It is rich, really rich, to look at the rantings of a bunch of bureaucrats and banking regulators who could not properly regulate banks for solvency from 2003-2008, and have them suggest solvency regulation for a class of businesses that they understand even less.
And, this is regarding an industry that posed little?systemic threat during the financial crisis. ?Yes, there were the life subsidiaries of AIG that were rescued by the Fed, and a few medium-large life insurers like Hartford and Lincoln National that took TARP money that they didn’t need. ?Even if all of these companies failed, it would have had little impact on the industry as a whole, much less the financial sector of the US.
Life insurance companies have much longer liability structures than banks. ?They don’t have to refresh their financing frequently to stay solvent. ?It is difficult to have a “run on the company” during a time of financial weakness. ?Existing solvency regulation done by actuaries and filed with the state regulators considers risks that the banks often do not do in their asset-liability analyses.
Systemic risk comes from short-dated financing of long-dated assets, which is often done by banks, but rarely by life insurers. ?I’ve written about this many times, and here are two of the better ones:
MetLife and other insurers should not have to live with the folly of “Big == Systemic Risk.” ?Rather, let the FSOC focus on all lending financials that borrow short and lend long, particularly those that use the repurchase markets, or fund their asset inventories via short-term lending agreements. ?That is the threat — let them regulate banks and pseudo-banks right before they dare to regulate something they clearly do not understand.
One of the best things for me regarding blogging are the readers who ask me questions. ?When I get a set of them that are general enough, I answer them for all my readers, after stripping out identifying data. ?Here is the most recent:
Thank you for your work on your blog which I read with great interest!
I would have a question for you regarding private equity vs. public traded stocks:
– Does a private investor who is investing/saving for?retirement?need?private equity investments?
– Does such an investor make a big mistake if only investing in publicly traded stocks?
– Do you also invest in private equity?
– Is there any evidence that private equity is outperforming simple passive index investing?
?Many thanks for your time and all the best.
Before I answer the questions, let me take a step backward, and be a little more general, asking a few questions of my own:
1) If you wanted to invest in private equity, how would you do it?
2) What are some of the disadvantages and advantages of investing in private equity?
3) Why don’t?amateur investors invest in just a few public stocks?
Okay, here goes:
If you wanted to invest in private equity, how would you do it?
There are two ways to do it, and I have done each one in my life:
a) invest in a private equity fund
b) invest in a friend’s business
I’m going to ignore the new phenomenon of crowdsourcing, because it is too new to evaluate. ?Wait for it to mature before committing funds.
Now, investing in a private equity fund usually requires being an accredited investor, because the legal form is that of a limited partnership, and those who invest in that are supposed to be sophisticated investors who can afford to lose it all.
Now, in my days of working inside insurance companies, late in?the ’90s, it was all the rage for life insurers to invest in private equity funds. ?I remember being brought in to vet deals after my boss had informally set his heart on doing them. ?As you might guess, I was not too crazy about a tech-heavy fund that was investing in dot-coms, still, we ended up doing it. ?I liked better a?private equity fund that was investing in small and medium-sized ordinary businesses in the Mid-Atlantic region.
We invested in both of them; neither one ended up returning the capital to the insurance company. ?Just because?the institution?is big enough to be a Qualified Institutional Buyer does not mean that it has?the smarts to actually evaluate the risks taken?on. ?Similarly, just because you are an “Accredited Investor” doesn’t mean you are capable of evaluating the risks you will be taking. ?All it means is that the government won’t stand in the way of you losing money that they keep the little guys from losing.
As for investing in a friend’s business, I have done it twice, and so far, seemingly successfully with each: Wright Manufacturing and Scutify. ?You don’t have to be accredited to be an angel investor, but it can be a take it as it comes sort of thing if you don’t live in an area where lots of new ventures get created.
In these situations, it is?good if you bring more than capital to the table. ?Particularly with Wright Manufacturing, I have tried to make my help available when needed when the firm has faced challenges.
What are some of the disadvantages and advantages of investing in private equity?
Disadvantages
Illiquid — in a fund, you are locked up for years. ?Investing in a friend’s business means you are at the mercy of the firm and other shareholders if you want to buy more or sell some. ?If you think bid/ask spreads for illiquid public stocks are wide, they are narrow compared to owning shares in a private business.
The management has information advantages, whether it is the fund or the friend’s business.
The variability of results is very high, with many investments being total losses. ?As true of public equities, don’t invest what you can’t afford to lose.
Your friend may try to raise capital at times where you can’t or don’t want to participate.
You may not get the same amount of data to analyze as with a public company; then again, you may get the inside scoop.
Advantages
The fund could have genuine professionals sourcing business prospects otherwise unavailable to most for investment.
Your friend could really be onto something big.
There is the remote possibility of hitting a home run and making a return many times greater than your capital.
Sometimes there are tax advantages (say, for creating manufacturing jobs in Maryland).
Stock prices are not posted for you, and so you don’t panic so easily, and after all, you would have a hard time selling.
Why don’t?amateur investors invest in just a few public stocks?
Most amateur investors are not good enough at business to find a few superior?businesses and hang onto only those. ?Don’t feel bad, though, that’s true of almost all professionals. ?Diversification is the only free lunch in the business,?because it reduces the variability of returns. ?If you think investors do badly panicking with diversified funds as in 2008-9, if they were only holding a few companies, the volatility would be so great that many more would lose confidence.
The upshot here is that the results of own shares in just a few private companies will vary tremendously; most people will not be able to live with that level of variability,?lack of liquidity, and lack of control.
So, onto my reader’s?questions:
Do you also invest in private equity?
I have done so, as I have said, but most of my investments are in public equities following my own strategies. ?My?asset allocation would look something like this:
Public equities 55%
Private equities 15%
House 15%
Bonds & cash 15%
No debt
Does a private investor who is investing/saving for?retirement?need?private equity investments?
Need it? No. ?Could you use it if accredited, or investing in the businesses of friends? Yes.
Does such an investor make a big mistake if only investing in publicly traded stocks?
No. ?Think of it this way — private equity tends to do about as well as leveraged index funds, on average. ?A portfolio of private equity and bonds will do about as well as some equity index funds, on average, with a much wider degree of variation than the index funds.
As an aside, to two private firms in which I hold shares carry little debt. ?That lowers my risk.
Is there any evidence that private equity is outperforming simple passive index investing?
It does better in good times on average, and worst in bad times, and is far more variable. ?One note, be careful about some of the Internal Rate of Return [IRR] figures that some private equity funds trot out. ?The returns are overstated because the capital is drawn on slowly, which inflates the IRR. ?That said, investors have to plan for that capital to be drawn, and must have some slack assets earning less to fund the later draws on capital. ?If that cost were factored in, the IRR would go down considerably.
In Closing
If I were talking to an amateur investor who wanted to run a concentrated portfolio of value stocks in the public markets, I would say, learn a lot, and put in enough time to make it a second job. ?The same would be more true for the fellow attempting to do the same thing in private equity — it is harder.
If I were talking with an amateur investor trying to find a very good?mutual fund manager or registered investment adviser [RIA] for his funds, I would tell him to look carefully for active share, is?the process sensible and repeatable, etc. ?If he were accredited, and wanted to do the same for private equity, I would be inclined to tell him to hire a specialist consultant to find it for him, because the data is not as available, and the games are more opaque. ?Add in that the big, respected names stick with institutions as clients — smaller amounts of money will have to find a good manager that is also off the beaten track.
So no, there is no advantage to private equity after taking into account the disadvantages. ?Both of my investments have had more than their share of ups and downs; I don’t think the average person is made for that.
About 1 1/2 years ago, I wrote a seven-part series on investing in insurance stocks. ?It is still a good series, and worthy of your time, because there aren’t *that* many writers freely available on the topic.
This particular article deals expands on part 4 of that series, which deals with insurance reserving. ?I wanted to do this at the time, but I was short on time, and wrote out the general theory there, while not actually doing the time-consuming job of ranking the conservativeness of P&C insurers reserving practices.
Let me quote the two most important sections from part 4:
When an insurance policy is written, the insurer does not know the true cost of the liability that it has incurred; that will only be known over time.
Now the actuaries inside the firm most of the time have a better idea than outsiders as to where reserve should be set to pay future claims from existing business, but even they don?t know for sure.? Some lines of insurance do not have a strong method of calculating reserves.? This was/is true of most financial insurance, title insurance, etc., and as such, many such insurers got wiped out in the collapse of the housing bubble, because they did not realize that they were taking one big nondiversifiable risk.? The law of large numbers did not apply, because the results were highly correlated with housing prices, financial asset prices, etc.
Even with a long-tailed P&C insurance coverage, setting the reserves can be more of an art than science.? That is why I try to underwrite insurance management teams to understand whether they are conservative or not.? I would rather get a string of positive surprises than negative surprises, and you tend to one or the other.
and
What is the company?s attitude on reserving?? How often do they report significant additional claims incurred from business written more than a year ago?? Good companies establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves.
So get out the 10K, and look for ?Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years.?? That value should be consistently negative.? That is a sign that he management team does not care about maximizing current period profits but is conservative in its reserving practices.
One final note: point 2 does not work with life insurers.? They don?t have to give that disclosure.? My concern with life insurers is different at present because I don?t trust the reserving of secondary guarantees, which are promises made where the liability cannot easily be calculated, and where the regulators are behind the curve.
As such, I am leery of life insurers that write a lot of variable business, among other hard-to-value practices.? Simplicity of product design is a plus to investors.
Today’s post analyzes Property & Casualty Insurers, and looks at their history of whether they consistently reserve conservatively each year. ? Repeating from above, management teams that reserve conservatively?establish strong reserves on current year business, which depress current year profits, but gain reserve releases from prior year strongly set reserves. ?This should give greater confidence that the accounting is fair, if not conservative.
So, I went and got the figures for “Increase (decrease) in net losses and loss expenses incurred in respect of losses occurring in: prior years,” for?67 companies over the past 12 years from the EDGAR database. ?Today I share that with you.
When you look at the column “Reserving by Year,” that tells you how the reserving for business in prior years went over time. ?A company that was consistently conservative of the past twelve?years would have “12N’ written there for twelve negative adjustments to reserves. ?Using Allstate as an example, the text is “5N, 1P. 3N, 3P” which means for the last 5 years [2013-2009], Allstate had negative adjustments to prior year reserves. ?In 2008, it had to strengthen prior year reserves. ?2007-2005, negative adjustments. ?2004-3,?it had to strengthen prior year reserves.
Now, in reserving, current results are more important than results in the past. ?Thus, in order to come up with a score, I discounted each successive year by 25%. ?That is, 2013 was worth 100 points, 2012 was worth 75, 2011 was worth 56, 2010 was worth 42 points, etc. ?Since not all of the companies were around for the full 12 years, I normalized their scores by dividing by the score of a hypothetical company that was around as long as they were that had a perfect score.
Now, is this the only measure for evaluating an insurance company? ?Of course not. ?All this measures?in a rough way is the willingness of a management team to reduce income in the short-run in order to be more certain about the accounting. ?Consult my 7-part series for more ways to analyze insurance companies.
As an example, imagine an insurance company that consistently writes insurance business at an 80% combined ratio. ?[I.e. 20% of the premium emerges as profit.] ?I wouldn’t care much about minor reserve understatement. ?Trouble is, few companies are regularly that profitable, and companies that understate reserves tend to get into trouble more frequently.
Comments and Surprises
1) Now, it is possible for a company to game this measure in the short run, where the management aims to always release some reserves from prior year business whether it is warranted or not. ?That may have happened with Tower Group. ?Very aggressive in growth, after their initial periods, they consistently released reserves for eight years, before delivering huge reserve increases for two years.
Now, someone watching carefully might have noticed a reserve strengthening for their non-reciprocal business in 2011, and then strengthenings in mid-2012, before the whole world realized the trouble they were in.
2) Notice in the red zone (scores of 40% and lower) the number of companies that did subprime auto insurance — Infinity, Kingsway, and Affirmative. ?That business is very hard to underwrite. ?In the short run, it is hard to not want to be aggressive with reserves.
3) Also notice the red zone is loaded with companies with much recent strengthening of reserves. ?Many of these companies are smaller, with a few exceptions — the law of large numbers doesn’t apply so well with smaller companies, so they mis-estimate more frequently. ?I won’t put companies with less than $1 billion of market cap into the Hall of Shame. ?It’s hard to get reserving right as a smaller company.
4) As for larger companies, they can be admitted to the Hall of Shame, and here they are:
Hall of Shame
AIG
The Hartford
AmTrust Financial Services
Mercury General, and?
National General Holdings
AIG is no surprise. ?I am a little surprised at the Hartford and Mercury General. ?National General Holdings and Amtrust are controlled by the Karfunkels, who are aggressive in managing their companies. ?Maiden Holdings, another of their companies is in the yellow zone.
Final Notes
I would encourage insurance investors to stick to the green zone for their investing, and maybe the yellow zone if the company has compensating strengths. ?Stay out of the red zone.
This analysis could be improved by using prior year reserve releases as a fraction of beginning of year reserves, and then discounting by 25% each year. ?Next time I run the analysis, that is how I will update it. ?Until then!
Above is the chart, and here is the data for tonight’s piece:
Date
T1
T3
T5
T7
T10
T20
T30
AAA
BAA
Spd
Note
3/1/71
3.69
4.50
5.00
5.42
5.70
5.94
6.01*
7.21
8.46
1.25
High
4/1/77
5.44
6.31
6.79
7.11
7.37
7.67
7.73
8.04
9.07
1.03
Med
12/1/91
4.38
5.39
6.19
6.69
7.09
7.66
7.70
8.31
9.26
0.95
Med
8/1/93
3.44
4.36
5.03
5.35
5.68
6.27
6.32
6.85
7.60
0.75
Med
10/1/01
2.33
3.14
3.91
4.31
4.57
5.34
5.32
7.03
7.91
0.88
Med
7/1/04
2.10
3.05
3.69
4.11
4.50
5.24
5.23
5.82
6.62
0.80
Med
6/1/10
0.32
1.17
2.00
2.66
3.20
3.95
4.13
4.88
6.23
1.35
High
8/1/14
0.13
0.94
1.67
2.16
2.52
3.03
3.29
4.18
4.75
0.57
Low
Source: FRED ? ||| ? ? * = Simulated data value ?||| ?Note: T1 means the yield on a one-year Treasury Note, T30, 30-year Treasury Bond, etc.
Above you see the seven yield curves most like the current yield curve, since 1953. ?The table also shows yields for Aaa and Baa bonds (25-30 years in length), and the spread between them.
Tonight’s exercise is to describe the historical environments for these time periods, throw in some color from other markets,?describe what happened afterward, and see if there might be any lessons for us today. ?Let’s go!
March 1971
Fed funds hits a local low point as the FOMC loosens policy under Burns to boost the economy, to fight rising unemployment, so that Richard Nixon could be reassured re-election. ?The S&P 500 was near an all-time high. ?Corporate yield spreads ?were high; maybe the corporate bond market was skeptical.
1971?was a tough year, with the Vietnam War being unpopular.?Inflation was rising, Nixon severed the final link that the US Dollar had to Gold, an Imposed wage and price controls. ?There were two moon landings in 1971 — the US Government was in some ways trying to do too much with too little.
Monetary policy remained loose for most of 1972, tightening late in the years, with the result coming in 1973-4: a severe recession accompanied by high inflation, and a severe bear market. ?I remember the economic news of that era, even though I was a teenager watching Louis Rukeyser on Friday nights with my Mom.
April 1977
Once again, Fed funds is very near its local low point for that cycle, and inflation is rising. ?After the 1975-6 recovery, the stock market is muddling along. ?The post-election period is the only period of time in the Carter presidency where the economy feels decent. ?The corporate bond market is getting close to finishing its spread narrowing after the 1973-4?recession.
The “energy crisis” and the Cold War were in full swing in April 1977. ?Economically, there was no malaise at the time, but in 3 short years, the Fed funds rate would rise from 4.73% to 17.61% in April 1980, as Paul Volcker slammed on the brakes in an effort to contain rising inflation. ?A lotta things weren’t secured and flew through the metaphorical windshield, including the bond market, real GDP,?unemployment, and Carter’s re-election chances. ?Oddly, the stock market did not fall but muddled, with a lot of short-term volatility.
December 1991
This yield curve is the second most like today’s yield curve. ?It comes very near the end of the loosening that the FOMC was doing in order to rescue the banks from all of the bad commercial real estate lending they had done in the late 1980s. ?A wide yield curve would give surviving banks the ability to make profits and heal themselves (sound familiar?). ?Supposedly at the beginning of that process in late 1990, Alan Greenspan said something to the effect of “We’re going to give the banks a lay-up!” ?Thus Fed funds went from 7.3% to 4.4%?in the 12 months prior to December 1991, before settling out at 3% 12 months later. ?Inflation and unemployment were relatively flat.
1991 was a triumphant year in the US, with the Soviet Union falling, Gulf War I ending in a victory (though with an uncertain future), 30-year bond yields hitting new lows, and the stock market hitting new all time highs. ?Corporate bonds were doing well also, with tightening spreads.
What would the future bring? ?The next section will tell you.
August 1993
This yield curve is the most like today’s yield curve. ?Fed funds are in the 13th month out of 19 where they have been held there amid a strengthening economy. ?The housing market is?doing well, and mortgage refinancing has been high for the last three years, creating a situation where those investing in mortgages securities have a limited set of coupon rates that they can buy if they want to put money to work in size.
An aside before I go on — 1989 through 1993 was the era of clever mortgage bond managers, as CMOs sliced and diced bundles of mortgage payments so that managers could make exotic bets on moves in interest and prepayment rates. ?Prior to 1994, it seemed the more risk you took, the better returns were. ?The models that most used were crude, but they thought they had sophisticated models. ?The 1990s were an era where prepayment occurred at lower and lower thresholds of interest rate savings.
As short rates stayed low, long bonds rallied for two reasons: mortgage bond managers would hedge their portfolios by buying Treasuries as prepayments occurred. ?They did that to try to maintain a constant degree of interest rate sensitivity to overall moves in interest rates. ?Second, when you hold down short rates long enough, and you give the impression that they will stay there (extended period language was used — though no FOMC Statements were made prior to 1994), bond managers start to speculate by buying longer securities in an effort to clip extra income. ?(This is the era that this story (number 2 in this article) took place in, which is part of how the era affected me.)
At the time, nothing felt too unusual. ?The economy was growing, inflation was tame, unemployment was flat. ?But six months later came the comeuppance in the bond market, which had some knock-on effects to the economy, but primarily was just a bond market issue. ? The FOMC hiked the Fed funds rate in February 1994 by one?quarter percent, together with a novel statement issued by Chairman Greenspan. ?The bond market was caught by surprise, and as rates rose, prepayments fell. ?To maintain a neutral market posture, mortgage bond managers sold long Treasury and mortgage bonds, forcing long rates still higher. ?In the midst of this the FOMC began raising the fed funds rate higher and higher as they feared economic growth would lead to inflation, with rising long rates a possible sign of higher expected inflation. ?The FOMC raises Fed fund by 1/2%.
In April, thinking they see continued rises in inflation expectation, they do an inter-meeting surprise 1/4% raise of Fed funds, followed by another 1/2% in May. ?It is at this pint that Vice Chairman McDonough tentatively realizes?[page 27] that the mortgage market has?now tightly coupled the response of the long end of the bond market to the short end the bond market, and thus, Fed policy. ?This was never mentioned again in the FOMC Transcripts, though it was the dominant factor moving the bond markets. ?The Fed was so focused on the real economy, that they did not realize their actions were mostly affecting the financial economy.
FOMC policy continued: Nothing in July, 1/2% rise in August, nothing in September, 3/4% rise in November, nothing in December, and 1/2% rise in February 1995, ending the tightening. In late December 1994 and January of 1995, the US Treasury and the Fed participated in a rescue of the Mexican peso, which was mostly caused by bad Mexican economic policy, but higher rates in the US diminished demand for the cetes, short-term US Dollar-denominated Mexican government?notes.
The stock market muddled during this period, and the real economy kept growing, inflation in check, and unemployment unaffected. ?Corporate spreads tightened; I remember that it was difficult to get good yields for my Guaranteed Investment Contract [GIC] business back then.
But the bond markets left their own impacts: many seemingly clever mortgage bond managers blew up, as did the finances of Orange County, whose Treasurer was a mortgage bond speculator. ?Certain interest rate derivatives blew up, such as the ones at Procter & Gamble. ?Several life insurers lost a bundle in the floating rate GIC market; the company I served was not one of them. ?We even made extra money that year.
The main point of August 1993 is this: holding short rates low for an extended period builds up imbalances in some part of the financial sector — in this case, it was residential mortgages. ?There are costs to providing too much liquidity, but the FOMC is not an institution with foresight, and I don’t think they learn, either.
This has already gotten too long, so I will close up here, and do part II tomorrow. ?Thanks for reading.
Warren Buffett has made such an impression on value investors and insurance investors, that they think that float is magic. ?Write insurance, gain float, invest cleverly against the float, and make tons of money.
Now, the insurance industry in general?has been?a great place to invest, but we need to think about float differently. ?Float is composed of two things: claim reserves and premium reserves.
Claim reserves are the assets set aside to satisfy all claims that likely will be made as of the current date.
Premium reserves are the assets set aside representing prepaid premiums that have not been earned yet.
Claim reserves can be long, short or in-between. ?Last night’s article dealt with long claim reserves — asbestos, environmental, etc. ?Those reserves can be invested in stocks, real estate, long bonds, etc. ?But most claim reserves are pretty short, like a year or so for most personal insurance auto & home claims — those typically get settled in a year.
The there are classes of insurance business that are in-between — workers comp, D&O, E&O, commercial liability, business continuation, etc. ?Investing the claim reserves should reflect the length of time it will take until ultimate payoff.
The premium reserves are very short. ?If premiums are paid annually, the average period for the premium reserves?is half a year. ?If premiums are paid more frequently, the average period for the float falls, but the premiums rise disproportionately to reflect the insurance company’s desire to have the full year’s premium on hand. ?It usually makes sense for policyholders to pay at the longest period allowed — thus, thinking about premium reserves as having a ?duration of half a year on average makes sense. ?Except auto — make that a quarter of a year.
Earnings financed by?float should be divided into two pieces — non-speculative, and speculative. ?The non-speculative returns on float reflect what can be earned by investing in high quality bonds that match the time period over which the float will exist. ?Short for premium reserves, longer for claim reserves. ?So, the value of float is this:
Present value of (investment earnings of high quality duration-matched assets plus underwriting gains [or minus losses]).
This is a squishy calculation, because we do not know:
the number of years to calculate it over
future underwriting gains or losses
The speculative earnings from float come from assuming that float will stay at the same levels or grow over many years, and so the insurer invests more aggressively, assuming that float will be a permanent or growing thing. ?He speculates by financing stocks or whole businesses using the float that could reduce, or that could become more expensive.
How could that happen? P&C insurance often gets very competitive, and the cost of maintaining float in a soft underwriting environment is considerable. ?Also note the claim reserves mean that the company took a loss. ?That the company earns something while waiting to pay the loss does not help much. ?Far better that there were fewer losses and less float.
Smart P&C insurance companies reduce underwriting in soft markets, and in such a time, float will shrink. ?Let aggressive companies undercharge for bad business, and let them choke on it, while we make a little less money.
Well-run insurers let float shrink – they don’t depend on float being the same, much less growing. ?If it does grow, great! ?But don’t invest assuming it will always be there or grow forever. ?That way lies madness.
Berkshire Hathaway has benefited from intelligent underwriting and intelligent investment over a long period. ?That is not normal for insurance companies. ?That is why it has done so well. ?Float is a?handmaiden to good results, but not worth the attention paid to it. ?After all, all?insurance companies have float, but none have done as well as Berkshire Hathaway. ?Better you should focus on underwriting earnings rather than float.
Underwriting insurance produces premium float. ?Underwriting bad business produces claim reserve float. ?Float is not an unmitigated good. ?Good underwriting is an unmitigated good. ?So focus on underwriting, and not float.
=-=-=-=-=-=-=-=-=-=-=-===-
Berkshire Hathaway has been in the fortunate position of having had wise underwriters, and and ability to expand into new markets for many years. ?Guess what, that was AIG up until 2003 or so. ?After that, they could not find more profitable markets to underwrite, and results began to deteriorate. ?They ran up against the limits of their ecosystem.
Buffett is a brighter man than Greenberg; he can consider a greater realm of possibilities in how to run an insurance conglomerate, and the results have been better. ?All that said, there is only so much insurance to underwrite in the world, and big insurers will eventually run out of places to write insurance profitably.
All that said — float is a sideshow. ?Focus on profitable underwriting — that is what drives the best insurers.
Recently, a friend of mine from Canada came to stay with me. ?We talked about a wide number of things, but when we talked about investing, I described insurance investing to him, giving my usual explanation on reserving.
Classical life insurance reserves are a science. ?Death happens with regularity, it is only a question of when. ?Short-tail P&C, health, etc, are almost a science — the claims come quickly, and the reserves get adjusted rapidly. ?Long-tail Casualty and Liability?is a dark art at best. ?Mortgage, financial, and title insurance reserving is?not even an art; there is no good theory behind them, as is true of life insurance products with secondary guarantees, particularly those dealing with variable products.
As an example of long-tail P&C, I told my friend about Berkshire Hathaway and asbestos — I mentioned to him how BRK has become the reinsurer of choice for insurers with uncertain asbestos liabilities. ?Buffett has reinsured White Mountains, AIG, CNA, Equitas. and many others, the most recent being Liberty Mutual, which happened after the talk with my friend.
This is retroactive reinsurance, where an insurer purchases insurance from a reinsurer to cover business previously written. ?This is an uncommon form of insurance, and most commonly used when the amount of claims is very uncertain.
Quoting from the Bloomberg article:
Liberty Mutual Group Inc. issued $750 million of bonds to help finance a payment to a unit of?Warren Buffett?s?Berkshire Hathaway Inc. (BRK/B)?for covering the insurance company?s liabilities tied to asbestos.
The 4.85 percent, 30-year notes were sold to yield 160 basis points more than similar-maturity Treasuries, according to data compiled by Bloomberg.?Standard & Poor?s?increased Liberty Mutual?s rating one level to BBB from BBB- after Berkshire?s National Indemnity Co. agreed last week to provide as much as $6.5 billion of coverage for the insurance company?s liabilities for asbestos, environmental and workers? compensation policies.
?This agreement covers Liberty Mutual?s potentially volatile U.S. A&E liabilities and largely mitigates potential risks from future adverse reserve developments,? Tracy Dolin, an S&P analyst, said in a statement.
Berkshire, which has grown over the last five decades by investing insurance premiums in stocks and takeovers, has assumed billions of dollars in asbestos risk from insurers including American International Group Inc. and CNA Financial Corp.
Liberty Mutual paid Omaha, Nebraska-based National Indemnity about $3 billion for the coverage, according to a July 17 company statement.
This is similar to the other deals, where the premium paid is roughly half the amount of what BRK could have ot pay out at maximum. ?Note that BRK has capped its exposure to the claims.? ?If asbestos claims against Liberty Mutual exceed $6.5 Billion, Liberty Mutual will have to pay the excess.
I don’t think there is another American insurance company with more asbestos exposure than BRK. ?That’s not necessarily a bad thing, though. ?Let me quote from BRK’s recent 10-K:
We are exposed to environmental, asbestos and other latent injury claims arising from insurance and reinsurance contracts. Liability estimates for environmental and asbestos exposures include case basis reserves and also reflect reserves for legal and other loss adjustment expenses and IBNR [DM: Incurred But Not Reported] reserves. IBNR reserves are based upon our historic general liability exposure base and policy language, previous environmental loss experience and the assessment of current trends of environmental law, environmental cleanup costs, asbestos liability law and judgmental settlements of asbestos liabilities.
The liabilities for environmental, asbestos and other latent injury claims and claims expenses net of reinsurance recoverables were approximately $13.7?billion at December?31, 2013 and $14.0?billion at December?31, 2012. These liabilities included approximately $11.9?billion at December?31, 2013 and $12.4?billion at December?31, 2012 of liabilities assumed under retroactive reinsurance contracts. Liabilities arising from retroactive contracts with exposure to claims of this nature are generally subject to aggregate policy limits. Thus, our exposure to environmental and other latent injury claims under these contracts is, likewise, limited. We monitor evolving case law and its effect on environmental and other latent injury claims. Changing government regulations, newly identified toxins, newly reported claims, new theories of liability, new contract interpretations and other factors could result in significant increases in these liabilities. Such development could be material to our results of operations. We are unable to reliably estimate the amount of additional net loss or the range of net loss that is reasonably possible.
Long tail P&C reserves are roughly 20% of the total gross P&C reserves of BRK, and this deal with Liberty Mutual increases it. ?Again, that’s not a bad thing, necessarily. ?Given the premium paid, even if BRK pays out the maximum on average 10 years from now, the deal is a winner if BRK earns more than 8% per year. ?If 15 years 5.3%. ?If 20 years, 4%. ?Given the long period before the ultimate payment of claims, BRK can make money in most scenarios.
That said, if anything bad ever did happen to BRK,?such that its solvency was impaired, there would be a lot of insurance companies hurting as a result. ?BRK is critical to the payment of asbestos claims. ?There is not a better company to entrust with this task.
Full Disclosure: Long BRK/B for myself and clients — we own the equivalent of one “A” share.
When I was a young actuary, say in the early 90s, my boss came to me, and gave me an unrequested lesson. ?He said something to the effect of:
Most pricing actuaries make assumptions. ?Well, I test assumptions. ?That involves checking how actual results are coming in?expected, but in the early phases of a new product, you are living under the law of small numbers — you don’t have enough data to be statistically credible. ?You should still do the statistical analysis, but I take it one step further.
I pull the first 10-20?claim files and look at the cause for the claim. ?If the qualitative causes are not chance events, but are indications that the business is being sold improperly to those who know they are close to death (or disability) and evade the limited underwriting of the group coverage, that means the group is low quality, and the program should be discontinued, or severely modified.
He then told me about some credit life insurance that the company was offering through two well known, prestigious banks, and how the deaths were coming in from non-random causes: AIDS, Cancer, Drowned in the Hudson River, Murder, etc.
He fought to get that insurance line shut down, and it took him five years, as the line manager argued there was not enough experience. ?The line manager tried to get my boss fired, and finally, the line manager was fired. ?But if the company had listened early they would have lost $10M. ?As it was, they lost several hundreds of millions of dollars.
Now, most of my readers don’t care much about insurance, but this tale is meant to illustrate that reason for losses matters as much, and sometimes more than the absolute amount lost. ?Now to illustrate this for a different and perhaps more timely reason:
Maybe I am growing up a little, but I am trying to have better titles for my articles. ?The subheading above would have been my title. ?But let me explain what it means:
The credit cycle tends to be like this: in the bull phase, a long period (4-7 years) with few defaults and low loss severity followed by a bear phase, a shorter period (1-3 years) with high defaults and high loss severity. ?This is a phenomenon where history may not repeat exactly, but it will rhyme very well.
In the bull phase of the credit cycle there are a few defaults, but when you analyze the defaults, they occur for reasons unrelated to the economy as a whole. ?What do the failures look like? ?Fraud (think Enron), bad business plans from a megalomanic (think Reliance Insurance, ACH, Southmark, etc.) , a sudden shift in relative prices (think Energy Future Holdings), etc. ?Bad banking — think Continental Illinois in 1984.
In the bull phase, companies that fail would fail in any environment. ?But now let’s talk about the transition between the bull and bear phase — that is the “pop, Pop, POP.”
As the credit cycle shifts, a few companies fail that are closely related to the crisis that will come. ?They are your early warning. ?Think of the subprime lenders under stress in 2007, or the failure of Bear Stearns in early 2008. ?Think of LTCM in 1998, or the life insurers that came under stress for writing too many GICs [Guaranteed Investment Contracts] in the late 80s and invested the money in commercial mortgages.
As the cycle moves on defaults become more closely related to the financial economy as a whole. ?Fed policy is tight, and a bunch of things blow up that borrowed too much money short term. ?This is when the correlated failures happen:
Banks, mortgage insurers, and overly leveraged homeowners default 2008-2011.
Dot-coms fail because they can’t pay their vendor finance.
Mexico and the mortgage markets blow up in 1994.
Commercial mortgages blow up in the early 90s.
LDC loans blow up in the early 80s.
To the Present
The present is always confusing. ?I get it right more often than most, but not by a large margin. ?We have companies threatening to fail in China?and?Portugal, but I don’t see much systemic lending risk in the US yet, aside from what is leftover from the last crisis.
It is worth noting that deleveraging has occurred more in word than in deed over the last five years. ?Yes, debt has traveled from public to private hands, but that only defers the problems, as governments will either have to inflate, tax more, or default to deal with the additional debts.
I am not trying to sound the alarm here. ?I am trying to tell you to be ready. ?During the intermediate phase between bull and bear, the weakest companies fail from unrecognized systemic risk. ?Personally, I think I have heard the first ‘pop.” ?It is coming from nations that did not delever, and that may suffer further if the bad debts overwhelm the banking systems.
Are you ready for the bear phase of the credit cycle? ?Screen your portfolios, and look for weak names that will not survive a general panic where only the best names can get credit.
Before I start, thanks to all those who e-mailed me over my “sorted weekly tweets.” ?I am likely to continue doing them. ?That will start next week, because I have had a flood of new clients, and other obligations.
On Fixed Payment Annuities
How often do you run into articles in quality publications talking about annuities that will pay a fixed sum over your life, or over your life if you live past a certain age? ?Not often, right? ?Right. ?Well, today I got two articles on the same day:
Longevity insurance is an important topic, and everyone should consider getting an income that they can’t outlive. ?That said, there are two problems with this:
Inflation, and
Credit risk (will the insurer survive to make the payments?)
It is possible to buy inflation-protected annuities, but at a cost of a lower initial payment. ?With credit risk, consider what the state guaranty funds will cover in insolvency, and realize that any payments over that amount could be lost due to insurer insolvency. ?If you have a large payment, only buy from strong insurers.
Then there are the deferred fixed payment annuities. ? You are 50 years old, and you want a payment stream that kicks in when you are 80, should you live so long. ?You can buy a lot of income that far out, which will help you if you survive, subject to the same two main risks: inflation and credit risk. ?I am not aware of any deferred inflation-adjusted payment annuities.
Now, you can think of your annuity as a replacement for long-dated fixed interest bonds. ?A portfolio of fixed payment annuities, cash, maybe some commodities/gold, and stocks could be very stable, balancing the risks of inflation and deflation, and of high and low real rates.
There is the added benefit of the regular income which is useful to average people, who are okay with budgeting, but really don’t understand investments. ?Just beware inflation and credit risk.
One more note: most insurance agents will never suggest immediate annuities to you because when you buy one, that’s the last commission the agent ever gets. ?They would rather you buy a deferred annuity, where they can gain another commission when the surrender charge period is up, and roll you to a new product.
Summary
Longevity insurance is good, but be sure you avoid credit risk, and have other assets to compensate for potential inflation risk.
Thank you very much for your blog! I am hooked since I found it and have been getting smarter by the day!
I like Safety Insurance Group, found it through your blog, noticed you were no longer long. They don’t do life insurance, just cars and houses – I know you say not to mix because they are sold and underwritten differently. They had a rough Q1 but a good 2013, seems like the winter Mass weather might have done it. They are over Book of 1 so there are other insurers that are cheaper, but they look like a good compliment to NWLI (also found through you and like very much) in the auto space, in a small (and thus dominate-able) market.?
Am I missing something about SAFT??
Many sincere thanks David!
I like the management team at Safety Insurance. ?When I met with them years ago, they impressed me as bright businessmen competing well in one of the most dysfunctional insurance markets in the US — Massachusetts. ?Most major insurers did not write auto and home insurance there as a result. ?But then the state of Massachusetts began to loosen up their tight regulations, and some of the bigger insurers that stayed away have entered — GEICO, MetLife, Liberty Mutual, etc.
When the market was more closed, SAFT had strategies that allowed them to profitably take market share Commerce Group [now Mapfre]. ?With more competition in Massachusetts, Safety’s earnings have suffered. ?I can’t get excited about a short tail P&C insurer trading above book at 13-14x forecast earnings.
Maybe people are buying it for the 4%+ dividend. ?I don’t use dividend yield as an investment criteria, for the most part. ?I would avoid Safety Insurance. ?It’s well-run, but the price of the stock is too high. ?If it drops below $35, it would be a compelling buy.
Hi David,
I was interested in your comment on Normalized Operating Accruals as an indicator of accounting quality.
Why is this?
I tend to view changes in accruals as an indication of the underlying strength of a business, but would appreciate your insight on this.
Thanks
The idea behind net?operating accruals is that accrual entries represent future cash flows, which are less certain than cash flows that have already happened. ?Companies that report high levels of accounts receivable, inventories, etc., as a fraction of assets or earnings, tend to offer negative earnings surprises, because many of those accruals will not convert to cash as expected.
An apology here, because the term commonly used is “net operating accruals” and I messed up by calling it “normalized.”
Companies with conservative accounting (fewer accruals) tend to have stronger earnings than those that are more liberal in revenue recognition.
Dave, you and I are too old school. We need to move into this century. The way that most people seem to get into the investment industry has nothing to do with what you talk about. It is far easier to become a “financial advisor” that pushes annuities on the 60+ crowd. You don’t really have to learn anything about investing. All you need to know is about salesmanship. Offer a free lunch/dinner and reel them in!
I honestly think that more folks are going this route instead of the “hard way” you have outlined. . .
Maybe you can do a sarcastic post: “How to NOT be valuable, but make a lot of money in the Investment Business.”
Personally I find the annuity and non-traded REIT pushers very repulsive. At the same time, I know several of them that have done very well . . .
There are two factors at work here — yield and illiquidity. ?The need for yield is driven by monetary policy. ?Particularly with a?sizable?increase in retirees, many of whom can’t make enough “income” when interest rates are so low, they take undue risks to get “income,” not realizing the risks of capital loss that they are taking.
When I was an analyst/manager of Commercial Mortgage Backed Securities, there was a key fact one needed to understand: safe mortgages?do not depend on whether the businesses leasing the properties operate well or not. ?Safe mortgages have no operational risk, and thus avoid theaters, marinas, etc. ?Stick to the four food groups: Multifamily, Retail, Office, and Industrial.
There will be negative events with insecure investments offering a high yield. ?You may not get the return of your money, as you try to get a high return on your money.
Then there is the illiquidity — that is what allows the sponsors the ability to pay high commissions to those who sell the annuities and non-traded REITs. ?Because the investors can’t leave the game, the income stream of the sponsor is very certain. ?They take a portion of the anticipated income stream, and pay it in a lump sum to their agents as a commission. ?And that is why the agents are so highly motivated.
Eventually, the demand for yield will be disappointed. ?Uncertain yields will fail in a crisis, and reset much lower. ?Income that stems from dividends, preferred dividends, MLPs, junk bonds, structured notes, etc., is not secure in the short-to-intermediate run. ?It is far better to invest to grow value than to invest for income. ?They can pay you a yield, sure, but if the underlying value is not growing, you will eventually get capital losses, and after that, much less yield.
Look for safety in yield investments. ?If you are going to take risks in investing, take risk, but ignore the income component. ?Don’t stretch for yield.
Buy side analyst for a financials only hedge fund 2003-2007. ?Managed the firm’s profit sharing and endowment monies using my value investing strategy.
Started my RIA in 2011, to offer clients my value strategy — they get a clone of what I own in my value strategy. ?I am my largest client, and I eat my own cooking.
2) What style of trading / investing do you practice (technically driven, fundamental, systematic, a combination etc)?
Mostly fundamental. ?Most of my trading is governed by these rules:
I tend to resist momentum in the intermediate term. ?From my era of hiring managers, those that used this technique said it added 1-3% to performance. ?I think that’s about right.
I limit changes to the portfolio, because it takes time for investment ideas to play out. ?I turn over the portfolio at a ~30% rate. ?I try to be as businesslike as possible when I sell a?company and buy another. ?Investors can be very good at evaluating whether a company or group of companies, is better than another company or group of companies. ?What is harder is asking, “Would I rather hold cash than this company?”
3) How do you feel when a trade goes against you?
Good. ?I get to buy a little more at a lower price, after I check my investment thesis, which if it does not check out, I sell the whole thing. ?For the few trades that do badly for a long time — 20 of them over the last 25 years, of course it hurts, but the gains far outweigh the losses, so I ignore those, except to memorialize why the failure happened, and feed that back into my investing processes. ?Every time I have lost badly, it was because I violated at least one of my rules.
4) How do you feel when a trade goes for you?
I like it, but I let my rules govern my trading. ?Everything is done by rules; there is almost no discretion in my trading.
5) How have these feelings changed over your trading career? ?(Can you recall how you originally used to feel and elaborate on how this has changed over time?)
When I was 20-25 years younger, every move in the markets would make me excited. ?By the mid-90s, I got my emotions under control. ?I learned to focus on eliminating risk on the front end, so that I would have fewer problems on the back end.
6) Do you have any practices that you do away from the trading screen to help you mentally and emotionally handle trading??(e.g. meditation, yoga, running, Tai Chi, kicking the dog, hitting the bottle etc)
I pray to Jesus Christ every day, but that is not a means to handle trading. ?I ask Him to guide?my decisions, and that I would do my investing to glorify Him.
Because I use my rules, there is little, if any, stress over trading. ?My processes are designed to take my emotion out of my infrequent buying and selling.
7) Have you always done this??
I’ve done this for the last 14 years. ?Prior to that, I was experimenting and developing my methods.
My time managing bond assets for life insurers taught me a lot about trading 1998-2003. ?I traded over $10 Billion in bonds over that short window of time. ?I was far more active as a bond manager, because it was simpler to ascertain when value-enhancing trades could be done. ?That fed into my value investing processes, which are designed to mimic the way a bond trader would look at stocks.
8) If not, how have you learnt to deal with the feelings that come up when trading?
Look, first, it’s only money. ?If you don’t take some significant losses during your life, you probably aren’t taking enough risk.
Second, investing takes time. ?I hold my positions three years on average, and the longest positions have been there for 5-10 years. ?A tree in my backyard won’t grow any faster if I worry about it. ?The same is true of my stocks. ?I review them quarterly. ?Between those times, I try to muffle the nose, aside from rebalancing trades which resist the market.
9) Can you describe a time in your trading life which really rammed home the point that so much of trading comes down to psychological factors?
As a value investor, I don’t worry much about trading. ?In 2000 & 2008, I did detailed studies of my trading. ?In 2000, I found that many of my best trades stemmed from getting the industry right. ?In 2008, I found that my top 11 gains paid for all of my losses, 2000-2008. ?That was with a 70/30 win/loss ratio, and 180-190 stocks held over the period.
10) If you could give aspiring traders one piece of advice about emotionally handling the market what would it be?
If we are talking traders, it would be this: start out each morning looking at the disasters of the day, and then wait for volume to climax, and price to nadir. ?Wait about 5-10?minutes, and then buy. ?Close out the trade within a week, maybe at the end of that day.
That said, I would encourage traders become investors. ?There is too much competition at the short time horizons of the market, and not so much over 3+ year periods. ?Study the greats: Graham, Buffett, Munger, Klarman, Price, Heine, Neff, Soros, Dalio, and many others. ?Learn to recognize long-term value, and wait for it to be realized. ?There are no barriers of entry to trading. ?Long-term value investing has natural barriers to entry, because it is work, and as such, few do it.
I don’t worry about my stock portfolio. ?Because my time horizon is long, day-to-day fluctuations don’t mean much. ?That makes me free to research ideas that can benefit me and my investors in the future. ?That’s a great place to be.
Closing
“Richard Chignell of Embrace The Trend asked me to take part in his Pro’s Process series.? Here are the first couple of answers and for the whole thing please read it here: www.embracethetrend.com“.
