A Piece of The Puzzle

Posted on by David Wright

Loving the Sector & Sovereign Blog.

One of my most enduring frustrations with the insurance industry is that there is this bizarre cycle:

For those that don’t want to read about this graph: the industry loses money when the lines cross the horizontal blue line.

This insurance cycle is somewhat related to the business cycle, but the relationship isn’t terribly strong. What the hell is going on then? Some of it is pricing, where rates are cut. But S&S suggest that this masks a shadowy increase in exposure, by way of loosening terms and conditions (T&C) [emphasis in original]:

Rather, we think price declines are concurrent with deteriorating policy term & conditions, and that this is the main source of loss trend deterioration. In other words, we think the industry contributes more to its own loss trend experience than external inflation

We test this theory using loss trend data for work comp, available from the NCCI. We model frequency, medical severity, and indemnity severity separately as well as together. In every case, pricing from 3 years ago matters more than any possible macroeconomic factor.

Now that’s a cool idea. And probably a correct one.

A problem, of course, is that it’s not a terribly useful idea, from the perspective of making money. The market stays stupid for longer than you can stay liquid, after all.

And this isn’t directly observable or measurable, even for reinsurers. People will conceal this kind of T&C deterioration and, because of its lag, the villains have good reason to believe they will get away with it in advance. And for good reason: everyone else in history has.

I’m still ruminating on my critique of S&S’s compelling but (I believe) flawed theory of supply and demand in the insurance market.

A Journey of a Thousand Miles

Posted on by David Wright

I’ve recently come across this new insurance blog by Todd Bault and it’s friggen catnip to me. I disagree with a lot of what goes on in there, in particular (I think) his strange and interesting theory of capital.

That’s cool, though, because it’s making me think my own perceived understanding through more carefully, which is always welcome. His posts are so content-heavy that I’m overwhelmed with where to begin the discussion, so…

I’ll take advice from Barker:

The first step is crucial — keep it tiny. Do not be ambitious yet. That leads to failure.

Consider this the first step: a simple declaration of intent. I intend to keep re-reading Todd’s old posts and figure out exactly where we disagree. Then I’ll try to write something small.

Build vs. Buy

Posted on by David Wright

Celent is releasing a report soon on build vs buy. I find this debate frustrating because I feel like it isn’t a difficult decision.

Insurance companies are made of three things: money, a processing system and an underwriting system. Money is money and at current regulatory margins I don’t believe there is an advantage to be gained for insurers having more or less of it. Underwriting systems exist to sniff out moral hazard so humans have to handle those (committees, referral, etc).

100 years ago, the processing was done by humans, too. Today, you choose between build or buy.

If you find yourself among the small minority of (re)insurers that write volatile, hard-to-price insurance, you don’t really need a rock-solid processing system. You probably write big deals and work more like a hedge fund than a retail bank. You can buy.

As for the rest: if you don’t build, the risks are simple and the money isn’t yours, your job is to provide a commodity on the cheap. If you aren’t building your own system, what on EARTH do you get paid to do?

Over time technology improves, making new systems better regardless of whether you build or buy. This will, however, rarely (never?) affect whether a company chooses picking clients or shaving margins as its business model.

The New Pitchbook Paradigm

Posted on by David Wright

One of my pet theories is that eventually all information is going to be distributed via the “web browser stack” of technologies. Here’s what I mean by this:

Today, people in jobs like mine spend a lot of time building sales presentations. People call these different things: “decks”, “pitchbooks”, “submissions”, etc. They’re all the same thing: a summary of deal-relevant data, narrative and visualizations available in both print and electronic form distributed by email or ftp.

The technologies used are still dominated by Microsoft Office, which is probably 90% of the reason why Microsoft is in any way relevant these days. We write using Word, we analyze using Excel and Access, we present with Powerpoint and we (ugh) code in VBA. We then ‘pdf’ (verb) the documents, which is another proprietary bit of software, and email the files out.

This setup is expensive, time consuming and will one day go to the way of the Telex and the Typing Pool. Here’s tomorrow’s paradigm:

  • Write Text In HTML
  • Style in CSS
  • Distribute Information by Web Server
  • Send Data via FTP
  • Visualize With Jquery-based applications (yikes!)

The data are immutable (bye bye adobe), the odious Microsoft Word is finally slayed and email file limits are forever circumvented. Microsoft’s last stand will be with Excel, as long as it doesn’t commit upgrade suicide, which the latest version suggests is a real possibility. That program is still one of the greatest products ever developed.

One of the projects I’m taking on at work is to build parallel sales documents in HTML/CSS (Powerpoint may already be almost dead). Because I don’t want to infect my mind with the odious MS Word any more than I need to, I’ll probably build everything in HTML and write a script that translates it into Word.

Hopefully, I’ll be successful and begin to engineer a transition from the old stack to the new. We may be first movers here, folks! We’ll be so high status, clients will shower us with business.

Third Point, LLC Destroys $100m

Posted on by David Wright

Sorry about the big quote, but I need to set the stage here:

Daniel Loeb, the founder of Third Point LLC, started a reinsurance company that can invest in his $8 billion hedge fund, joining rival David Einhorn in seeking more permanent capital.

Third Point Re, which is based in Bermuda, hired John Berger as chief investment officer and has about $500 million in capital, according to two investors familiar with the plan. New York-based Third Point wants to raise $250 million to $500 million more and plans to eventually sell shares of the reinsurer to the public, said the investors, who asked not to be identified because the firm is private.

Here’s more.

First, let’s clear one thing up: the insurance market is soft because there’s too much capacity. Reinsurers are running break-even and, to the extent that there is any price increases in catastrophe-driven lines, it’s in tiny little corners of the market (New Zealand EQ, Japan EQ and other non-US, non-EU catastrophe zones).

And these price increases don’t matter globally because they are being completely captured by incumbent players. Until a company or two dies by the sword and the market reprices the business that killed them (ie policies with lots of claims and fat renewals), nobody is getting rich.

So the market would instantly value a startup at 80% of book. In this case that destroys 100m. Why does Third Point want to lean into these headwinds?

Well, he wants to create a little walled garden where he can play by himself:

Loeb follows Einhorn, head of New York-based Greenlight Capital Inc., in creating a reinsurer as a way to raise capital for his hedge fund that isn’t subject to client redemptions. Reinsurers, which help insurers shoulder risk, earn premiums that they invest to make a profit.

When you put money into a regulated entity, it’s stuck. This is why AIG policyholders had nothing to fear from all the bond insurance shenanigans. Loeb is locking down a chunk of capital into a straight-up illiquid private equity bet.

What’s more, cat reinsurers do not invest for profit. Their liabilities have an 18-to-20-month duration at best and last time I checked, nobody’s getting rich on 2-year paper.

From a straight-up financial perspective, this move is lunacy. But Loeb gets his sandbox, even if he’s trading liquidity for nothing.

Good luck, Danny-boy.

Progress And Unreliable Sponsors

Posted on by David Wright

Here’s Jeff Masters.

NHC director Bill Read stated in a interview this week that had Hurricane Irene come along before the recent improvements in track forecasting, hurricane warnings would have been issued for the entire Florida, Georgia, and South Carolina coasts. At an average cost of $1 million per mile of coast over-warned, this would have cost over $700 million.

Wow. The article goes on to lament the potential budget cuts to the NHC that threaten further improvement in this forecasting system.

But this isn’t really ‘pure science’ in the classic sense: there’s a genuine commercial application for the stuff the NHC puts out. As Masters points out, $700m is not a small number.

I guarantee that some kind of private (re)insurer consortium would step in to fill the funding gap in this research budget were credibly threatened. They’re a group that can easily measure how much money is on the table to lose.

Heck, I’d bet that the budget would increase.

Hurricane Irene

Posted on by David Wright

I’m watching this situation pretty closely for all kinds of reasons. It’s not often my professional and personal interests coincide.

Best resource, hands down, is Jeff Masters’ blog. The source of all the raw analysis is the National Hurricane Center.

The latest modeling is annoyingly inconclusive.

I’m going to focus on New York, because that’s where I live. (In general I’d say the Carolinas are effed and most of Jersey is in for a beating)

There are three scenarios for New York, all of which seem plausible from that modeling output.

  1. If the storm stays inland and heads over the Pocono mountains, we get some serious flooding and damaged countryside, but nothing too crazy. The storm weakens considerably and the wind dies off.
  2. Toss up over which of the next two is worse: if the storm goes straight across the Carolinas and streaks along the coast, we’ve got a problem in the city. This means that all of the coastal areas (ie the most vulnerable to storm surge) get battered and (AND) the warm water keeps the storm strong. NY will probably get flooded right up to 14th street, I get evacuated from Battery Park City and it takes days for the Subway system to drain.
  3. Door #3 has the storm veer off into the ocean, really really power up and hammer (absolutely clobber) Long Island. This will have the worst wind damage, though Jersey and NYC will probably be spared. Next up is Cape Cod and Nantucket. These probably get a big helping of Hurricane winds, too.

Using this, I’m trying to handicap the models and am having some serious trouble. I’ll probably keep updating this post as the day wears on.

Edit 1:

I keep saying Carolinas, but I really mean North Carolina and Virginia

Edit 2:

Wowee. Jeff Masters gives us lots to think about. A few key points:

  • They eyewall has collapsed, which means higher pressure and a less powerful heat engine. We’re in the endgame, so rapid, massive intensification is unlikely now.
  • Wind shear, hurricane Kryptonite, is moderate (note on pic: red line is direction relative to storm track, I think, and blue is speed) but doesn’t seem to be having a big effect.
  • This sucker is a monster, which means more storm surge, damage potential measured at an eye-popping 5.1/6.
  • Masters gives a 20% chance of topping Manhattan’s flood walls and filling the Subway system with seawater.
  • Wind damage likely won’t be a big deal, now. The heaviest winds are East and out to sea (sorry, Long Island!), but aren’t crazy-strong, just strong.
  • Probability of big winds in NYC has plummeted
  • Get ready for blackouts

Personally, I’m scheduled to fly to Florida tonight for a wedding in the Jacksonville area tomorrow. 20% chance of complete flooding is probably high enough to evacuate and fleeing to the Hurricane’s wake is probably my best bet.

How and in what manner I get back is the trick.

Edit 3:

Well, looks like I’m outta here. From my building management:

The NYC Office of Emergency Management is strongly advising all residents of Battery Park City to evacuate today.  While the evacuation is not mandatory at this time, it seems clear that it will become mandatory at some point today or tomorrow.  Since the MTA is going to shut down at some point tomorrow, we strongly urge everyone to make immediate arrangements to evacuate now.

To JAX!

Pricing Power

Posted on by David Wright

Looks like Buffet invested in Verisk Analytics, which is an organization that I am familiar with. Here is the real point:

Verisk is an American company that was founded in the 1970s by the major US property and casualty insurance companies. These companies collectively provided Verisk with their claims data in order to create a centralized database that would allow the industry to analyze risk better.

The analyst gets the point right but the names wrong. The Insurance Services Office (ISO) was created as an information mutual for the industry. It’s now a subsidiary of Verisk.

There’s no doubt Buffet’s onto something, though. This is a company with a gigantic ‘moat’, as he likes to call it.

ISO pulls off the confidence trick that I’ve seen before. They poll member companies for data, aggregate it and then sell it back to them. For quite a price, I’m told.

ISO data gives every insurance company a benchmark for claims costs and trends in various lines of business. It is literally the only way people have of guessing whether they can make a profit in a particular line of business if they aren’t currently in it.

Imagine a mining company that pulls zinc out of the ground and is mulling over the possibility of opening up a copper mine next door. How would this company make this decision? Well, they’d probably check the pricing history for copper and see whether they think they can make money on it. They know their costs of production, but they don’t know the price.

Insurance companies don’t have this information. They literally do not know how much their policies cost up front, which means that they need intimate knowledge of a market before they can decide whether investing in new products is a good idea or not. ISO is the only way they can get this data out of their competitors’ hands.

I’ve often toyed with the idea of what it would take to start a company that would compete with ISO. The problem is that ISO benefits from gigantic network effects. Without any scale you’re just one insurance company’s data. And I know that the biggest insurance companies (like AIG) guard their data jealously, so you HAVE to rely on the little guys banding together.

What I’d need to identify is a blind spot for ISO. A line of business that they don’t serve very well and probably won’t start serving soon. I’m sure it exists. The other thing I’ve heard about ISO is that it’s an antiquated, backwards organization. Doesn’t surprise me. They’re practically the insurance government. What incentive do they have of serving someone well?

None.

Holy Cow, Lots Going On

Posted on by David Wright

Some links:

Here’s a scathing review of S&P’s conduct, generally:

To say that S&P analysts aren’t the sharpest tools in the drawer is a massive understatement.

Naturally, before meeting with a rating agency, we would plan out our arguments — you want to make sure you’re making your strongest arguments, that everyone is on the same page about the deal’s positive attributes, etc. With S&P, it got to the point where we were constantly saying, “that’s a good point, but is S&P smart enough to understand that argument?” I kid you not, that was a hard-constraint in our game-plan. With Moody’s and Fitch, we at least were able to assume that the analysts on our deals would have a minimum level of financial competence.

Yikes. And imagine what the real regulators are like.

As for S&P’s downgrade, here’s Sumner’s take, under the title of 1.07% on the 5-year and falling fast.

The markets this morning gave a massive vote of no confidence to S&P ratings service, as yields plunged on Treasuries.

The real after-tax rate of return on the 30 year Treasury is now negative, assuming a 30% MTR.  That means the tax rate on capital now exceeds 100% in real terms over the next thirty years, which doesn’t seem particularly conducive to capital formation.

Yikes.

But what’s the ultimate signal that things are bad? Berkshire’s getting the itch.

Here’s Ajit swooping in and demolishing the incumbent bidders’ stock/cash offers with an all-cash, thank-you-very-much email.

Mr. Robert Orlich
President & CEO
Transatlantic Holdings, Inc.
80 Pine Street
New York, NY 10005

Dear Bob:

As you can imagine, subsequent to our telephone conversation yesterday, I have been watching the screen all morning. With your stock trading at $45.83, I have to believe that you will find our offer to buy all of Transatlantic shares outstanding at $52.00 per share to be an attractive offer. As such, I am now writing to formally inform you of National Indemnity’s commitment to do so at $52.00 per share under customary terms for a stock purchase agreement of a publicly traded company to be agreed (but not subject to any due diligence review or financing condition of any nature [emphasis DW’s]). This commitment is subject to:

  • A formal response from you no later than the close of business, Monday, August 8, 2011.
  • Should you decide to accept this offer, your agreement that should the deal not close for any reasons that are under your control by December 31, 2011, a break-up fee of $75.0 million would be paid to us.
  • Your commitment that until the deal closes, you will continue to manage the affairs of the company in a manner that is consistent with how you have managed it historically.

I have deliberately tried to be brief and to the point. I will be happy to discuss any details that you would like at your convenience. I can be reached at [number withheld] (work), [number withheld] (cell) or [number withheld] (home).

Regards,

Ajit Jain

TRC probably figured there wasn’t any point in summarizing the offer and just published it in whole online. Also gives us our “parenthetical statement of the day”.

Note that this values TRC’s stock at something close to the incumbents’ bids BUT the value of the stock portions of the bids have diminished substantially since they were made.

Timing is everything, n’est-ce pas?

update:

Here’s a neat post speculating on who got the margin call today:

You see the desperate selling of the biggest liquid names is a sign of margin calls.

The market is not puking. Some prime broker is puking the stocks held by one or more very large hedge funds.

So lets play the game: guess who got the margin call!

So What Is Default, Anyway?

Posted on by David Wright

Here is Felix:

ISDA has made the right decision: the Greek bond default does not and should not count as a “credit event” for the purposes of whether Greek credit default swaps will get triggered.

As Felix rightly points out, if you take a 21% haircut on your bond principal and can’t call that a default, what good is CDS protection?

A few years ago, just about every reinsurance broker in the world (us included) was looking at CDS as a way of hedging insurers’ exposure to reinsurance recoverables in the event of reinsurer insolvency. It only took a few days’ work to realize the whole thing was useless.

The problem in insurance is that reinsurers don’t go into ‘default’. They go into something called “run-off”.

Insurer obligations are fundamentally negotiable. If an insurer declares itself ‘in runoff’ (ie it is accepting no new business) it has signaled its financial weakness and warned claimants that the pot might run dry before they get paid. Suddenly a claimant will accept 0.80 on the dollar for fear of getting even less later.

Well, that improves the solvency of the insurer but the people owed money get screwed.

Bankers tend to feel pretty smug about their black-and-white default definitions because the cross-default provision lets most lenders push the big red button when they get miffed. Looks like the Eurocrats have got that one sewn up somehow, though. Oops.

All anyone really wants is protection against principal reductions on what’s owed ’em. Throw in a bit of relief from the legal nonsense of squeezing your last few pennies out and you’ve got yourself a product.

Problem is, this is a product that doesn’t exist.  In any financial market, it seems.