Um, Which Way is Downstream?

Posted on by David Wright

My boss sometimes laments that we’re in a declining industry and, to be honest, the statistics do show the absolute level of employment in Reinsurance on a steady downward trend.

That doesn’t mean the industry is declining, though. Quite the opposite: it grows with the economy.  Insurance is a business that passes the ‘grandmother test’ because “there will always be insurance”.

So what’s happening?

Here’s Paul Krugman, commenting on an old article of his:

[I argued that] information technology would end up reducing, not increasing, the demand for highly educated workers, because a lot of what highly educated workers do could actually be replaced by sophisticated information processing

And again, citing the work of Autor:

[they] argued that the crucial difference in terms of possible replacement of humans by machines was one of routine versus non-routine, rather than white-collar versus blue-collar

So, to the degree that the insurance business is a collection of routine processes, folks get replaced by flops and the balance slowly moves from labour to capital.

I’m rather obsessed by this macro trend, as a quick flick through this blog would plainly show.

But it’s bigger than insurance, of course. And ain’t no recent thing.

I like to think of economic progress as the decline of the share of our income spent on food, water, shelter and other ‘necessities’. As they get cheaper, we get richer.

Here’s Arnold Kling:

As the cost of food and durable goods falls, what are you going to do? You only consume more health care services if you think you are sick and that the doctor can do something for you. So you either consume more education or more leisure.

These trends matter. The strongest businesses don’t fight the current, they ride the crest.

So, at the margin I expect three types of businesses to grow in the near term. The first is the medical industry (easy).

The second supply things people do in for leisure and/or education. The Silicon Valley social media types are all over this, along with self-help gurus and tv producers.

The third business joins the chorus crushing the costs out of the the rest of life’s pursuits. Think commodity producers (insurance!) and the news media. Over time, their quantities supplied grow with the (world) economy, but their share must fall.

To my boss, then, I say: “watch your margins, insurers grow by adding capital in innovative ways”.

If he’s still worried, I say: “write a book and go on CNBC: become a media darling and guru”.

Still upset? Go to med school.

“Some Day I’m Going to Start My Own Company” – Douchebag

Posted on by David Wright

Perhaps surprisingly, there is a vibrant startup community in the insurance world. In any sales-driven industry, those who can start a business that locks in a distribution channel get rich.

In insurance, these businesses are called Managing General agents (MGAs). They are to insurers what hedge funds are to pension managers.

Anyway, the part about successful MGA owners making big money isn’t lost on many. Predictably, there’s a multitude of frustrated middle managers harboring a deep desire to put their shingle out and strike it rich.

Easier said than done, of course, but it can serve to salve a beaten down ego for a while.

Obviously, I eagerly count myself among these despondent douchebags.

Interestingly, most MGAs are only barely viable. They typically identify some market micro-segment with only enough scale to make a little money; the rest is hopes and dreams stuff that never comes true (but proven by hockey stick growth targets!). Economists would say price equals marginal cost here, and go to bed happy with the state of the world.

At scale, the insurance market is a commodity business, but at the local level it’s a relationship business. Different skills.

Those with the best view of the big picture are the corporate types and they just aren’t entrepreneur material. Too secure, too much to lose. They overthink and do things like write blogs about entrepreneurs while having started nothing at all in their lives.

The local shark is often a champion salesman but runs out of gas when he runs out of hours in the day to sell. No scale.

When lightning strikes and you get the natural entrepreneur with a solid grasp of the whole thing?

That dude gets rich.

Villains of Insurance

Posted on by David Wright

So the folks down under are in a spot of bother and insurers are starting to pay up.

I’ve never been one to shy away from a bit of armchair theorizing in this space, but there’s sausage being made here, folks, so it’s worth zooming in to see if all’s working as I’d expect.

Clearly a disaster? check

Insurers paying? check

Reinsurers paying? check

And the regular folk? What do they think about all this?

I’m sent to this article, which makes a few points:

1. Insurable loss is smaller than ‘economic loss’

2. Governments shouldn’t buy insurance because they should be able to “manage the risk within their own budget”

3. Insurers have been struggling to make their margins recently

4. Insurers should have ‘costed in’ this disaster (unless less than “1-in-100” year event)

5. Poorer people live in flood zones and will opt out of higher premiums

6. The government should pay for insurance because the government zoned these places in the first instance

A few doozies in there. Less charitable bloggers would revel in the logical inconsistencies (#3 vs #4) and sloppy thinking (#6) here.

Instead, I shall mock caricatures of the sides of this debate.

Press Release: BIG GREEDY COMPANIES SCREW EVERYONE OVER

Subconscious Thoughts: I pay premium and don’t read/understand my policy. I am crap at evaluating tail risk so I never actually thought I’d have to suffer the consequences of living in a flood zone. I’m also crap at comparing large magnitudes so I don’t understand why a company with ‘billions of dollars’ can’t pay $400,000 to 2 or 3 million people to rebuild their lives, stay solvent and renew my policy without a fuss.

When I do submit my claim I think I might try to squeeze out a few extra bucks and get ahead on the deal; after all, you’ve got ‘billions of dollars’ and I ‘work hard every day’. And, regardless of how my choices have affected this outcome, I’m firmly invested in the ‘victim’ mindset here because I know people are nicer to victims. Politicians especially like to appear magnanimous to us victims. Watch your ass!

Press Release: GREEDY ILLITERATES SHOULDN’T LIVE IN FLOOD ZONES

Subconscious Thoughts: This business was horribly underpriced and I’m on the edge of a knife, here. If only those muppets at XYZ company hadn’t gone after our customers we wouldn’t have had to cut our rates by 30% to keep them.

The last few times, I was able to earn my way out after jacking up rates, but if I get downgraded, I’m belly-up. Maybe I should forego that expensive backup reinsurance cover and bet the house on no more disasters this year. What month is it again?

Maybe there are some loopholes in my policies. If I can string out the payments for a while I’ll be able to earn my way through. I hope someone else gets downgraded and pulls out; that way, rates will really skyrocket and we’ll make a killing. The problem is, as soon as some competition shows up I’d rather take the pipe than actually innovate a bit and make money the hard way.

Why Does Berkshire Hathaway Hold Any Debt At All?

Posted on by David Wright

You could be forgiven for not noticing with pages of self congratulatory pagentry like this:

Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor…

But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces  zeroes, even when it is employed by very smart people…

On the facing page you can read a letter sent in 1939 by Ernest to his youngest son, my Uncle Fred. Similar letters went to his other four children. I still have the letter sent to my Aunt Alice, which I found – along with $1,000 of cash – when, as executor of her estate, I opened her safe deposit box in 1970. Ernest never went to business school – he never in fact finished high school – but he understood the importance of liquidity as a condition for assured survival. At Berkshire, we have taken his $1,000 solution a bit further and have pledged that we will hold at least $10 billion of cash…

Flip over a few pages. Now, what do you see on the balance sheet?

Cash and cash equivalents:

(2010) $ 34,767

(2009) $ 28,223

yep, that looks right. But wait a sec, what’s THIS?!

Notes payable and other borrowings:

(2010) 14,477

(2009) 13,769

Growing every year. Why oh why?

Here’s David Merkel:

What I am saying is that once the discipline against debt is breached, it becomes easy to justify more debt.  I think we are seeing that now, and Buffett is compromising his principles.

Hey, Greenberg eschewed debt for two decades, and then piled it on for two decades.  Is Buffett doing the same thing?  Personally, I think he is, though I don’t think he has thought it through.  Warren, if you are reading me, pull back on the debt.  It killed Hank.

Insurance is Complicated

Posted on by David Wright

Insurers are set up to pay three kinds of expenses:

1. overhead and commissions (under their control);

2. predictable claims (whose risk insurers ‘understand’); and,

3. crazily aggregating black mamba catastrophe claims (bolts from the blue).

Let’s play CEO: which one of these keeps me up at night?

Well, #3 looks pretty scary: that’s where the jacked-up Hollywood-style company killers lie in wait. It’s not just hurricanes, earthquakes and asteroids, either. Corporate scandals (think Enron and all the resulting litigation) and ‘latent’ exposures (Asbestos). Lots of drama, lots of victims and look! There’s Anderson Cooper, brows a-knitted, standing knee-deep in a floodplain shouting at a TV camera.

Meh.

Believe it or not, just knowing that some hairy stuff can happen keeps things in check: lots of capital, expensive insurance for Florida homeowners and constant testing of the market through the reinsurance process.

The softer blood-suckers (Asbestos and Corporate Scandal) resolve through the courts, which drag things out for EVER. This means an insurer, now anticipating lots of claims, can crank up the prices and effectively earn its way out of trouble.

Ok, how about #2? Tread carefully, there’s some action here, but the problem isn’t the cost, it’s the revenue and pricing. An organization needs to willfully brush aside good sense and undercharge for this to be a problem. And as stupid as that sounds, it happens because of…

#1: here’s the killer. No sucker is going to pay a premium for a fancy Louis Vuitton logo on the top of his/her policy, so insurers differentiate on price.

There are two ways of going about this: first, by identifying a poorly served subgroup. This is everyone’s favourite because the ‘winners’ feel smart for identifying a niche and the ‘losers’ feel smart for avoiding a trap. Realistically, this is hardly a scalable and sustainable business model.

The real answer is to pull costs from your process. Think like a manufacturer. Make. It. Cheaper. Then you know you’re in a better financial position at any market price. And the market does weird things.

For instance, imagine you’re a typical underwriter CEO when he finds he’s too expensive.

You’re losing money, but out of ideas. Cut your prices, fiddle the reserves a bit to buy time and hope the market turns!

I imagine these poor suckers like submarine captains who just realize they’ve been spotted on sonar and quickly rig for silent running.

Hundreds of feet beneath the sea, quiet as a mouse, on the brink of death and waiting, desperate for a happy ending…

I Do/Don’t Understand Risk

Posted on by David Wright

I hear this all the time and get irritated. Consider these two statements:

1. An investor at a conference: “we think that investors are good at understanding super-catastrophe risk, reinsurers are good at understanding higher frequency risk and insurers best understand high frequency risk”

2. We are looking at this marketplace and just don’t understand the risk.

What does it mean to “understand” risk? I’ll tell you: not a damn thing. If you understood it, it wouldn’t be risky, would it?

Statistics can useful at describing processes without using incorporating any ‘fundamental’ analysis of the drivers of that process.

Coin flipping? Sure, I can get my head around the probabilities in that. Aggregate cost of slip and fall accidents in Montana in 2006 being greater than 2005? Yeah, right!

So we approximate, test, get it wrong and (hopefully) refine. Nobody understands risk any better than anyone else. Those two statements SHOULD read:

1. Investors are happy with returns commensurate with insuring extremely rare events because we don’t ever expect to pay any claims and we (the managers) are happy to get fired if we do. Everything else? I have no idea how their businesses work.

2. We like markets where we think people don’t know what they’re doing and we can convince ourselves that we do. Risk is in the eye of the beholder and we can’t believe that REAL risk exists here. We must be the sucker at the poker table.

Market Avatars

Posted on by David Wright

Really cool article on how entrepreneurs think, here’s the gist:

Rather than meticulously segment customers according to potential return, they itch to get to market as quickly and cheaply as possible, a principle Sarasvathy calls affordable loss.

And the zinger:

They do not believe in prediction of any kind.

The point is that you’re only focused on something when you’re asked to spend money. This is why prediction markets are so interesting. No amount of fancy pants grad degrees or big scores on I.Q. tests can replace the focusing power of cash on the line.

I work in a business that is obsessed with forecasting the future: no surprise when you sell a product without knowing how much it will cost! The people who are in charge of figuring out the COGS are actuaries, who use all kinds of fancy math for describing (and so forecasting!) processes nobody really understands.

Now, the frustrating thing about actuaries is that they know they’re going to be wrong. And that if they’re wrong in the wrong direction (ie understating the COGS), the company blows up and everyone has to go find a new job. The incentive is pretty strong to overstate the COGS.

Not only is this forecasting, but it’s deeply biased forecasting. To an entrepreneur this kind of thinking is radioactive.

The New Manufacturing

Posted on by David Wright

I think of the insurance business (and banking for that matter) as a process-driven technology industry, like manufacturing.

We have a very similar value chain, with engineers pulling costs out of the system and slowly tailoring products to peoples’ uses. Over time, the systems employ fewer, more skilled people and the products become ever more commoditized.

Value and innovation are not revolutionary in these businesses, but incremental, and brands are a key differentiator among the otherwise indistinguishable elite few operators.

The most powerful in the business are those most gifted salesmen that can make a commodity feel less like one, all while quietly making it more so.

Culture Rules

Posted on by David Wright

Saw a lifetime achievement award given last night. Good speeches, decent food and a borderline bizarre biographical video of the recipient.

The one thing that really sticks with me is how there are four or five really prominent CEOs that all ‘grew up’ together in the business. Can’t be a coincidence.

So what’s the explanation? Talent? Sure. Social dynamic of peer competition? Probably. But surely those things are common enough.

The thing that I think has to have been truly special is the culture of their common employer. They are the product of their environment. So what is someone to do who finds himself in a mediocre environment? How does a leader create such an environment? Do all leaders want to create such environments?

The leaders of tomorrow are being groomed at an extraordinary organization somewhere. Almost every other organization is busily destroying or limiting its talent. Why? How?

Tech Trends

Posted on by David Wright

I’m beginning to think that there are only hardware trends in tech (faster, cheaper) and social trends in software.

My favourite question to ask people in tech is: “what about your job could not be done 15 years ago?”. Most of their answers have to do with standards (common protocols emerging) and organizational will towards technological solutions (“my boss 15 years ago didn’t understand the benefits and the employees didn’t have the skills to implement”).

This says to me that innovation is not cross-pollinating between software industries. The fact that google and 4square exist doesn’t have any direct implications for insurance company efficiency.

To understand where the next breakthrough will come, take today’s technology and add higher median computer familiarity within an organizational system.

The days have arrived where back offices of companies are populated by middle-aged men and women who do nothing but administer computer systems all day. That’s a pretty interesting development.

So, what’s next?