Search Results for “insurance investing” – Page 4

To What Degree Were AIG?s Operating Insurance Subsidiaries Sound? (4)

Posted on 29 April 2009 by David Merkel

Unrealized Capital Losses

Subsidiary	C UR CG / Surplus	2008YE Surplus
Pacific Union Assurance Co	-385%	20
AGC LIC	-360%	5887
American Life IC “Alico”	-118%	3900
American General LIC	-89%	5185
SunAmerica LIC	-74%	4653
AIG Casualty Co	-46%	1457
AIG Annuity IC	-29%	3045
American Home Assurance Co	-21%	5702
The Variable Annuity LIC	-20%	2841
Hartford Steam Boiler IAIC	-16%	443
Commerce and Industry IC	-16%	2678
Audubon IC	-15%	39
AIG LIC	-15%	360
Lexington IC	-10%	4263
Am Int Specialty Lines IC	11%	726
AIU IC	32%	726
UG Residential IC of NC	34%	200
AIG SunAmerica LAC	50%	1271

The table to the left indicates current unrealized capital gains as a fraction of surplus.? When I first looked at this, I though most of these must have been from unrealized losses on bonds, but to my surprise, they are mostly losses from affiliated company stocks, which must be valued at market price or net worth.

But as I began to dig into the losses, I found something unusual at Alico. At the end of 2007, almost the entirety of their surplus assets were composed of AIG common stock.

Delaware regulators, please tell me, why would you allow this?? It is one thing to allow this for a pup subsidiary like Pacific Union, and quite another thing for a big dog like Alico.

For those less aware, holding affiliated stock of subsidiaries is capital stacking, which raises leverage, but owning holding company stock is creating capital out of thin air.? When things are going good capital rises disproportionately.? When things are bad, the opposite happens.? We are experiencing that negative part of the cycle now.

Now there were other areas of loss for AIG OISs, many are detailed in this article here.? I’m not generally a fan of insurance companies investing in anything more dangerous than investment grade bonds.? My main reason for this view is the outlier types of events, like that which we are seeing now.? Insurance companies should never want to be in a situation where they are suffer underwriting losses at? a time where they are taking losses on the investment side as well.? Most of these losses from limited partnerships (private equity and hedge funds), though unrealized, have already hit capital levels.? Some will make part of the losses back, but many will not.? In this environment, high risk investments are not being rewarded.

Investing in Financial Stocks is Tough

Posted on 13 September 2008 by David Merkel

At RealMoney, I wrote an article in 2005 called, Buyers Beware: Financials are Different.? In addition to many other things I mentioned there, I gave six ways that financials were different:

Tangible assets play only a small role in a financial company. What constrains the growth of an industrial company? The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year. Demand is the ultimate limiting factor, but this affects financial, industrial and services businesses alike. But with a financial company, sometimes the limits are akin to a service business (“If only we had more trained sales reps”), but more often, capital limits growth.

The cash flow statement plays a big role with industrials and utilities, but almost no role with financials. One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow. Free cash flow is the amount of cash that the business generates in a year that could be removed with the business remaining as functional as it was at the start of the fiscal year. Deducting maintenance capital expenditure from EBITDA often approximates free cash flow. Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks. Capital is released as business matures. In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.

Sadly, the change in required capital is not disclosed anywhere in a typical 10K. Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on. Sometimes the federal or state regulators provide the most constraint. This is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers. For entities that raise their capital in the debt markets, or do business that requires a strong claims-paying-ability rating, the ratings agencies could be the tightest constraint. Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures. Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.

Financial institutions are generally more highly regulated than non-financial institutions. There are several reasons for this: the government does not want the public exposed to financial risk or systemic risk; guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.); and defaults are costly in ways that defaults of non-financials are not. The last point deserves amplification. In a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy. Confidence cannot be allowed to fail. Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
Rapid growth is typically a negative. Financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality. In normal situations, a financial institution can get only two out of three. In bad times, it would be only one out of three.
Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions. Typically, borrowing occurs at the holding company. The regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company. This makes the common stock more volatile. In a crisis, the regulators only want to assure the safety of the operating company; they don’t care if the holding company goes bust and the common goes to zero. They just want to make sure that the guaranty funds don’t take a hit, and that confidence is maintained among consumers.

In general, accruals are weaker than cash entries in accounting.? Not all accruals are created equal either.? Some are less certain to be collected/paid, and some are further out in the future than others.

Financial stocks are generally bags of accrual entries in an accounting sense, with some more certain than others.? E.g., a short-tail personal lines P&C insurer’s accounting is a lot more certain than that of an investment bank.

This is why management quality matters so much with financial stocks.? The managements of financial companies must be competent and conservative, and all the more so to the degree that the accruals that they post are less certain.? Companies that grow too rapidly, or lack obvious risk control are to be avoided.

Looking at the Present Concerns

I own a bunch of insurance companies, but no banks or other financials.? Why?? Insurers are profitable and cheap, and are not under threat from credit risk to the degree that other financials are.? Consider the threats to AIG, Citi, Lehman, Merrill, GM, Ford, Wamu, etc.? The companies that got into trouble grew too fast, levered up too much, neglected risk control disciplines, and more.

Now their valuations have been crunched, and their financing options are limited.? Fortunately there are the options of last resort:

Have you maxed out trust preferred obligations? Other subordinated debt?
Have you maxed out preferred stock?
Have you issued convertible debt to monetize volatility?
Have you diluted your equity through secondary IPOs, rights offerings, PIPEs, and/or deals with strategic investors?
Have you sounded out investors in your corporate bonds about debt-for equity swaps?
And, unique to Fannie and Freddie, have you asked the US government for a capital infusion or a debt guarantee?

Given that Bear got a guarantee, perhaps others could too, though I think the US Government is far less willing now.? I could also add another point: have you sold your most valuable liquid assets?

With the crises being faced by financial companies, there is a rule that separates the survivors from the losers: Losers sell their best assets, and play for time.? Survivors/winners sell their worst assets and hunker down — they have enough financial slack that they don’t have to engage in panic behavior.

In an environment like this, where there is a lot of uncertainty, avoiding suspect financials is prudent.? This applies to those who take on the risks from such institutions when the decisions have to be made quickly on whether to buy them or not.? Thus I would be careful on the equities of any buyers in this environment, and would be a seller of any company that is a rapid buyer during this time of financial stress.

Full disclosure: no positions in companies mentioned.? I own SAFT LNC AIZ MET RGA HIG UAM among insurers, and might buy some more….

The Banking Industry Should Learn from the Insurance Industry

Posted on 2 September 2008 by David Merkel

I can’t comment on everything, at least above the degree of quality that I try to impose on myself.? (I know, the standards could be raised. 😉 )? But I did want to comment on a paper on banking capital regulations that came out of the Jackson Hole conference.? Odd Numbers and Naked Capitalism commented on it, and I thought both had good things to say.? I have my own twist to share, having been a risk manager inside two insurance companies.

The basic idea of the paper is that risk levels have to be reduced at banks, but banks want to stay highly levered so that they can earn high returns on equity, so asking them to reduce debt levels or internal leverage is not feasible.? Instead, why not have them buy insurance policies that pay out during banking crises?? Then they will have the capital when it is needed, and they can continue to lend in all environments.

(SIgh.)? I have oversimplified their arguments, but I have done it to help make some points, which are:

1) The cost of the insurance policy will get factored into the equity calculation for return on equity, at least at far as a prudent bank manager would view it.? The insurance policy is illiquid, and its cost should be reckoned as a part of the surplus it replaces, which may allow for a reduction in overall surplus levels carrying the business.? (Note to regulators: anytime you allow a financial entity a reduction in required surplus from a risk transfer agreement, you should analyze the alternative of using the premium(s) paid to add to surplus, and ask, which looks better.? Also, these are collateralized agreements, but in uncollateralized agreements, analyze the counterparties, and deny surplus credit frequently.)

2) Do the authors realize how expensive these agreements should be?? Consider:

The insurer is asked to post the collateral, which takes money out of its surplus.
The insurer is asked to be ready to lose an asset at a very bad point in the credit cycle.
The monies are invested in Treasury securities, so there is no possiblity for the insurer to make money from investing the premium more aggressively, but still safely.
Large banking crises happen about once every 20 years or so, with smaller ones more frequent.? With a long enough agreement, the loss of the Treasury collateral is almost certain, making the cost high.
If these were common, a sort of moral hazard would develop, similar to what has happened with the financial guarantors.? Banks would conduct business aggressively, realizing that they have the capital backstop.? Initial results would look good, until the crisis. Then, double surprise! The insurers figure out that they didn’t charge enough for the insurance, and the banks find out that their losses were larger, because of their aggressive behavior.? Wound banks be willing to pay premiums around 5-15% of the face amount insured, depending upon where the risk trigger kicks in?

3) Beyond that, there would probably be a scarcity of providers.? Few want to dedicate a large portion of their capital bases to the events that are entirely a process of human action.

Take a lesson from the reinsurance industry.? Ideally, you would want an agreement that took the risks directly off of your books, such that the capital would come when you specifically had losses above a threshold.? That’s been done in the insurance industry for reinsuring companies as a whole, and the reinsurers have usually come off the worse for it.? The insurers almost always know their risks better than the outsiders.? Reinsurers prefer to reinsure specific risks that they can underwrite, not companies as a whole.

But, lest I merely seem to be a critic, let me offer three suggestions for how to try to make this work.

1) Call Ajit Jain at Berkshire Hathaway.? They have the capital.? Give him a detailed proposal of what you want, and let him give you the quote that makes your jaw drop, or, watch him decline the business, unless you put your bank into a straitjacket of terms and limitations of coverage.

2) Try setting this up through an Industry Loss Warranty.? You would get paid capital during bad times if the industry has suffered losses past a threshold, and you have suffered losses in excess of a threshold as well.

3) Or, try setting this up as a catastrophe bond.? Borrow money through the bond at a high rate of interest.? Junk bond buyers will fund you.? During a crisis, if the banking industry losses exceed a threshold, the principal of the notes gets written down, and voila!? You have capital when you need it.? Note that the junk bond buyers should require more of a premium here, because bank losses tend to be correlated with other junk bond losses — no big benefit from diversification here.

I will leave aside the idea of setting up captive reinsurance sidecars, because those are just regulatory arbitrage.

My main point here is that I don’t think that this type of insurance will work.? Even for those willing to contemplate the structure, the true price will be too high for the banks to gain any benefit.? Perhaps this could be done on a limited basis for one more turn of the credit cycle, but I think for those that offer the insurance, the banks that buy it, and the regulators, they will be less than happy with the results.

In my opinion, we need to bring down leverage ratios for the banks, slowly but inexorably.? If that hurts their ROEs, well, I’m sorry.? If we are going to do a leveraged fiat money system, the leverage must be considerably lower than where we are now, and all synthetic exposures (derivatives) must be brought on balance sheet as if they were cash transactions.? It is that lack of transparency and increase in leverage that has made our financial system so much more risky, as this other paper from the Jackson Hole conference states.? I did not feel that the discussants really understood what they were talking about, because they could see the micro level risk reductions from derivatives, but miss the added leverage, lack of transparency, and concentration of risk in the hands of parties that were greedy for yield, and may not be able to make good on all agreements in a crisis.

Much complexity and leverage will need to be unwound before this credit crisis is over.? The era of high ROEs for banks should be over for some time, that is, until the regulators fall asleep again during the next boom phase.? Some things rarely change.

Don’t Overpay, for Insurance M&A

Posted on 14 August 2008 by David Merkel

I’ve been mulling over whether I should write about insurance M&A.? Ugh, yes, I should say something.? What pushed me over the edge was a piecein the WSJ on the purchase of Philadelphia Consolidated.? When I first heard about the deal, I blinked, and said, “Foreign acquirer overpays to enter the US.”? Is Philly a good company?? It’s a great company, but it may not be so under foreign ownership.? And, the price was well in excess of what it would have taken to create/attract the talent for a new venture.? Paying 2.7x book is not a winner.

But, the have been other missteps as well recently.? Liberty Mutual buys Safeco and Ohio Casualty for 1.8x and 1.6x book.? High prices for the assets obtained, and Liberty Mutual can’t lever that much as a mutual company.? It feels like the current management is going for growth at all costs, and the only losers will be the participating policyholders, who will eventually get a lower dividend stream.

I’m also not into funky holding company structures, for example, where a mutual company sells off a piece of a subsidiary to be publicly traded.? In that sense, it was good of ALFA to buy in their stock subsidiary (2.0x book), and now Nationwide is doing it as well (1.6x book).? Someone buying Nationwide Financial Services at the IPO earned an 8.7% annualized returnto the buyout.? ALFA shareholders did better, but I am not sure how much better, because I can’t tell how many times the stock split.? Both beat the returns on the S&P 500.? (I won’t mention the details of how Provident Mutual took Nationwide to the cleaners when they sold themselves; that had an effect on the returns.)

But, think about it from the perspective of the participating policyholders, who nominally own the mutual insurance companies.? That was expensive capital that diluted the dividends that they would have received.? But, mutual policyholders are sleepy, and mutual company managements take advantage of them.

I will mention three more deals before I close.

Commerce Group sold itself to Mapfre SA (1.6x book).? Another foreign company overpaying for a US presence.? I like the deal, because Safety Insurance will out-compete Commerce/Mapfre.
Midland Companies was bought by Munich Re for 2.0x book.? Midland was well-run, but I don’t see the fit with Munich Re.
Castlepoint Holdings was bought by Tower Group at 1.0x book value.? Perhaps a little incestuous, because it was Tower Group’s main reinsurer, but Tower helped bring th IPO to market, and I can’t tell whether this is a bright or dumb idea.

Insurance accounting is opaque to outside experts, and sometimes even to those doing the figures inside the companies.? Management often see marketing or cost synergies in doing deals, but my experience says those aren’t common.? Also, diversification benefits have to be weighed against lack of focus.? It is very difficult to manage disparate business lines.

To those are getting bought out, or who have been bought out, I encourage you to be grateful for the gift that you have received.? For those who own the acquiring company, I must say that the return performance for acquiring companies has been poor.? Consider investing in companies pursuing organic growth, which is often a better idea.

Full Disclosure: long SAFT

Of Value Investing, Industry Rotation, and Selling

Posted on 15 July 200822 June 2017 by David Merkel

At RealMoney, I wrote two articles called “Become a Smarter Seller.”? Part 1 dealt with price targets, and part 2 dealt with reshaping/rebalancing.? Let me try to summarize the core ideas:

If an investment becomes so expensive that bond yields are more attractive, sell it.
If you find another investment significantly more attractive than a current investment, sell it, and buy the new investment.
Sell into price rises, and buy into price declines, if you can’t find economic reasons not to do it.

In other words, trade what you think will perform less well for what you think will do better over your time horizon.

Part of my philosophy in investing is simplifying investment decisionmaking.? Good corporate bond managers have an intuitive feel for when yield relationships justify a trade.? I have tried to do the same thing with equity investing, looking at when valuation relationships justify a trade.? My process where I add new companies four times a year aids the process, because it forces me to evaluate the whole portfolio versus contenders.

Now, many value investors have been hurt recently because financial stocks have done badly.? Included here are many investors that I admire.? I have not suffered along with them, but I offer no guarantee for the future.? I judged that credit-sensitive financials would be bad investments, and avoided them.? Most value investors have a large chunk of their portfolios dedicated to that area.? There were few ways to avoid the crisis.

As for non-insurance financials, we haven’t worked through the effects of all of the bad lending.??? Even with cheap “sticker prices” I am still reluctant to go there.

In closing, I completed my reshaping today.? I sold Helmerich & Payne and Alliance Data Systems.? I bought CRH plc and Kapstone Paper & Packaging.? I like both industries, and both companies are cheap and well-managed.

This takes me a step away from financials and energy, and into two softer materials related names.? There will be pricing power in each company before long.

Full disclosure: long KPPC CRH SAFT

PS — I have one more trade that I am likely to do in the future — trade Safety Insurance for Flagstone Reinsurance (or a similar name).? What I am waiting for is a greater development of the current hurricane year.? If we get near the end of August, and there are no significant damages, it is time to do the windstorm trade.? Sell SAFT, buy FSR, or something like that.

Again, Not Worried About Reinsurance Group of America

Posted on 3 June 20083 June 2008 by David Merkel

From the 6/2 RealMoney Columnist Conversation:

		David Merkel
		Rebalancing Sales, and a Buy
		6/2/2008 4:08 PM EDT

Late last week, I had two rebalancing sells, Charlotte Russe and Smithfield. Today, two more, Honda Motor and Nam Tai Electronics. As the market has risen (or, some of my stocks at least), cash has been building up, and I have added some of my own free cash to the Broad Market portfolio. I’m at about 14% cash.

So, it’s time to buy something, though I am waiting on the market to show a little more weakness before I act. But, though dinner may wait, perhaps an appetizer is in order: today I added to my position in Reinsurance Group of America. MetLife finally decides to shed this noncore asset in a tax-free stock swap, allowing current MetLife shareholders to swap their MetLife shares for shares in RGA.

RGA should get a higher multiple as a “pure play” life reinsurer; that will come later. Today was the selling pressure in advance of the new supply. I like the management team at RGA, and think this will allow them the freedom to add value on their own. One other odd kicker… it might allow them to do more reinsurance business with MetLife, because they will be independent and thus truly be a third party.

Position: long CHIC SFD HMC NTE RGA

A few additional notes, for me long only means running with 0-20% cash. I don’t go above 20%; I don’t borrow. Under normal conditions, I like running around 5-7% cash. If the NAHC stake is counted in, (arbitrage gets a pseudo-cash return) then we are at that 20% upper limit.

That leads me to take a few actions — I have bumped up my central band for my holdings by 16%. Translated, the points at which I do buy and sell rebalancing trades has risen 16%, as has my normal position size. Looking back through the years, back to 1992 when I started value investing, my position sizes were 5% of what they are today, and back then I had 10 positions, not 35. There’s been growth. 🙂

My second action was a temporary purchase of some RGA. I doubled my position temporarily, because I think most analysts will smile on the deal, and RGA has always been a good buy at book value.

No telling whether buying at 1.0x book will continue to be a good idea in the future. RGA is a well-run company in an oligopolistic industry. The management is smart and conservative. They have international growth opportunities, and now, possible new business from MetLIfe. The moat is wide here. You can’t reverse engineer the #2 life reinsurer in the US and the World.

So, I’m happy with my position here. That said, I may trade away the speculative part of my holdings in the short run, and I may buy some MetLife as well. MetLife is cheap, though not as cheap as RGA, but I suspect when MetLife offers RGA shares in exchange for MetLife shares, they will have to make the tradeoff sweet in order to get some flexible institutional investors to do the swap. Why? MetLife is a large cap stock that is very diversified. RGA is a midcap that is not as diversified. MetLife is a well-respected brand name. RGA? Who?

Insurance is opaque; reinsurance is doubly so. There are no comparables for RGA. MetLife has Pru, Principal, Lincoln National, and a few more. So, I may speculate on MetLife in order to get some cheap RGA. Most likely, I’ll need to see the terms, but if RGA is up a lot tomorrow, and MetLife is not, I may just do the swap.

Note to my readers: one odd thing about my blog is that I write about a wide number of issues. I know I have been doing more on my stock investing lately, but that is partially due to the lack of news on the macro front. That’s the nature of what I do. I am an investor that pays attention to the global economy. I’m trying to make money off my insights, and not merely report on what is happening. I hope some of it rubs off on my readers also, and that you personally benefit from it. For those who find my blog to be a confusing melange — well, that’s who I am, a generalist whose interests are broad.

But, if you like the individual stock coverage, let me know. If you hate it, let me know also.

Full disclosure: long CHIC SFD HMC NTE RGA NAHC LNC

What Did Buffett Know about the Gen Re Finite Reinsurance Deal with AIG?

Posted on 2 January 20082 January 2008 by David Merkel

Start with my disclaimer: I don’t know for sure. Buffett says that he didn’t know about the details, and certainly didn’t approve of the deal. From the Dow Jones Newswires:

Buffett said in a 2005 statement that he “was not briefed on how the transactions were to be structured or on any improper use or purpose of the transactions.”

Buffett’s attorney, Ronald Olson, said in a recent statement that Buffett “denies that he passed judgment in any way on the challenged AIG/Gen Re transaction in November 2000 or at any other time.”

Personally, I find this amazing for a few reasons. 1) In any dealings with AIG, a smart insurance executive would want to know what was going on. AIG has had a history of getting the better end of the deal in working with reinsurers. Buffett is not dumb, and there had been a decent amount of rivalry between the two companies over the years. 2) Buffett was not “hands off” on the insurance side of the house when it came to large insurance contracts. From his 2001 Shareholder Letter (page 8 ):

I have known the details of almost every policy that Ajit has written since he came with us in 1986, and
never on even a single occasion have I seen him break any of our three underwriting rules. His extraordinary
discipline, of course, does not eliminate losses; it does, however, prevent foolish losses. And that?s the key: Just as
is the case in investing, insurers produce outstanding long-term results primarily by avoiding dumb decisions, rather
than by making brilliant ones.

Now, maybe Buffett was overstating the case of how much he knew about what Ajit did. It is clear that he spent more time with Ajit than the managers at Gen Re, but I find it difficult to believe he didn’t review a major contract of a client who was also a major competitor known to be tough reinsurance negotiator.

3) He understands finite insurance very well. From this article of mine at RealMoney about the 2004 Shareholder letter, my last point:

12) Finally, what was not there: a discussion of Berkshire’s activities in the retroactive (or retrocessional or finite or financial) reinsurance business. This is notable for two reasons: first, in 2003, he split out the retroactive reinsurance in order to give a clearer presentation of the insurance groups operating results. This year the data is only presented in summary form. Second, Buffett made a big positive out of the retroactive reinsurance results, going so far as to explain the business in both the 2000 (page 8 ) and 2002 (page 9) shareholder letters.

Now, to varying degrees, Buffett made effort over the prior four years to explain the profitability of Berky’s retroactive reinsurance business, because it skewed the loss ratios of Berky upward. In the 2004 Shareholder letter, it was too much of a hot potato to give similar coverage to, even eliminating the entries that would have allowed one to see the accounting effect. In 2000 and 2002, he gave mini-tutorials on the business. In 2000 (page 8 ):

There are two factors affecting our cost of float that are very rare at other insurers but that now loom large at Berkshire. First, a few insurers that are currently experiencing large losses have offloaded a significant portion of these on us in a manner that penalizes our current earnings but gives us float we can use for many years to come. After the loss that we incur in the first year of the policy, there are no further costs attached to this business.

When these policies are properly priced, we welcome the pain-today, gain-tomorrow effects they have. In 1999, $400 million of our underwriting loss (about 27.8% of the total) came from business of this kind and in 2000 the figure was $482 million (34.4% of our loss). We have no way of predicting how much similar business we will write in the future, but what we do get will typically be in large chunks. Because these transactions can materially distort our figures, we will tell you about them as they occur.

Other reinsurers have little taste for this insurance. They simply can?t stomach what huge underwriting losses do to their reported results, even though these losses are produced by policies whose overall economics are certain to be favorable. You should be careful, therefore, in comparing our underwriting results with those of other insurers.

An even more significant item in our numbers ? which, again, you won?t find much of elsewhere ? arises from transactions in which we assume past losses of a company that wants to put its troubles behind it. To illustrate, the XYZ insurance company might have last year bought a policy obligating us to pay the first $1 billion of losses and loss adjustment expenses from events that happened in, say, 1995 and earlier years. These contracts can be very large, though we always require a cap on our exposure. We entered into a number of such transactions in 2000 and expect to close several more in 2001.

Under GAAP accounting, this ?retroactive? insurance neither benefits nor penalizes our current earnings. Instead, we set up an asset called ?deferred charges applicable to assumed reinsurance,? in an amount reflecting the difference between the premium we receive and the (higher) losses we expect to pay (for which reserves are immediately established). We then amortize this asset by making annual charges to earnings that create equivalent underwriting losses. You will find the amount of the loss that we incur from these transactions in both our quarterly and annual management discussion. By their nature, these losses will continue for many years, often stretching into decades. As an offset, though, we have the use of float — lots of it.

Clearly, float carrying an annual cost of this kind is not as desirable as float we generate from policies that are expected to produce an underwriting profit (of which we have plenty). Nevertheless, this retroactive insurance should be decent business for us.

The net of all this is that a) I expect our cost of float to be very attractive in the future but b) rarely to return to a ?no-cost? mode because of the annual charge that retroactive reinsurance will lay on us. Also ? obviously — the ultimate benefits that we derive from float will depend not only on its cost but, fully as important, how effectively we deploy it.

Our retroactive business is almost single-handedly the work of Ajit Jain, whose praises I sing annually. It is impossible to overstate how valuable Ajit is to Berkshire. Don?t worry about my health; worry about his. Last year, Ajit brought home a $2.4 billion reinsurance premium, perhaps the largest in history, from a policy that retroactively covers a major U.K. company. Subsequently, he wrote a large policy protecting the Texas Rangers from the possibility that Alex Rodriguez will become permanently disabled. As sports fans know, ?A-Rod? was signed for $252 million, a record, and we think that our policy probably also set a record for disability insurance. We cover many other sports figures as well.

And 2002:

Ajit Jain?s reinsurance division was the major reason our float cost us so little last year. If we ever put a photo in a Berkshire annual report, it will be of Ajit. In color!

Ajit?s operation has amassed $13.4 billion of float, more than all but a handful of insurers have ever built up. He accomplished this from a standing start in 1986, and even now has a workforce numbering only 20. And, most important, he has produced underwriting profits.

His profits are particularly remarkable if you factor in some accounting arcana that I am about to lay on you. So prepare to eat your spinach (or, alternatively, if debits and credits aren?t your thing, skip the next two paragraphs).

Ajit?s 2002 underwriting profit of $534 million came after his operation recognized a charge of $428 million attributable to ?retroactive? insurance he has written over the years. In this line of business, we assume from another insurer the obligation to pay up to a specified amount for losses they have already incurred ? often for events that took place decades earlier ? but that are yet to be paid (for example, because a worker hurt in 1980 will receive monthly payments for life). In these arrangements, an insurer pays us a large upfront premium, but one that is less than the losses we expect to pay. We willingly accept this differential because a) our payments are capped, and b) we get to use the money until loss payments are actually made, with these often stretching out over a decade or more. About 80% of the $6.6 billion in asbestos and environmental loss reserves that we carry arises from capped contracts, whose costs consequently can?t skyrocket.

When we write a retroactive policy, we immediately record both the premium and a reserve for the expected losses. The difference between the two is entered as an asset entitled ?deferred charges ? reinsurance assumed.? This is no small item: at yearend, for all retroactive policies, it was $3.4 billion. We then amortize this asset downward by charges to income over the expected life of each policy. These charges ? $440 million in 2002, including charges at Gen Re ? create an underwriting loss, but one that is intentional and desirable. And even after this drag on reported results, Ajit achieved a large underwriting gain last year.

What I am trying to point out here is that Buffett had significant knowledge of the retroactive (finite) deals at Berkshire Hathaway. He was even somewhat proud of them, though perhaps that is a matter of interpretation. He liked the almost riskless profits that they provided.

Before I move onto my last point, I’d like to digress, and simply say that not all finite reinsurance is a matter of accounting chicanery. The key is risk transfer. Without risk transfer, regardless of what the technical accounting regulations might say, there should be no reserve relief granted, regardless of the amount of money given to the cedant by the reinsurer; that money should be treated as a loan, because it will have to be paid back with interest. With full risk transfer, the company ceding the risk should not have to hold any reserves for the business. In between, the amount of reserve credit is proportional to the amount of risk shed; excess money given to the cedant by the reinsurer should be treated as a loan. Economically, that’s what it should be, even though that is not what always happens in the accounting. (Side note: yes, I know that it is difficult to determine the amount of risk shed, and different actuaries might come to different conclusions, but can’t we at least agree on the underlying theory?)

What has happened is that in many cases, little risk is shed, and a full credit for risk reduction is taken. Sometimes FAS 113 would be followed, with its 10% chance of a 10% loss as a miserably low tripwire for risk transfer. Sometimes FAS 113 would get bent, and other times, badly bent. That brings me to point 4.

4) Berky had a lot of experience with many different types of finite insurance. I remember a notable asbestos contract they took on for White Mountains where they would bear a large amount of risk. (On that one, I think White Mountains got the better end of the deal.) There were others, like the finite contract with Australian insurer FAI, which made them look solvent while experience was deteriorating. HIH bought FAI, and later went bankrupt, partly due to the acquisition. There were other finite reinsurance deals, like Reciprocal of America, where it made a company that was insolvent look solvent.

I can argue that in many cases, Berky’s underwriters did not know the accounting treatment that the cedant would use, and could not be responsible for the troubles that followed. In many cases, Berky bore significant, if limited, risk. That’s fine too. The greater question is if they were a large writer of finite coverages, which they were, they would have to have some knowledge of the cedant’s goals if they were to underwrite properly. Also remember that Buffett watches the “float” that his insurance businesses generate like a hawk. If there was a large amount of float that would come from a new contract, he likely would have known about it.

The AIG contract was big. AIG is a tough reinsurance negotiator. AIG and Berky have been rivals (Greenberg insulted Buffett on at least one occasion). Buffett watches underwriting carefully, even that of his trusted lieutenant Ajit Jain (a nice guy, really). That makes it really hard for me to believe that Buffett did not have any significant knowledge of the AIG finite reinsurance contract. In the end, I really don’t know; I’m only guessing. My guess is this: Buffett had general, but not detailed knowledge of the deal with AIG. In my estimation, he probably checked to see that there were adequate risk controls to make sure that AIG was not getting too good of a deal.

I admire Buffett. I have learned a lot from him. In general, compared to most businessmen, he is an honest and open guy who speaks his mind. If he said that he never had any significant knowledge of the contract with AIG, we should give him the benefit of the doubt, maybe. But from my angle, it is inconsistent with the way he has done business generally.

Tickers mentioned: AIG, BRK/A, BRK/B, WTM

PS — If you ask me how I feel about writing this, I will tell you that I am not crazy about what I have written. I’m not after publicity for criticizing a man that I admire greatly. I think that Buffett should be more forthcoming on the topic, and be willing to be a witness in the trial. Five people are facing ruined lives, and if Buffett really knew about it, and is saying nothing now because he is powerful enough to get away with it, well, shame on him. If he didn’t know anything about it, well, his testimony would clear the air, because it is a distraction at the trial.

Value Investing is Dull

Posted on 10 November 2007 by David Merkel

In The Art of War, Sun Tzu makes a great deal out of concealing one’s intentions, even to the point of making it look like you are dumb.? Value investing has elements of that, though we are not trying to deceive anyone.

Most investors fall for the idea that rapidly growing companies will produce greater returns.? Sadly, that’s not true most of the time, because investors usually overpay for growth.? That leaves investors like me puttering over companies that have grown slowly and have modest valuations.? They are in boring industries: cement, insurance, shoe retailing, etc.

This is a major reason that I like value investing.? It doesn’t appeal to most people.? Buying exciting companies with great stories is a lot more fun than buying slow-growing companies at modest multiples of earnings.? Sad, but the growth investor will earn less over the long haul.

My way of managing money will go out of favor someday.? That’s the nature of money management, though for the last seven years I have been immune to troubles.? I keep applying my strategy, because over the long run it will out perform indexes.? Courage is most needed, and least available, during the bear phase.

Stocks Don’t Care Who Owns Them; Social Insurance and Private Markets Do Not Mix

Posted on 16 October 2007 by David Merkel

Actuaries are bright people.? Okay, present writer excepted.? That’s a danger when you give a talk to a bunch of them.? Every now and then you will end up with a questioner who is a bit of a crank.? Now, I have a soft spot in my heart for actuarial cranks, because I have done more than my fair share to question other presenters over the years.

At my talk yesterday, one actuary suggested turning the Social Security system into a defined benefit plan, and having it invest in stocks, which would provide cheap capital to corporations.? The Social Security system gets better returns. Everyone wins, right?

Well, no.? Here is what is amiss with the idea:

It would favor public companies over private companies.
Active managers would be useless, because the fund would be too big.? They would have to index.
Initially the stock market would shift up as the money began to be invested, but once fully invested, P/E multiples would be so high that future returns would be lousy.? Once the liquidation phase began, this fund would be so big that stocks would fall in advance of the liquidation, even if everything were indexed.
Marginal companies with lousy profitability would come public to take advantage of the cheap funds.
Corporate governance issues would be tough; how does the government vote its proxies?? How would activist investors get treated?? Which side would the government favor?? If they left this in the hands of active managers to take care of, could the managers stand up to all of the political pressure?
Do we really want the Socialism associated with the government owning 20% of every corporation?? What additional regulations might be put on corporations that are owned or not owned by the government?
Would we give the Fed a third mandate to try to improve corporate profitability, because it would have a greater effect on the economy?
Why limit the asset classes invested in?? Why not other bonds, loans, commodities, real estate (commercial and residential) and perhaps international investments?? At least if we liquidate international investments, we don’t hurt our own economy.
For that matter, the US government could contribute all of its property to a great big REIT, and use it to fund a small portion of Social Security.? Of course, the deficit would rise as the government made dividend payments.
Medicare is the tougher issue to solve; Social Security is small compared to it.? Solve that one first.

My last reason is that for the most part, stocks don’t care who owns them.? In the long run, they are weighing machines, and not voting machines.? They will produce the stream of cash flows as a group that will be pretty invariant to who owns them.? Activist investors may have an effect in the short run, but on the whole, the effects of activism on the index returns as a whole will be paltry at best.

This tired idea of investing the Social Security trust funds in equities came up during the Clinton Administration (hopefully there will not be a second one).? I view it as the ultimate “dumb money” for the stock market.? If it were ever implemented, you would invest into the wave of new money, and create IPOs to sop up money.? Then once the money flow was largely deployed, you would sell along with other smart investors, and invest overseas.

My own view is that Social Security and Medicare should be wound down over a 80-year period.? They were bad ideas to begin with, but getting us out of that business with fairness to promises made would have to take two generations or so to complete.? I know, that’s a non-starter, but most reasonable ideas regarding social insurance programs are.? The eventual “solution” will come through higher ages for benefit receipt, lower benefits, higher taxes, limitation of inflation adjustments (already done, and quietly) and means-testing.? Not that I like it, but we will have to face realities eventually.

The same issues will apply to Medicare.? Eventually we will have a two-tier healthcare system (we won’t call it that), because we can’t afford the promises made to Medicare recipients.? It will be “The government pretends to pay us, and we pretend to treat you.”? It will be a mess, and that one should begin to come into clear focus within ten years.

PS — My talk went well yesterday.? If there is ever a recording of it on the web, I will put a link at my blog.

Investing in a Stagflationary Environment

Posted on 19 September 2007 by David Merkel

I intend to get back to answering more reader questions, and doing it through posts.? I’ve been somewhat derelict in responding to comments, and I want to do it, but time has been short.? Here is a start, because I think the answer would be relevant to a lot of readers.

From a reader in Canada:

I enjoy your writing as many of your comments generate a wider perspective than my own.? There is always something to learn.

I was too young to appreciate the last stagflationary period.? Yet, I need to manage my portfolio.? My approach is more ETF based, whereas, I see that you prefer specific stocks.

I struggle in anticipating the currency impact on my foreign holdings.? I’m a Canadian based investor.? The simple solution is to pull in my exposure and be more Canada centric.? This idea conflicts with my goal to have my portfolio weighted in similar fashion to the global markets (i.e., Canada is a very small percentage relative to the total).? I also do not subscribe to the excessive weighting in gold as a major investment theme.? To me, it’s insurance to help offset risk elsewhere.

I’m not asking for specifics as you are not familiar with my situation.? Do you have any recommended reading or suggestions to help me test my thoughts and to identify options, so that I can arrive at a better decision?

Well, I’m not that old either.? During the last stagflation, I was aged 13 to 22, from junior high through my Master’s Degree in Economics at Johns Hopkins.? That said, I have read a lot on economic history, so I understand the era reasonably.? I also spent many of my Friday evenings as a teenager watching Wall Street Week with my first teacher on investments.? (Hi, Mom! 🙂 )? Another thing I remember is being the student representative to the school board for two years 1977-1979, when our district in Brookfield, Wisconsin decided to do a wide number of capital improvements in order to save energy, at the peak of the “energy crisis.”? I remember that the payback periods were 15 years or so, not counting interest that they would have to pay on the munis that they issued.? No way that project saved money on a net present value basis.? (And it was depressing to see 2/3rds of the windows covered up.)

During the last Stagflation, bonds were called “certificates of confiscation” by many professionals in fixed income.?? It paid to have your fixed income assets as short as possible.? Money market funds, a new invention at the time, were the optimal place to be until about 1982, when the cycle shifted, and the longest zero coupon bonds were the new best place to be.? Timing the shift between cycles is difficult, so don’t try to time it exactly, but add more longer bonds as long rates rise.? Right now, I would stay in money market funds, inflation protected bonds, and foreign currency denominated bonds.? You have enough Canadian exposure, so aside from you money market funds, consider bond investments in the yen, Swiss franc and Euro.

As for equities, pricing power is critical.? Who can raise prices more than the cost of their inputs?? Producers of global commodities like oil, metals, etc., typically do well here.? Financial companies with short duration assets or exposure to hard assets should do better here.? Staples should do better versus durables.? Growth investing should beat value investing (uh, oh, what do I do?? All of my processes are geared toward value investing).?? Cyclical names may beat them both.

If inflation really takes off, hard assets will offer some shelter though housing will lag until the inflation of real estate exceeds the deterioration of the debt.? I occasionally like gold, but it’s not a panacea.? I’d rather own the economically necessary commodities.

But what if stagflation does not become a reality?? That’s why we diversify.? I don’t tie my whole portfolio to one macroeconomic view.? Instead, I merely tilt it that way, leaving enough exposure elsewhere to compensateif my economic forecast is wrong.? I am a value investor, and almost always have a a few companies that will do well even if my economic forecast fails.

In summary: keep your domestic bonds short.? Diversify into foreign currency bonds.? Keep a diversified equity portfolio, but focus on companies that are immune to, or can benefit from inflation.