Insurance – Page 9 – The Aleph Blog

Letters from Readers

Posted on 12 October 2013 by David Merkel

I’ve been reading your blog for quite sometime and I’ve always been astounded by your vast knowledge of just about everything in investments. I’m new to this game and I hope to learn from you, which brings me to the following:

I know we have to calculate “float”, “cost of float” and find the “combined ratio” for an insurance company to value it more accurately. However, I’ve spent hours googling around and I still can’t find what exactly in the balance sheet/P&L/CF statement (or even in the footnotes!) that constitutes as:

loss adjustment expense,?unearned premiums,?other policyholder liabilities,?premium balance receivable,?loss recoverable from reinsurance ceded,?deferred policy acquisition costs,?deferred charges on reinsurance,?related deferred income tax, etc.?

In most insurance companies’ balance sheets, all I see are the usual suspects “cash & cash equivalents”, “goodwill”, “intangible assets”, “derivative financial instruments”, “PPE” and the likes. I’ve never seen any of those above-mentioned terms, are there substitute words for them? I’m obviously missing something out. Thank you for your time!

Let’s clear something up here — there is no GAAP financial statement item called float.? What is float?? Let me teach you something deeper.? How does a property & casualty insurer invest?

There is some wiggle room around this, but typically, the premium reserves are invested in high quality short-term debt.? Premium reserves represent the premiums paid in advance that have not yet been taken into income, because some insureds don’t pay month-by-month, but they have paid for many months in advance.? They are often called unearned premiums.

Claim reserves are typically invested in longer-term debt, where the term of the debt will approximately match the period over which the claim will be paid.? Much of the claim reserves fall into the category “Incurred but not Reported [IBNR].? Insurance claims are not always filed immediately.

Finally, the surplus of the insurance company is usually invested in risk assets — equities, private equity, real estate — whatever area the insurance company thinks they have expertise to make money.

The first two categories, premium and claim reserves, comprise float.? You can try to measure them by looking at the statutory statements of the insurer, where those are real line items on the liabilities page, or you can approximate it by looking at the current liabilities, and adding in the claim reserve, which is usually in one of the footnotes.

Reinsurance can mess this up a little, so try to work with numbers net of reinsurance.

Property & Casualty Insurers do not have to credit interest as they delay paying claims, or receive premiums in advance.? Thus the concept of float.? Few insurers use float to be as aggressive as Buffett.? They invest more conservatively, especially among insurers where claims get paid quickly (home & auto).? With long-tailed claims, like asbestos & environmental, the claims may take so long to emerge that the insurer can be investing in stocks, and that will be the optimal investing decision.

The so-called “cost of float” is net underwriting losses.? If there are no net underwriting losses, float is free, or more often, is a source of profit.

But float isn’t worth much unless you have a clever investor investing the cash that stems from the delay of paying claims.? Even with Buffett, that advantage is uncertain.

Tell you what, I never analyze float in insurance.? I analyze management teams.? Insurance is uncertain enough, that I want a margin of safety, and the best way that I can do that is find management teams that are conservative.? Do they consistently make money on underwriting?? Do they occasionally/frequently deliver negative surprises?

I wouldn’t spend time on float.? Any insurer can generate float.? Look at how they make money.? How do they underwrite?? How do they invest?? Are they conservative in their accounting?? That is what you should look for.

Next letter:

I hope you are doing well.? I have been reading your blog for the last few years and have found myself thoroughly educated and entertained.? My favorite series of posts has been your explanation on the holders’ hands, which is a unique and more useful way of classifying market participants, rather than just using timeframe.

A little bit about myself: I am currently a student at zzzzzzzzz studying Economics and before that I was in the Marine Corps Reserves where I served a tour in Iraq.?

I managed to save some money from that time and began investing, which dovetailed nicely with my burgeoning interest in macroeconomics (particularly through the Austrian and Post-Keynesian lens).

As I learned from my mistakes and improved, I recently felt confident enough to form my own LLC in the hopes of bringing on close family and friends as part owners (essentially limited partners) and manage our savings in a more productive and less expensive manner than the current meta of mutual funds or indexing.

This brings me to the the reason I am emailing you: suppose I would like to expand this type of business…How would I go about this? Am I reliant on word of mouth via friends and family?? I also plan to talk to the Small Business Administration for investors, but I don’t think anybody will even give me a chance until at least after a few years.?

Would it be feasible to talk to pension/asset management firms for interest in investing?? I would love to hear your opinion on the matter and please let me know if there is someone more appropriate for me to send this email to.

If I have this straight, you have started a firm that invests in other firms, not all that much different from Buffett in his days after ending his limited partnership.? In this case, you are limited by the number of people that can invest in your private firm, which in these days, I believe is 1000 people.? I could be wrong here, so consult competent legal counsel to guide you.? Not sure how the SBA would fit in here, though I know they aid funding small firms together with venture capitalists.

What you are doing is too small for pension and asset managers.? Given the JOBS Act, your best option is to recruit medium-sized investors, and invest wisely.? Given that you run a private firm, you might not want to limit yourself to public companies.? You might be able to compound capital faster by buying whole small companies, or large portions of medium-sized companies.

Of course, this all presumes that you have a real talent here.? If you’re not sure, give it up now, and give the capital back to your shareholders.

I wish you well, but if you are doing public assets, far better that you do what I do and manage separate accounts for investors.? It’s a lot cleaner.

On Tower Group

Posted on 9 October 2013 by David Merkel

Lo, how the mighty have fallen.

Let’s take a step back and see the full stock chart.

My, but Tower Group [TWGP] was a juggernaut in its time, but I never bought it or sold it.? Let me explain:

In 2005 my boss at the hedge fund came to me and said, “Why don’t we own Tower Group?? One of my friends owns it and says it is the greatest company in insurance.”

Me: “They are a new company underwriting in tough lines, with a weird reinsurance agreement from a small Bermuda company.? They are growing too fast, and I doubt they are as profitable as they claim.”

Boss: “Well, should we short them then?”

Me: “I don’t think shorting into strength is smart, so no.? We should do nothing here.” (After a little more, boss leaves, probably annoyed at me because I recommended no action.? He was a man of action!? I am a prudent risk-taker, and very selective about when I short.)

As an analyst of insurance stocks, I was always skeptical of Tower Group for three reasons:

The acquisitive nature of Tower Group.
The rapid growth in premiums, 52% per year over the last 10 years — no insurance company can successfully grow that rapidly in a mature market.
Odd reinsurance agreements that made me wonder.

But by the time I ceased being a buy side analyst for a hedge fund in 2007, there was nothing to make me short Tower Group, much as I did not like it.? And so, I stopped following the company, because it is much easier to look only for companies to be long.? (TWGP remained on my “consider shorting” list till the end of 2007.)

I stopped following it.? Had I been following it, I would have noted the unusual strengthening of reserves for losses from prior year business (Page F-32, worth $69 Million) from the 10-K filed on 3/4/2013.? Someone selling on that day or soon after would have received something in the $18s/share vs. $4s/share now.? Large reserve strengthenings are often a harbinger of greater reserve strengthenings to come.

After their writedown, Tower Group was downgraded by the rating agencies to the degree that few will buy new insurance or reinsurance from them.? Further, they are seeking a buyer, and the buyers are skittish.

Thus, the company is probably in runoff. Runoff means there are no more new premiums, and the company aims to pay all legitimate claims until it closes its doors, hopefully leaving the equity investors a little.? Unless you are an expert, I would avoid taking any action here.? It is quite possible that reserves were set fraudulently, and that we have been given as much as the market can absorb in losses.? It’s also possible that the third-party actuaries have given a conservative view of reserves, and things get better from here.

I feature this company tonight to indicate how fraught with uncertainty it is to invest in insurance stocks, particularly those that grow premiums fast — that is usually a negative sign.

I have no idea where Tower Group goes from here, but they are a poster child for past fast growth and weak reserving.

The Education of an Investment Risk Manager, Part IX (The End)

Posted on 3 October 2013 by David Merkel

I’m bringing this series to a close with some odds and ends — a few links, a few stories, etc.? Here goes:

1) One day, out of the blue, the Chief Investment Officer walked into my office, which was odd, because he rarely left the executive suite, and asked something like: “We own stocks in the General Account, but not as much as we used to.? How much implicit equity exposure do we get from our variable annuities?”? The idea was this: as the equity markets go up, so does our fee stream.? If the equity market goes up or down 1%, how much does the present value of fees change?? I told him I would get back to him, but the answer was an easy one, taking only a few hours to calculate & check — the answer was a nickel, and the next day I walked up to the executive suite and told him: “If we have 20% of our liabilities in variable annuities it is the equivalent to having 1% of assets invested in the stock market.

2) This post, Why are we the Lucky Ones? could have been a post in this series.? At a small broker-dealer, all sorts of charlatans bring their ideas for financing.? The correct answer is usually no, but that conflicts with hope.? Sadly, Finacorp did not consult me on the last deal, which is part of the reason why they don’t exist now.

3) The first half of the post, The Education of a Mortgage Bond Manager, Part IX, would also fit into this series — the amount of math that went into the analysis was considerable, but the regulatory change that drove it led us to stop investing in most RMBS.

4) While working for a hedge fund, I had the opportunity to sit in on asset-liability management meetings for a bank affiliated with our firm.? I was floored by the low level of rigor in the analyses — it made me think that every bank should have at least one actuary to do analyses with the level of rigor in the insurance industry.

Now, this doesn’t apply to the big banks and investment banks because of their complexity, but even they could do well to borrow ideas from the insurance industry, and do stress testing.? Go variable by variable, on a long term basis, and ask:

At what level does this bring line profits to zero?
At what level does this bring company profits to zero?
At what level does this imperil the solvency of the company?

5) This story is a little weird.? One day my boss called me in and said, “There’s a meeting of corporate actuaries at the ACLI in DC.? You are our representative.? They will be discussing setting up an industry fund to cover losses from failures of Guaranteed Investment Contracts.? Your job is to make sure the fund is not created.”

His concern in 1996 was that it would become a black hole, and would encourage overly aggressive writing of GICs.? He didn’t want to get stuck with losses.? I told him the persuasion was not my forte, but I would do my best.? I said that my position was weak, because we were the smallest company at the table, but he said to me, “You have a voice at the table.? Use it.”

A few days later, I was on the Metroliner down to DC.? I tried to understand both sides of the argument.?? I even prayed about it.? Finally it struck me: what might be the unintended consequences from the regulators from setting up a private guaranty fund?? What might be the moral hazard implications?

At the meeting, I found one friend in the room from AIG.? We had worked together, and AIG didn’t like the idea either.? In the the early parts of the meeting it seemed like there were 10 for the industry fund, and 3 against, AIG, Principal, and us.? Not promising.? We talked through various aspects of the proposal, the three representatives taking the opposite side — it seemed like no one was changing their minds, but some opinions were weaker on the other side.

By 3PM the moderator asked for any final comments before the vote.? I raised my hand and said something like, “You have to think of the law of unintended consequences here.? What will be the impact on competition here?? What if one us, a large company decides to be more aggressive as a result of this?? What if regulators look at this as a template, and use it to ask for similar funds more broadly in life insurance??? The state guaranty funds would certainly like the industry to put even more skin into the game.”

The room went silent for a few seconds, and the vote was taken.

4-9 against creating the guaranty fund.

The moderator looked shocked.

The meeting adjourned and I went home.? The next day I told my boss we had won against hard odds.? He was in a grumpy mood so he said, “Yeah, great,” barely acknowledging me.? This is the thanks I get for trying something very hard?

6) In early 2000, I had an e-mail dialogue with Ken Fisher.? I wanted to discuss value investing with him, but he challenged me to develop my own proprietary sources of value.? Throw away the CFA syllabus, and all of the classics — look for what is not known.

So I sat down with my past trading and looked for what I did best.? What I found was that I did best buying strong companies in damaged industries.? That was the key idea that led to my eight portfolio rules. Value investing with industry rotation may be a little unusual, but it fit my new view of the world. I couldn’t always analyze changes in pricing power directly, but I could look at industries where prices had crashed, and pick through the rubble.

In Closing

My career has been odd and varied, which has led to some of the differential insights that I write about here.? In some ways, we are still beginning to understand investment risks — for example, how many saw the financial crisis coming — where a self-reinforcing boom would give way to a self-reinforcing bust?? Not many, and even I did not anticipate the intensity of the bust.? At least I didn’t own any banks, and only owned sound insurers.

Investment risk is elusive because it depends partly on the collective reactions of investors, and not on external shocks like wars, hurricanes, bad policy, etc.? We can create our own crises by moving together in packs, going from bust to boom and back again.

It is my hope after all these words that some will approach investing realizing that avoiding risks is as important as seeking returns, and sometimes, more important.? It is not what you earn, but what you keep that matters.

The Education of an Investment Risk Manager, Part VIII

Posted on 2 October 2013 by David Merkel

“So you’re the new investment risk manager?”

“Yes, I am,” I said.

CA: “Well, I am the Chief Actuary for [the client firm].? I need you to do a project for me.? We have five competitors that are eating our lunch.? I want you to figure out what they are doing, and why we can’t do that.”

Me: “I’ll need to get approval from my boss, but I don’t see why not.? A project like this is right up my alley.”

CA: “What do you mean, right up your alley?”

Me: “I’m a generalist.? I understand liabilities, but I also understand financing structures, and I can look at assets and after a few minutes know what the main risks are and how large they are.? I may not be the best at any of those skills, but when they are combined, it works well.”

CA: “When can you have it to me?”

Me: (pause) “Mmm… shouldn’t take me longer than a month.”

CA: “Great.? I look forward to your report.”

The time was late 1998, just prior to the collapse of LTCM.? Though not well understood at the time, this was the “death throes” of the “bad old days” in the life insurance industry for taking too much asset risk.? Yes, there had been bad times every time the junk bond market crashed, and troubles with commercial mortgages 1989-1992, but the industry had not learned its lessons yet.

The 5 companies he picked were incredibly aggressive companies.? One of them I knew from going to industry meetings came up with novel ways of earning extra money by taking more risk.? I thought the risks were significant, but they hadn’t lost yet.

So what did I do?? I went to EDGAR, and to the websites of the companies in question.? I downloaded the schedule Ds of the subsidiaries in question, as well as the other investing schedules.? I read through the annual statements and annual reports.? I had both my equity investor and bond investor “hats” on.? I went through the entirety of their asset portfolios at a cursory level, and got a firm understanding of how their business models worked.

Here were the main findings:

These companies were using double, and even triple-leveraging to achieve their returns.? Double-leveraging is a normal thing — a holding company owns an operating insurance subsidiary, and the holding company has a large slug of debt.? Triple leveraging occurs when a holding company owns an operating insurance subsidiary, which in turn owns a large operating insurance subsidiary.? This enables the companies to turn a small return on assets into a large return on equity, so long as things go well.
The companies in question were taking every manner of asset risks.? With some of them I said, “What risks aren’t you taking?”? Limited partnerships, odd subordinated asset-backed securities, high yield corporates, residential mortgage bonds with a high risk of prepayment, etc.

So, when I met with the Chief Actuary, I told hid him that the five were taking unconscionable risks, and that some of them would fail soon.? I explained the risks, and why we were not taking those risks.? He objected and said we weren’t willing to take risks.? As LTCM failed, and our portfolios did not get damaged, those accusations rang hollow.

But what happened to the five companies?

Two of them failed within a year — ARM Financial and General American failed because they had insufficient liquid assets to meet a run on their liquidity, amid tough asset markets.
Two of them merged into other companies under stress — Jefferson Pilot was one, and I can’t remember the other one.
Lincoln National still exists, and to me, is still an aggressive company.

Four of five gone — I think that justified my opinions well enough, but the Chief Actuary brought another project a year later asking us to show what we had done for them over the years.? This project took two months, but in the end it showed that we had earned 0.70%/yr over Single-A Treasuries over the prior six years, which is? a great return.? The unstated problem was they were selling annuities too cheaply.

That shut him up for a while, but after a merger, the drumbeat continued — you aren’t earning enough for us, and, in 2001-2, how dare you have capital losses.?? Our capital losses were much smaller than most other firms, but our main client was abnormal.

To make it simple, we managed money for an incompetent insurance management team who could only sell product by paying more than most companies did.? No wonder they grew so fast.? If they had not been so focused on growth, we could have been more focused on avoiding losses.

What are the lessons here?

Rapid growth with financials is usually a bad sign.
Analyze liability structures for aggressiveness.? Look at total leverage to the holding company.? How much assets do they control off of what sliver of equity?
If companies predominantly buy risky assets, avoid them.
Avoid slick-talking management teams that don’t know what they are doing.? (This sounds obvious, but 3 out of 4 companies that I worked for fit this description.? It is not obvious to those that fund them.)

And sadly, that applied to the company that I managed the assets for — they destroyed economic value, and has twice been sold to other managers, none of whom are conservative.? Billions have been lost in the process.

It’s sad, but tons of money get lost through some financials because the accounting is opaque, and losses get realized in lumps, as “surprises” come upon them.

Be wary when investing in financial companies, and avoid novel asset risks, credit risk, and excess leverage.

The Education of an Investment Risk Manager, Part VI

Posted on 29 September 201329 September 2013 by David Merkel

My boss walked in and said that we needed to terminate our annuity reinsurance treaty with an entity that I will call Bigco (this happened in July).? Senior management had deemed that we should do it, and in days we visited Bigco, assuming that the actuary in question would approve a termination of the treaty where:

There was no termination provision.
There was a guaranteed minimum return to the reinsurer.
The reinsurer had participation in the upside of profits.

Who negotiated such a treaty?? Very one-sided, and Bigco needed to deploy capital, not contract it.

Could a negotiating position be worse?? Yes, it could, just wait.

When we got to Bigco, we talked with the actuary for a little while, and then he handed us over to the head of M&A.? Uh-oh, he sized up the situation perfectly, and denied our request, unless we were willing to pay considerably above book value to repatriate the assets.

We went home depressed, and a few months after that my boss was summarily fired.? In those days, September was the firing time.? You can imagine what that did for morale.? Personally, I expect my boss was fired because he was most similar the the CEO, and had done things well in managing his line of business.

One day the chief actuary came to me and said, “We have to terminate that treaty.”? I explained to him the backstory, that we had offered to buy it back at an ROE of 9%, and Bigco was demanding 6%.? I said to him, “I’ve already compromised the 10% ROE objective of our company, I don’t want to go further.? I’m free to walk away, right, if we can’t get a decent price?”? He said, “No, the deal must be done.? Under no circumstances can you walk away.”

The sad thing was that any termination of the treaty would positively affect management bonuses.? (That was the real target.)

I had a strong sense that I should always serve the ultimate owners of the firm — the dividend receiving policyholders.? But this was at variance from that.

So, with the weakest bargaining hand that I can imagine, I used the following strategy.? I did nothing.? Nothing. Nothing until early December, where I called the M&A guy at Bigco and and told him, “I’ve had a change of heart.? I’ll accept an ROE of 6.9%.? That’s my final offer!”? This was ticklish because I *had* to get the deal done.

He bit on the offer, and I pressed him saying that between this time and the closing, my market value adjustment formula would rule.? He agreed.? (He probably had a profit goal as well, which was what I was counting on.)

But, he didn’t look closely at the Market Value Adjustment formula.? I gave him one that was volatility-loving, that would adjust of the greater of the absolute value of the yield changes in 3-month T-bills or 30-year Treasury Bonds.? Don’t criticize the guy too much, the Federal Reserve fell for the same tactic on GICs they bought from us.

Before the deal closed, the Fed started tightening monetary policy, and the Market Value Adjustment got us out at an ROE of 9.1%.? What a win, and for the policyholders.? Management got more as well, and I got almost nothing.

I took risks trying to do the right thing, praying the God would help me, and in this case, it worked.? Can you be more righteous than your management team?? In most cases, no, but in this case I succeeded.

I would say to all, try to serve the interests of owners rather than management.? Act like an owner, not like a manager hauling down a fat salary.

Sorted Weekly Tweets

Posted on 21 September 2013 by David Merkel

Monetary Policy

Buffett Calls Fed History?s Greatest Hedge Fund http://t.co/vToZwL7D21 Buffett great on practical business economics, lousy on politics $$ Sep 21, 2013
Bernanke Faith in Housing Seen Shaken in Bonds http://t.co/F0xtRsM13v The Fed never had control of the long end of the yield curve $$ #barmy Sep 20, 2013
The Fed has lost all credibility http://t.co/NhXbQjxiNa For an institution that values clear communications, things have been murky $$ Sep 19, 2013
Excellent question on financial regulation from the lady from the American Banker. $$ Sep 18, 2013
Good question from @pdacosta on the labor force participation rate and unemployment. $$ #Fed Sep 18, 2013
Less Tapering Becomes Tightening Credit No Matter What Fed Says http://t.co/rQMp900dxA Q: what total pkg does 2 forward rate expectations $$ Sep 17, 2013

Janet Yellen (we get what we deserve)

White Houses Urges Democratic Senators to Defend Yellen http://t.co/pBd1U1dz7u She seems like a lock: to QE Infinity & Beyond! $$ #FTL Sep 21, 2013
Yellen Chances Grow as Obama Aides Test Senate Support http://t.co/kbDdWmlX4L “She will make Bernanke look like a hawk.” Marc Faber $$ Sep 19, 2013
White House official says Yellen front runner for Fed chair http://t.co/wGor8xIJoI This is to make us oppose the uber-dove #anyonebutyellen Sep 19, 2013
Yellen No Lock for Fed Chair Despite Summers Exit http://t.co/ycEBcedvTe “This was an unprecedented struggle for leadership of the Fed.” $$ Sep 17, 2013
Yellen Now Front-Runner for Fed Chief http://t.co/H4xh8vmot1 Yellen means no change from the current failed policies $$ #anyonebutyellen Sep 17, 2013
Fed Leader Doubt Erodes Low-Rate Message as QE Taper Looms http://t.co/CgyxacYaap Can’t appoint Yellen now, lest it look like a loss $$ Sep 16, 2013
Why Larry Summers Bailed on the Fed http://t.co/lVn10kgYIL Bring on Don Kohn, better still, bring on that monetary dissident John Taylor $$ Sep 16, 2013

Rest of the World

Bermuda’s Search for New Wealth http://t.co/LPMJJvD6QE I like Bermuda a lot, & learned a lot here. No paparazzi, much privacy $$ #humble Sep 20, 2013
Rebel-on-Rebel Violence Seizes Syria http://t.co/LsZUvpQTuo Two player games r easy; Three-or-more player games r tough & confusing $$ Sep 20, 2013
What Happens When the US Isn?t the Biggest Gas Guzzler? http://t.co/pl8X9TkOUM 1 reason y I am long energy stocks: rising global demand $$ Sep 20, 2013
Olympic Athletes in Tokyo Risk Hottest Weather in 120 Years http://t.co/4E9MnDTzv5 Same for FIFA in Qatar, but humidity in Tokyo is a factor Sep 19, 2013
Why Even the Worst Bloggers Are Making Us Smarter http://t.co/PhztCBG6kP It is amazing how many people are writing their ideas on the web Sep 19, 2013
China?s Choking Cities Means Job Cuts at Steel Town: Commodities http://t.co/3Xmz1Z7zqh China has over-invested in heavy industry #japan1989 Sep 19, 2013
In Post-Tsunami Japan, Homeowners Pull Away From Grid http://t.co/kPUIVdYq8b Power is now less reliable, some move to solar & fuel cells Sep 19, 2013
What Egypt Wants: Cheaper Bread http://t.co/S8NE6Zo8JU Demand for Subsidized Food Vexed Ousted President and Pressures Interim Government Sep 19, 2013
Obama Rifts With Allies on Summers-Syria Limit Debt Dealing http://t.co/M8f1f1fPm6 Weakened by bad choices but he is the President! $$ Sep 18, 2013
How Did Advanced Economies Get in So Much Debt? http://t.co/QGF1acUQf8 They absorbed bad private debts, rather than letting them fail $$ Sep 18, 2013
On Putin, his NYT editorial: http://t.co/eb45qkGBq1 Peggy Noonan responds: http://t.co/qwFRsk83cR Avoid interfering in foreign wars $$ Sep 18, 2013
Canadian Household – Drowning in Debt http://t.co/hJz8057OMF Total Canadian Household Debt-to-Income Ratio Rises to Record 165.6% @ 6/13 $$ Sep 17, 2013
$$ @paulvieira Point taken. Q: If someone bot an avg house in Canada 2 rent it out, would he make money; if arb is neg, Canada faces probs Sep 17, 2013
Eleven Countries with Soaring Inflation http://t.co/xl6Ivzr5bx Soaring means >6%/yr; leading the parade are Venezuela, Argentina & Egypt $$ Sep 17, 2013
Political Risk: What Should Investors Know About China’s Interest In Peru? http://t.co/85wGZJ1x3W Biz in Peru means negotiate w/locals $$ Sep 17, 2013
Smallest Ships Profitable Again as Logs Feed China Boom http://t.co/YsPOJMW9ul Chinese demand for wood raises freight 4 small ships $$ Sep 17, 2013
Vladimir Putin, the Richest Man on Earth http://t.co/bpLFDXtPWw Who needs wealth when you control a country? Putin makes his cronies rich $$ Sep 17, 2013
China Reins in Popular Voices With New Microblog Controls http://t.co/0tlX38uI1q The internet is a threat & an aid 2 every government $$ Sep 17, 2013
No Confidence in China Markets Inflates Housing Bubble http://t.co/G8qgXC8OEW Distrust other assets leads Chinese 2 invest in real estate $$ Sep 17, 2013
Germany’s Migrating Seniors http://t.co/Bhsqr6TePo Good care cheap, but you have to move 2 Poland to get it. Solves some old age problems $$ Sep 17, 2013
Germans Export Grandma to Poland as Costs, Care Converge http://t.co/e9w45mHkQe But where will the Poles export their Grandmas? $$ #long Sep 17, 2013

US Politics & Policy

Benghazi investigators gave Hillary Clinton heads-up on findings http://t.co/6Oimx1LhSx Mrs. Clinton appointed 80% of the review board $$ Sep 21, 2013
Weeds amidst the ivy |http://t.co/nvMFuNioFN A long & relatively thorough analysis of for-profit colleges & how they milk student loans $$ Sep 21, 2013
House GOP Ties Government Funding to Health Law http://t.co/rcNBBl2c6m This is a Q of short- vs long-run. Balancing budget best 4long-run $$ Sep 20, 2013
Big Insurers Skip Health Exchanges http://t.co/JWvGJSYVdQ Y deal w/ markets that attract sick people w/limits on underwriting & pricing? $$ Sep 20, 2013
What caused the financial crisis? The Big Lie goes viral http://t.co/1qFMg1BYGo The crisis was not merely caused by bad regulation Sep 19, 2013
The Queen Mary of macro trends: Rising rates http://t.co/OSgaYzIQkg Less certain than article says, as the economy weakens, no loan growth Sep 19, 2013
Walgreen will drop its traditional health insurance and instead give its 160,000 workers payments 2buy plans http://t.co/dpvbC8IigC via @WSJ Sep 19, 2013
National pension group challenges Pew?s work http://t.co/iiZROFHzRy! Cash balance plans give lower benefits, but maybe that’s affordable Sep 19, 2013
Puerto Rico can only cover 11.2% of pension costs http://t.co/wdnQJFniEF! Puerto Rico exists 2 make Illinois think it is prudent $$ Sep 19, 2013
Obama Feels a Pinch From Congressional Democrats http://t.co/d78z6b9a2c Obama gets constrained by the Left as much as the Right $$ Sep 18, 2013
Republicans Weigh Defunding Health Law, Avoiding Shutdown http://t.co/cbiqo2vBoW Ignore the economists, they don’t know anything, & cut! $$ Sep 18, 2013
Republican Newcomer Influence in Congress Risks Shutdown http://t.co/dtdHcg59po 3-player games r much less stable then 2-player games. $$ Sep 18, 2013
The Financial States of America http://t.co/xGQ8c6uajo Clever infographic; click a state 2c how it ranks; click on categories 4 diff maps $$ Sep 17, 2013
States With The Most Zombie Homes http://t.co/Dj6hphkUrM >20% of foreclosed homes vacant: Indiana, Nevada, Georgia, Florida, MD, AZ, SC $$ Sep 17, 2013
Heroin Pushed on Chicago by Cartel Fueling Gang Murders http://t.co/GmuhpbSxIk Getting a receipt from the Indiana police 4 forfeited cash $$ Sep 17, 2013
Armed EPA raid in Alaska sheds light on 70 fed agencies w/armed divisions http://t.co/90YKg3TWB2 Interesting how many have police units $$ Sep 16, 2013
Obama stands firm on refusal to negotiate over US debt ceiling http://t.co/kUDp9Q4ZL2 Nothing bad happened from sequester; do it again $$ Sep 16, 2013
How the SOPA law got defeated politically http://t.co/X3ZJiTiJ48 Creation of a website to highlight & affect legislative markups was key $$ Sep 16, 2013
Health Law Faces Skepticism http://t.co/AYf9IjdUL9 Complex laws typically don’t work well; Obamacare/PPACA is the epitome of complexity $$ Sep 16, 2013

Market Impact

The Long, Sorry Tale of Pension Promises http://t.co/6Pi2V0yiPA It started w/accounting rules allowing2much flexibility4funding/valuation $$ Sep 21, 2013
ING CEO Says Stress Tests Without Safety Net Bring Risks http://t.co/Bi7IKXvuYK If u fail the stress test, y would anyone recapitalize u $$ Sep 21, 2013
Challenging the Imperial Boardroom http://t.co/VW6IrzKIF9 @Carl_C_Icahn argues 4 mgmt transparency, competence, & shareholder orientation $$ Sep 20, 2013
Money Market Funds Ready for Battle with Regulators http://t.co/1VIxWqfVLE Floating NAVs will kill money market funds; better solutions $$ Sep 20, 2013
Banks? $10B Sweet Spot Sets Off Buying Spree for Lenders http://t.co/2oDNEEqEdY Bank capital rules r helping create medium-large banks $$ Sep 20, 2013
Avoid ?Dividend Yield Traps?, Look To Releveraging Stocks http://t.co/0k3Qs4mJHx 2 risks: higher bond yields compete; free cash flow 2low $$ Sep 20, 2013
Longevity-Proof Your Future http://t.co/0MB5S7Yx5S The main point is that you need to save. Beyond that, invest well, but savings r capital Sep 19, 2013
Novogratz to Burbank See Stocks Surviving First Fed Taper http://t.co/Xeig2UVtvT So what? We already know “Three steps and a stumble.” Sep 19, 2013
How Social Responsible Investing Can Be Irresponsible — Pension Fund To Sell Energy Stocks? http://t.co/JE6g2S8hHC Vacuous city council Sep 19, 2013
Remembering the families at the center of the financial crisis http://t.co/ICSLkY2TcD If finances were related 2 finance/housing it hurt $$ Sep 19, 2013
Judge Dismisses Bank Lawsuit Over Mortgage Foreclosures http://t.co/aJ5VmA64x2 Richmond needs supermajority 2 use eminent domain $$ Sep 17, 2013
Dr Copper & his funny friends disagree tremendously with SP500 level http://t.co/uNpdfvlbC9 On the divergence of stocks & commodities $$ Sep 16, 2013
Is Fiscal Austerity Good for the Economy? http://t.co/gQif4JHXqc “austerity is costly in the short run, it can provide long-run benefits” $$ Sep 16, 2013
Gross?s Trade Sours as Bonds Lose Faith in Fed Guidance http://t.co/YGZgvVries Depends on level of future GDP growth, keep watching $$ Sep 16, 2013
Montepeque of Platts Caught in Battle Over Oil Assessments http://t.co/4o0wvVyCEz All human systems r gamed, just a question of how much $$ Sep 16, 2013
Wall Street trading in US fuel credits hurts consumers http://t.co/8hZ8shAIJJ Very difficult 2manipulate prices in long run: sup/dem chgs $$ Sep 16, 2013
Uh oh. People buying houses fear rising prices http://t.co/FWAAeHwKdz Bubbles persist until financing costs more than implied rents $$ Sep 16, 2013

Companies & Industries

Twitter announces IPO: The Pricing Game begins http://t.co/GlR7MWJz4X Daring Damodaran gives a value 4 $TWTR w/out having any financials $$ Sep 21, 2013
Secret Rocks and Gem Hunters http://t.co/4Dpm6jGavk Colored gems r like small cap stocks, they r unique & illiquid mkts w/odd characters $$ Sep 20, 2013
Companies Seize on Rate Reprieve to Issue Bonds http://t.co/qQJzknEqhp Many think rates will go higher, & so they issue debt now $$ Sep 20, 2013
Google May Stop Using ‘Cookies’ to Track Web Users http://t.co/MgvZtEHo1Q Could concentrate marketing power in hands of a few companies $$ Sep 20, 2013
How ?Cord Never? Generation Poses Sales Drag for Pay TV http://t.co/10M73Td7jL Once you get used to not paying for your video, u don’t pay Sep 19, 2013
Verizon Pays $5.1 Billion in Extra Interest http://t.co/om7PsDAwzO That was the price of getting a big deal done in the short-run. Sep 19, 2013
Companies are increasingly choosing to generate their own power, delivering a jolt to utilities http://t.co/brVyNOWokp Disintermediation Sep 19, 2013
For TV Shows, It’s a Seller’s Market http://t.co/eja7JEhl1t Producers have many more outlets for content & networks must pay up 4 content $$ Sep 18, 2013
Capstone Metering Provides Smart Water Management Solution, Powered By Verizon Wireless Network http://t.co/0xd77Bnz0q fascinating tech $$ Sep 17, 2013
Berkshire Billionaire Found With More Shares Than Gates http://t.co/wqoceUXHJW Tales of old buyers of $BRK.A & cpmny sellers taking stock $$ Sep 17, 2013
Retailer REI Ends Era of Many Happy Returns http://t.co/0xDYFXDV95 Abuse leads REI to end returns on items bought more than one year ago $$ Sep 16, 2013
Wildcatter Hunch Unlocks $1.5T Oil Offshore US http://t.co/4lTsK10aj0 Longish story of how a hunch led2 deepwater drilling, amid failures $$ Sep 16, 2013
How Did Wal-Mart’s IPhone Discount Defeat Apple’s Price Controls? http://t.co/F3ZuYFvbWM $WMT takes a low margin on sales of $AAPL phones $$ Sep 16, 2013
Home, Sweet (Crude) Home in Fort McMurray, Alberta http://t.co/GpuUq289T8 Economies based on resource extraction flourish 4 a time & die $$ Sep 16, 2013

Economics

Women Waiting Tables Provide Most of Female Gains in US http://t.co/eoetZdyRAi Not so much demand 4 workers w/degrees in certain majors $$ Sep 20, 2013
Martin Feldstein: How to Create a Real Economic Stimulus http://t.co/bH2e2Z67mb Suggests mild entitlement reform; we need retirement @ 72 $$ Sep 17, 2013
Want Marital Bliss? Pool Your Money http://t.co/mJQb3XEkZn The more things r shared in marriage the better/tighter the bond becomes $$ Sep 17, 2013
Mysterious Disappearance of James Duesenberry http://t.co/LD3GfjTyka Old article on relative income hypothesis. Ppl r envious not greedy $$ Sep 16, 2013
Explanation of the discrepancy is that poverty is relative. Ppl r not maximizers & economists resist this b/c the pretty math falls apart $$ Sep 16, 2013
& if the pretty math falls apart, economists can’t publish & there goes their jobs. That is y they would rather hang onto a wrong theory $$ Sep 16, 2013

Other

The Time a Cleveland Newspaper Divulged Manhattan Project http://t.co/mFDKvhJTlW Fascinating tale; clever reporter http://t.co/o5CzDU61nL $$ Sep 21, 2013
Our Chat With Jeremy Grantham http://t.co/FSlADefGi0 In general, need 4 technological change has driven technological change; we will win $$ Sep 21, 2013
Marc Faber’s Biggest Mistake http://t.co/Dui1ZehA09 Really pretty minor. Interesting guy who gets things right, but speaks bearish Sep 21, 2013
Pope Warns Church Focusing Too Much on Divisive Issues http://t.co/2yEMa3O89I More than other Popes, this one is a slave2 liberal opinion $$ Sep 20, 2013
How a 91-Year-Old Geek Helped Keep the Aged Independent http://t.co/GD1AmUK6OQ Small cheap sensors monitor oldsters, watching their needs Sep 19, 2013
Say Goodbye to the Password http://t.co/pTnQ4ng2Xn New technology aims to offer security that is more convenient and more effective $$ Sep 18, 2013
Veggie-Heavy Stress Reduction Regimen Shown to Modify Cell Aging http://t.co/b3KNrSOdSY Cooking from scratch improves your life & health $$ Sep 17, 2013
Jonathan Jacobs: As Education Declines, So Does Civic Culture http://t.co/tk7WHue1mS Biggest complaint about new analysts: can’t write $$ Sep 17, 2013
Gonorrhea Among Drug-Resisting Germs Sickening Millions http://t.co/Fbgw14Q4ZQ Add C. difficile & E. coli; resistance 2 antibiotics grows $$ Sep 17, 2013
Twitter Co-Founder Evan Williams Lays Out His Plan For The Future Of Media http://t.co/e7nv4u8Z0T Need the equivalent of @abnormalreturns $$ Sep 16, 2013
Google?s Boss and a Princeton Professor Agree: College Is a Dinosaur http://t.co/ffUTIQFxdV True, but what do we do 2prove knowledge then $$ Sep 16, 2013

Replies, Retweets, & Comments

Thanks @MarshaCollier @EdmundSLee for being top new followers in my community this week 🙂 | insight by http://t.co/sern3wLA13 Sep 20, 2013
#FollowFriday Thanks @ReformedBroker @pelias01 @researchpuzzler for being top influencers in my community this week 🙂 Sep 20, 2013
@dpinsen I almost never read fiction. Sep 20, 2013
RT @interfluidity: the Fed has learned the trick about stretching your feet out beyond the covers then pulling them back in to feel warm. Sep 19, 2013
RT @BloombergNews: Sold for sex at puberty is village girls’ fate in wealthier India | http://t.co/oZsp9d2LcV Saddest article I have read Sep 19, 2013
@ppearlman Congratulations, Phil. One of my favorite websites is going to get better still. Sep 17, 2013
$$ @joebrusuelas Wrong. Yellen is an imitation of the policies of Bernanke & QE. They don’t work. Summers — rejection of the Rubin clique. Sep 17, 2013
@rj_trades Worked 4 me. Don’t know what’s wrong… Sep 16, 2013

On Principles-Based Accounting for Financials

Posted on 18 September 201318 September 2013 by David Merkel

I may lose some friends in the industry for writing this.? Accounting bases vary for three reasons at minimum:

Accurate portrayal of the change in value of the firm (GAAP, IFRS)
Assuring solvency of financial institutions (Statutory)
Making sure taxes get paid (Tax)

Here’s the problem: when assets or liabilities get complex, accounting rules have a hard time setting values for them.? This is especially difficult for anything that does not trade regularly, if at all, and anything that has unique personal characteristics.? The value of a life insurance contract varies from person to person, even if major underwriting variables are the same.

But this applies to other areas.? Living benefits for variable insurance contracts do not have a good theory behind them, because the performance of asset markets is unpredictable.

Another example: letting banks set reserves for credit losses off of internal models.? Remember the rating agencies calculating subordination levels for ABS, RMBS & CMBS?? These securities had never been through a failure cycle, so they used default rates from non-securitized lending.? But those that lend and retain the risk are more conservative than those that lend and sell the risk.

The internal models have the potential to be more accurate than accounting rules, but they have greater potential to be more liberal, as management teams lean on accountants, quants, and actuaries for a desired accounting result.

I think it is better the the accounting standards setters to spend some money, hire people with expertise, and craft better rules.? Here’s another example: I think that the pension accounting standard should not allow investment earnings and discount rate assumptions higher than 2% over the ten-year Treasury.

I am in favor of rules-based accounting for solvency purposes.? Let the regulators be conservative.? Principles based accounting might be fine for GAAP/IFRS, but it destroys comparability across companies, and makes equity analysis a lot harder.? Better to have rules-based accounting there too.

If we had God doing accounting, yes, principles-based would be better, because he knows the future perfectly.? But we don’t know the future, so we have to build in conservatism via rules.

I have two more ideas for accounting simplification.? First, tax financial companies on their GAAP income.? That aligns taxation with their priorities.? If they offer a modified GAAP income that reflects how value is delivered, tax them on that.? Income should be taxed on the true increase in value.

Second, eliminate the statutory accounting basis by using GAAP/IFRS, and boost the level of statutory capital that financial firms need to hold.? Adjust the capital levels off of the business mix, penalizing secondary guarantees.

These two proposals would radically reduce the accounting efforts that financial firms go through, while increasing taxes, and enhancing solvency.

One final note: require that those who prepare the squishy parts of financial statements have an ethics code, like CFAs and Actuaries.? That’s not perfect, but training in ethics generally makes people more conservative in accounting.

The Rules, Part LIII

Posted on 9 September 201320 June 2017 by David Merkel

The tech market washes out about every eight years or so.? The broad market, which is a more robust beast, washes out far less frequently.? My question: are these variants of the same phenomenon?

I wrote this back in early 2003.? I can now answer my own question: No.

I’ve looked at this question many times, and debated the answer, but there are a few things that have made me decide “No.”

Sectors often move independently of the market as a whole, particularly growthy sectors that lose their growth.
The big moves of the market as a whole have usually been correlated with credit crises, which are part of the financial sector, not the tech sector.
The tech sector grows more slowly as a whole now, and hasn’t washed out for a while.
The financial sector fails because of financial leverage, the firms are too levered, and take too much credit risk.? The tech sector fails because market players bid up the prices of stock assuming permanently high rates of growth.? These are fundamentally different reasons for over-valuation, because most tech stocks have little debt.

Credit crises lead to big overall declines in market values, particularly with financial stocks, but affecting all other stocks, because when credit conditions are tight, things slow for all firms.

When tech stocks are overbid, it is more of a local mania where market players overestimate the degree of growth the sector can achieve.? There is little collateral damage to the market.? A seeming exception to this is 2000-2002, where the market went down with tech, but financials were less affected. In that drawdown, tight Fed policy drew everything down, and tech more than everything else.? Remember the NASDAQ over 5000?? Still hasn’t returned there, while the Dow, S&P 500, and Russell 2000 have hit new highs.

Here’s the summary: financial stress tends to be pervasive, affecting everything.? Stress from growth expectations that disappoint tend to be sector-specific, and don’t drag down the market as a whole.

And so the answer to my question that I asked 10+ years ago is “no.”

On Reinsurance

Posted on 31 August 20132 September 2013 by David Merkel

From a reader:

Was reading a history of AIG and it was discussing the early years. There was a line to the tune of ‘anything Hank reinsured paid off’.

You’ve written many times usually in the context of LTC, that insurers should not insure anything where the customers have a better idea of future claims than the company does. How is this rule not violated by reinsurance? Are reinsurance actuaries better, or are most deals in agreement about the risk and more about regulatory arbitrage/capital relief?

My response:

Which history are you talking about?

His response:

Fatal Risk – “They pretty much hit it perfectly. Whatever they laid off risk-wise seemed to result in claims and it was during a period where reinsurance was fairly cheap. They got the best part of the deal, by far.”

Okay, now I get it.? I’ve reviewed Fatal Risk, and have the most helpful 5-star review at Amazon.? I also have a special discussion with Roddy Boyd here.? I regard him as a friend of mine.

If insurers are supposed to be conservative, their reinsurers should be doubly so.? But AIG was a big company, and a plum to have as a client, many imagined.? But AIG would hand off underpriced risks to reinsurers, and there was a saying current when I worked at AIG 1989-92 “Never give a reinsurer an even break.”? This varies from the clubby reinsurance world pre-1980, where reinsurers and insurers would adjust terms of agreements in order to be fair, whatever that means.

AIG broke from that, and stressed the strict letter of the contract, and did not compromise.? An example from my time at AIG: a reinsurer of annuity business was caught short when Congress implemented the “DAC tax,” which was really a tax on new insurance premiums.? The reinsurer lost and asked us to compensate them.? We refused; there will always be more reinsurers.

Much reinsurance on the life side does cover regulatory arbitrage and capital relief.? With P&C, that’s not a big factor; rather it is risk reduction.

Reinsurers see more of the industry than a single insurer, that partially compensates for the reinsurer not having as much detail as the ceding insurer.? Reinsurers underwrite insurance companies and their management teams, in addition to the exposures at hand.? If an insurer gets a reputation for being too slick, reinsurers back off.

AIG may have been different because they were so big.? But even AIG had rough times with reinsurers: rescission of annuity treaties with Lincoln National in the mid-90s (costing hundreds of millions), and earnings management with General Re, on a reinsurance deal that did not pass risk, which led to the downfall of Hank Greenberg.

P&C reinsurers have other ways of mitigating risk as well, for example, requiring the company to take the first $XX million of losses, and limiting total losses covered.

So, no, reinsurers aren’t brighter than insurers, but they have to be selective, and not write business just to deploy capital.? If they are disciplined, they will turn down business when they can’t make money on underwriting, and send shareholders the excess capital.

The Fed Needs Valuation Actuaries (and More Steel in the Spine)

Posted on 20 August 2013 by David Merkel

I reviewed the following report from the Federal Reserve to Congress today, and found it disappointing.? From my prior experience as an actuary, and the time that I spent on the asset-liability committee of a small bank, I know that? the banking industry is far behind the life insurance industry on risk control.? The Fed would have done far better to have studied the works of the Society of Actuaries and the National Association of Insurance Commissioners, and learned from their efforts.

Now, I know that the contingencies of banks are far less predictable then those of life insurers.? Further, life insurers have long liabilities, whereas the liabilities of banks are short, and thus, they are more subject to runs.? But liquidity risk management does not play a large role in their document — and this is a severe defect in what they write.? Almost all failures of financial firms are due to loss of liquidity.? The word liquidity only appears once in the document, on page 15.? This shows the amateurish work of the writers.

The Fed focuses on a lot of process issues that don’t matter as much as the substantive issues of discovering forward-looking measures of risk, and changing business processes to reflect those risks.

Here are some examples:

1) Internal controls matter, but it is a rare internal control auditor that can truly analyze a complex mathematical process.? They don’t have the capacity to review those processes, or they would be doing it and earning far more.

2) Risk identification is important, but the Fed document would have not helped in 2007-2009.? How do you detect risks that have (seemingly) never happened before?? Further, if you do detect a major problem that has happened before, and it would impair some very profitable businesses, why do you think management will kill profits to appease your lunacy?

3) Governance is important, but the board gets data so late that it is useless.? This is not worth bothering with.? Management has to do the job here.

4) The language on capital targets is weak, and allows the banks way too much latitude in performing their own calculations.? The Fed needs to be far more specific, and prescribe the scenarios that need to be tested.? It need to prescribe the loss severities, asset class by asset class.? It needs to prescribe the correlations, if any, that can be used in the models.

5) The document does not speak of ethics.? Valuation Actuaries do the same work on a higher level, and they have an ethics code.? That may occasionally make them oppose the management team that pays them, but it is a necessary check against managements trying to manipulate results.

6)? The piece spends too much time on the dividend policies of bank holding companies, and no significant time on the abilities of the subsidiaries ability to dividend to the bank holding companies.? The proper focus of a bank regulator is on the health of the operating subsidiaries.? Who care if the holding company goes broke?? Big deal, at least we protected depositors.

Banking regulators should adopt the same policy as insurance regulators.? Outside of ordinary limits, they can deny any special dividends from subsidiaries to the holding company.

7) The piece does not get forward-looking estimates of risk.? On new classes of assets, you don’t have historical data to aid in estimates of risk.? At such a point, one must look at similar businesses that have gone through a failure cycle, or do something even more difficult: do a cash flow model to estimate where losses will fall if asset values decline for an unspecified reason (okay, no more ability to buy…)

8 ) Macroeconomic factors rarely correlate well with the factors that lead to losses on assets.? Most of that effort is a waste.

9) As Buffett said (something like): “We’re paid to think about things that can’t happen.”? This is why the Fed has to specify scenarios, and be definite.? The mealy-mouthed language of the document can be gainsayed.? Life Actuaries have better guidance.

10) So all of the banks did not pass the mark.? With the vagueness of the guidelines, no surprise.? Let the Fed put forth real guidelines for bank stress tests, and let the banks scream when they get them.? Better to have slow growth in the banking sector than another crisis.