trennert thought it was amusing.)
I disagree a little with this otherwise useful piece from Investment Postcards.? In the middle of the graphic it reads “Subordinate bonds (junk-bond quality) on balance sheet.”? Usually not true.? Banks are typically more senior in the financing structure, unless they originated the loans themselves, and retain the equity residual.? In the first case, there is low probability of a large loss.? In the second case, a high probability of a more modest loss.
Countrywide has certainly scared a number of people, including depositors.? First time I’ve seen anything resembling a bank (S&L) run in a while.? Here’s a quick summary on what went wrong.
Now, US mortgage lenders are not the only ones having trouble, but also those in the UK.? Part of the issue there is that a larger part of their mortgage finance is adjustable rate, which makes rising short rates proportionately more painful there.? Maybe the Bank of England, which has been among the more aggressive inflation fighters, will have to loosen soon.
One problem with securitization is that that legal documents are complex, and arguments over which party has what right become more common when deals go bad.? I’m no lawyer, but expect to see more situations like this one between CSFB and American Home.
Okay, a rundown.? What markets have been hit so far?? Emerging markets, real estate and funds that invest in real estate,? merger arbitrage and LBOs, art, many hedge funds (an article on the demise of Sowood), high yield debt, and the stock market globally.? I’m sure I’ve missed some, but I can’t remember a time when so many implied volatilities went up so much at the same time.
What’s not hurt as much?? Life insurance companies, though you sure can’t tell it from their stock prices.? I like Life the best of all my insurance sub-industries.? This area will come back sooner than most financials.
What might have scared the FOMC most?? The move in T-bills.? It was the biggest rally over one or two days ever, as the Wall Street Journal concludes, that is panic.? Such an incredible bid for safety demonstrated a lack of confidence in the banking system, as well as other riskier elements of the markets.? It’s rare for T-bills and LIBOR to get so out of whack.
But maybe things aren’t that bad, after all, US corporate earnings are rolling ahead at over a 10% rate.? I can live with that.
Is Citadel a rescuer of Sentinel, or a rogue-ish clever firm that took advantage of panic at weakly managed Sentinel? Penson argues for the latter, but if there were multiple bids considered, it may be a difficult case for Penson to prove.? I would guess that Sentinel is toast, and that their clients will take most of the financial hits.
Now, will the carry trade finally blow up?? After the move in the yen on Thursday, some thought so.? Some felt that it would plunge the world into a deflationary collapse.? I don’t think it will be that bad, but it will lead to inflation in the US, and an increase in the purchasing power of Asia and OPEC, at the expense of the US and a host of smaller countries (NZ, Iceland, etc.).? The parallels to LTCM are interesting; that’s the last time the carry trade got blown out.
Finally, Hurricane Dean.? I wasn’t so bold two days ago, but I felt that damage to the US would be limited.? I’m more certain of that now.? (Someone tell the Louisiana Governor that there is no bullseye on her state.)? I’m an amateur meteorologist, but what I do in situations like this is measure the deviation of the track of the storm from the forecast.? In my experience, deviations tend to persist.? That told me that Dean was likely to miss Texas.? That’s more likely now; bad news for Mexico.? Pray for those in harm’s way.

Triage

Posted on 16 August 200717 August 2007 by David Merkel

I’m still working through my portfolio, but I have categorized some stocks:

The Dead — Companies with bad balance sheets, but have been whacked so bad that it is still worth playing

Jones Apparel
Deerfield Capital
YRC Worldwide

Walking Wounded — Companies with okay balance sheets that we feed more cash to

Lafarge
Industrias Bachoco

Seemingly healthy that might have financing problems — Sold

Lithia Automotive
Group 1 Automotive

Uncertain as of yet

Barclays plc

Safe New Names Bought

PartnerRe
Microcap yet to be named when I have my full position on.

More tomorrow. As you can tell, I am positioning my broad market fund more conservatively. I am not optimistic on how we work through the amalgam of debts that might not get paid.

Full disclosure: long PRE IBA DFR JNY YRCW BCS LR

Afternoon Actions

Posted on 16 August 2007 by David Merkel

I sold Lithia Automotive in the late morning for the same reason as Group 1 Automotive.? Mid-afternoon, I replaced the position with PartnerRe.? As I commented at RealMoney:

		David Merkel
		Bought Some PartnerRe
		8/16/2007 3:35 PM EDT

Trades well below adjusted book.

Reserves are conservative even prior to the fact that they don’t discount their reserves.

Reasonable P/E multiple

Quality balance sheet

Quality management team.

Conservative asset policy

Not overexposed to southeastern property risks.

Position: long PRE

What I didn’t mention was how much not discounting their reserves is worth after-tax: nearly $20/share.? Take out a few other items, and you get an adjusted book value of around $85 on a very strong and diversified reinsurer.? I can live with that.

Full disclosure: long PRE

Eight Great Straight Points on Real Estate

Posted on 7 August 20078 August 2007 by David Merkel

So Moody’s tries to clean up its act, and finds itself shut out of rating most Commercial Mortgage-backed Securities [CMBS] deals? That’s not too surprising, and sheds light on the value of ratings to issuers and buyers. With issuers, it’s easy: Give me good ratings so that I can sell my bonds at low yields. With buyers, it is more complex: We do our own due diligence — we don’t fully trust the ratings, but they play into the risk management and capital frameworks that we use. We like the bonds to be highly rated, and misrated high even better, because we get to hold less capital against the bonds than if they were correctly rated, which raises our return on capital. Moody’s was always in third place behind S&P and Fitch in this market, so it’s not that big of a deal, but I bet Moody’s quietly drops the change.
The yields on loans are not only going up for LBOs like Archstone, leading to further deal delays, but yields are also rising on commercial real estate loans generally. Here is an example from one of the big deals. The risk appetite has shifted. Is it any surprise that equity REITs are off so much since early March? The deals just can’t get done at those high cap rates anymore.
An old boss of mine used to say, “Liquidity is a ‘fraidy cat.” It’s never there when you really need it, and with residential mortgage finance now, the ability to refinance is being withdrawn at the very time it is needed most. What types of mortgages are now harder to get? No money down, Jumbo loans, Alt-A, more Alt-A, and you don’t have to mention subprime here, the pullback is pretty general, with the exception of conforming loans that are bought by Fannie and Freddie. For (perverse) fun, you can see how detailed the guidance to lenders can become.
Should it then surprise us if some buyers of mortgage loans have gotten skittish? No, they forced the change on the originators. A buyers strike. But maybe that’s not the right move now. Let me tell you a story. When I came to Provident Mutual in 1992, the commercial mortgage market was in a panic. The main lines of business of Provident Mutual, hungry for yield, had accepted low-ish spreads from commercial mortgages from 1989-1991, because it improved their yield incrementally. The Pension Division avoided commercial mortgages then, because they felt the risks were not being fairly compensated. In 1992, the head of the commercial mortgage area came to the chief actuary of the pension division, and told him that unless the Pension Division bought their mortgage flow, they would have to shut down, because the main lines couldn’t take any. The chief actuary asked what spreads he would get, and the spreads were high — 3% over Treasuries, much better than before. He asked about loan quality, and was told that they had never had such high quality loans; only the best deals were getting done because of the panic in the market. The chief actuary, the best actuarial businessman I have ever known grabbed the opportunity, and took the entire mortgage flow for the next two years, then stopped. (Saving the Mortgage Division was icing on the cake.) Spreads normalized; credit quality was only average, and the main lines of the company now wanted mortgages. The point of the story is this: the firms that will do best now are not the ones that refuse to lend, but the ones who lend to high quality borrowers at appropriate rates. It’s good to lend selectively in a panic.
Eventually the ARM mortgage reset surge will be gone. Really. We just have to slog through the next two years or so. This will lead to additional mortgage delinquencies and defaults. We’re not done yet. There is a lot of mis-financed housing out there, and unless the borrowers can refinance before the fixed rate period ends to a cheap-ish conventional loan, I don’t see how the defaults will be avoided. Remember houses are long-term assets. Long term assets require long-term financing. Floating rates don’t make it. Non-amortizing loans don’t make it.
Should it then surprise us that the downturn in housing prices is large? No. With all of the excess supply, from home sellers and homebuilders, current prices are not clearing most of the local real estate markets, and prices need to fall further. (Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. A win-win-win. Excess supply goes away. Current account deficit reduced. Wealthy foreigners get a safe place to flee, should they need it. 😉 )
As a result, the homebuilders are doing badly. They aren’t making money on the hgomes they build and the value of the land (and land options, JVs, etc.) that they bought during the frenzy is worth a lot less. Sunk costs are sunk, and though you lose money on an accounting basis, in the short run, it is optimal to builders to finish developments that they started.
Could I get John Hussman to like this Fed Model? It’s from the eminent Paul Kasriel, and it compares the earnings yield of residential real estate and Treasury yields, and he suggested in early June that residential real estate was overvalued. There are limitations here; no consideration of inflation and capital gains, no consideration of the spread of mortgage yields over Treasuries. The result is clear enough, though. Don’t own residential real estate when you can earn more in Treasuries than you can in rents. (I know real estate is local, frictional costs, etc., but it does give guidance at the margins.)

Dealing with Underperformance

Posted on 7 August 20077 August 2007 by David Merkel

Over the past seven years, my broad market strategy done well against the S&P 500. I reach the seven year anniversary at the end of August, and should business prospects require it, I will get the results audited. But since the start of the quarter, the strategy has not done so well, trailing the S&P by a little less than 4%. Why have the results been so bad?

My portfolio has concentrations in a number of areas. I have a slight overweight in financials (though only one company affected by the current crises), a large overweight in energy, and an overweight in cyclicals, though cyclicals targeted at foreign demand, not US demand. These areas have underperformed, and so have I. Industries are 60% of the performance of the market in my opinion, so when you run a portfolio that concentrates industries, there will be periods of underperformance.

Value is out of favor at present as well. My approach is “all cap” value; I don’t care about the size of companies that I buy. I’m only 2% or so behind the Russell 1000 Value, but I am more than 4% ahead of the Russell 2000 Value. Small cap value has gotten smashed, and I am a partial casualty along with it.
So, maybe I’m not doing that badly. What I do at times like this is to try to identify the factors leading to underperformance and ask whether those factors are likely to persist for a year or more. Let me go through my major exposures, updating what I wrote previously:

Energy ? Integrated, Refining, E&P, Services, Synfuels. I am still a bull here; we aren’t finding enough energy supplies to meet the needs of our growing world. (15%)
Light Cyclicals ? Cement, Trucking, Chemicals, Shipping, Auto Parts. These areas are undervalued, given the way our world is growing. (20%)
Odd financials ? European banks, an odd mortgage REIT [DFR]. Largely insulated from the credit crises, and cheap. (10%)
Insurance — AHL, AIZ, SAFT, and LNC. All of them cheap, and with good earnings prospects. (10%)
Latin America ? SBS, IBA, GMK. All are plays on the growing buying power in Latin America. (8%)
Turnarounds ? SLE, JNY. Give them time; Rome wasn?t burnt in a day. (5%)
Technology ? NTE, VSH. Stuff that is not easily obsoleted. (5%)
Auto Retail ? LAD, GPI. Out of favor. (5%)
Cash (15%) — 5.25%/year is not bad.

That’s 93% of my broad market portfolio. Three other miscellaneous companies make up the rest. You can find the complete portfolio here.
After writing this, my tentative conclusion is that my methods still work, but that I am fighting temporary setbacks from value being out of favor, and from financials getting taken out and shot, even if there is no connection to the current credit crises. Therefore I soldier on, trusting the methods that have brought me this far.

Full disclosure: long LAD GPI NTE VSH SLE JNY SBS IBA GMK AHL AIZ SAFT LNC DFR

A Tale of Two Insurance Companies

Posted on 6 August 20076 August 2007 by David Merkel

As I write this, I am listening to a replay of the RAM Holdings Conference Call that happened on Monday.? RAM Holdings did not have a good day in the market yesterday, losing 44.5%? of their market value.? What went wrong?

Investors are more attuned to subprime, and so the merest hint of trouble sends them running for the exits.
They are more attuned to CDOs, and so the merest hint of trouble sends them running for the exits.
They commented that premium volume might decline over the remainder of the year.
They only met the earnings estimate.
The cost of their soft capital facility has risen to LIBOR+200, the maximum, leading them to question whether they can’t replace the facility with something better.?? (My guess? No.)
The conference call focused on subprime, CDOs, and the more shadowy bits of their guarantees.

So what does RAM Holdings do?? They reinsure the primary AAA financial guarantors.? They are the only AAA reinsurer that does not compete with the primary insurers.? Typically, they try to take an equal slice of all of the business that MBIA, Ambac, FGIC, FSA, and the three others produce each year.? In that sense, you can think of them as a small version of what the average of the financial guarantee industry would be like if it were a single company.? Unlike a P&C reinsurer, losses kick in only after a threshold is met, and then a lot of losses get paid, with RAM Holdings, the losses are pro-rata from the first dollar.? The primary insurers would have no advantage passing them bad business, because they would be more affected by the bad business.

I’m reviewing RAM Holdings as a possible purchase candidate.? If I were running a small cap fund, I would definitely start tossing some in now.? Why?? It’s trading at less than 35% of adjusted book value, and the balance sheet is good in my opinion, and the opinions of S&P and Moody’s.?? If I were running a hedge fund, I would buy RAM and short equal amounts of MBI, ABK, SCA and AGO.? Why?? If RAM is really in this much trouble, it is likely that MBIA, Ambac, Security Capital and Assured Guaranty are in the same trouble.

Aside from that, their subprime exposure is small-ish and seasoned.? Their CDO exposure is almost all AAA, with super-senior attachment points (i.e. non-guaranteed AAA bonds would have to lose it all before thet pay dollar one of guarantees).? Honestly, I’m probably more concerned about the BBB HELOC and closed-end second lien mortgage exposure.? I would need more data on that before I could act.

Then there’s Safety Insurance, which was up 12.0% on Monday.? What went right?

Unlike Commerce Group, which missed, they beat estimates handily.
They raised their dividend by 60%, from $1.00 to $1.60.
They announced a $30 million buyback (and they have the money to do it).
The asset side of their balance sheet carries little credit risk.

Now, Safety faces its challenges as the Massachusetts auto insurance market possibly partially deregulates, but Safety has successfully competed in a variety of different market regimes in the state.? The current management team has shown itself to be very adept at adjusting to changing conditions.

Even with change, Massachusetts will still be the most heavy handed state in the US with auto insurance.? It won’t attract a lot of new entrants.? And, it is possible that no change will happen… previous deregulatory plans have come and gone, though this one has more political clout behind it.

Safety is still cheap to me at 1.0x book value, and 7.6x 2008 estimated earnings.? I’m hanging around for more.

Full Disclosure: long SAFT