What happens to a bad insurer: the Ambac example
Insurance companies are very difficult to analyze. I have a feeling they are outside my circle of competence and will probably never invest in them again. If Montpelier Re rises a bit (I'm still negative), I might exit the position.
One of the special problems posed by insurance companies is that, unless you are an expert and know exactly what they are doing, it is difficult to figure out if they are mispricing their policies. They can easily post good returns for a long time, before they blow up spectacularly one day. The classic example is catastrophe insurance. If you insure against hurricanes and if nothing happens for two decades, your profits will be really good. But when a hurricane does hit, as it inevitably will, you better have priced it properly. If you mispriced your insurance, you will suffer monumentous losses, and may even face insolvency.
It's not just newbies who have problems understanding insurance companies. Many professionals have been absolutely decimated by companies like Hartford Insurance (HIG) and AIG. I'm talking about people who are experts and follow these companies daily for a living.
I want to illustrate what happens to bad insurers that misprice insurance. I'm going to pick Ambac because I'm familiar with it but this idea applies to types of insurance other than bond insurance as well.
Perhaps the most important measure for insurers is the combined ratio. This ratio measures the profitability of the company, with anything over 100% representing losses. As you can see, Ambac had spectacular combined ratios for more than a decade. The bond insurance industry as a whole had very low combined ratios for a long time. You can see the book value growth and the spectacular share price gain since its IPO. Ambac's stock price seems to have gone up roughly 88% per year from 1991 until the peak in 2006.
But, all of a sudden, everything blew up in 2007 and 2008. You can see this mostly clearly in the combined ratio which skyrocketed to 639% in 2008. In essence, all the gains of the past few decades were undone within a short period of time. Shareholders essentially lost everything.
Someone looking at an insurer like Ambac in the pre-2005 period would have said that its risk management was very good. After all, combined ratio was below 40% for many decades. But it was all an illusion.
As crazy as this may sound, anyone investing in Ambac in the last couple of years actually had a bit easier time than someone investing in other insurers. The reason is because it was obvious how the monoline bond insurers were making money and one could have placed a bet based on their judgement of the situation. I obviously made the wrong decision but others, such as William Ackman, were shorting the monolines mostly based on a macro view. When it comes to property & casulty insurers or life insurers or other type of insurance companies, I think it's actually more difficult to figure out if they are mispricing their policies. I don't think it's easy to make a macro bet. For instance, deaths/diseases/etc don't change that much so it's not easy to see if life insurers are mispricing their policies. Or if we look at property & casulty, it's really difficult to say if someone is mispricing a hurricane or a fire. Extremes (say someone offering insurance with very low premiums) can probably be detected by skilled investors but, overall, I think it's though.
One of the special problems posed by insurance companies is that, unless you are an expert and know exactly what they are doing, it is difficult to figure out if they are mispricing their policies. They can easily post good returns for a long time, before they blow up spectacularly one day. The classic example is catastrophe insurance. If you insure against hurricanes and if nothing happens for two decades, your profits will be really good. But when a hurricane does hit, as it inevitably will, you better have priced it properly. If you mispriced your insurance, you will suffer monumentous losses, and may even face insolvency.
It's not just newbies who have problems understanding insurance companies. Many professionals have been absolutely decimated by companies like Hartford Insurance (HIG) and AIG. I'm talking about people who are experts and follow these companies daily for a living.
I want to illustrate what happens to bad insurers that misprice insurance. I'm going to pick Ambac because I'm familiar with it but this idea applies to types of insurance other than bond insurance as well.
Perhaps the most important measure for insurers is the combined ratio. This ratio measures the profitability of the company, with anything over 100% representing losses. As you can see, Ambac had spectacular combined ratios for more than a decade. The bond insurance industry as a whole had very low combined ratios for a long time. You can see the book value growth and the spectacular share price gain since its IPO. Ambac's stock price seems to have gone up roughly 88% per year from 1991 until the peak in 2006.
But, all of a sudden, everything blew up in 2007 and 2008. You can see this mostly clearly in the combined ratio which skyrocketed to 639% in 2008. In essence, all the gains of the past few decades were undone within a short period of time. Shareholders essentially lost everything.
Someone looking at an insurer like Ambac in the pre-2005 period would have said that its risk management was very good. After all, combined ratio was below 40% for many decades. But it was all an illusion.
As crazy as this may sound, anyone investing in Ambac in the last couple of years actually had a bit easier time than someone investing in other insurers. The reason is because it was obvious how the monoline bond insurers were making money and one could have placed a bet based on their judgement of the situation. I obviously made the wrong decision but others, such as William Ackman, were shorting the monolines mostly based on a macro view. When it comes to property & casulty insurers or life insurers or other type of insurance companies, I think it's actually more difficult to figure out if they are mispricing their policies. I don't think it's easy to make a macro bet. For instance, deaths/diseases/etc don't change that much so it's not easy to see if life insurers are mispricing their policies. Or if we look at property & casulty, it's really difficult to say if someone is mispricing a hurricane or a fire. Extremes (say someone offering insurance with very low premiums) can probably be detected by skilled investors but, overall, I think it's though.
The key is to invest in short tail companies and check their investment portfolio beforehand. In short tail companies, auto insurance or HMOs for example, previous history is much more significant and it is much more easy to avoid the killed-goose effect , the goose feed only to be decapitated at the end, that happened in credit risk insurance.
ReplyDeleteCheck for example Assurant. Very conservative investment portfolio and they look for specialized insurance niches where they can have market dominance and usually short tail. Even in their CAT risk they have the luxury of avoiding coastal regions.
The other option is go for the good investors that take the float for big investment gains that compensate for so, so CORs. The Berkshires, Fairfax's and Markel's of the world
Thanks for the suggestions. I appreciate your insights.
ReplyDeleteThe thing is, these guys are supposed to be pricing risk. That's their job and their livelihood. I don't know if the nature of the probability distribution and potential pay-offs should matter. After all, if you were insuring against hurricanes, you are not betting that there won't be any hurricanes. Instead, you are betting that when a hurricane does hit, that you charged enough in premiums to pay off the losses.
I don't know anything about Assurant but the market detects some danger. If Assurant is less vulnerable to tail risks, why did its stock price fall more than 70% at one point in the last year?
Market could be irrationally selling it off but some of the other insurers like Berkshire Hathaway and one of my holdings, Montpelier Re, didn't fall that much.
You suggestion about insurers that invest well is very good and is pursued by some investors. But I feel that opens up another can of worms. It is difficult to figure out who the good investors are. Warren BUffet is but he is old so it's risky to invest in Berkshire even if one wanted to. But others like Prem Watsa (Fairfax) or David Einhorn (Greenlight) are questionable. They have made some good investments but you really have to measure their investment acumen. After all, it wasn't even 5 years ago when many, including prominent short-seller Jim Chanos, thought Fairfax was dead and was going bankrupt.
BTW, what are your thoughts on the Bermuda reinsurers? I own Montpelier Re (MRH) and wonder if I should get rid of it at an opportune time or hold on to it. I like them because they are not correlated with the economy. But they are risky and I have come to the realization I have no idea what the hell they do and how to figure out their inherent risk. I was sorely dissapointed last year when their investment portfolio declined substantially due to poor investment decisions. I thought these guys were investing in super-safe securities but guess not.
Do not know Montpellier in particular, but most reinsurers are a at discount to book. Also the distruction of capital because of hurricans and bad investments should be the beggining of improving pricing conditions. That is a third strategy to invest in insurance companies, described in one Lynch's books, invest in Reinsurance and P&C as cyclical companies.
ReplyDeleteThe ones that I have in my wishlist at the moment are ACGL, IPCR and PRE. And regarding AIZ, I thought you were a value investor so you were skeptic of Mr Market. Do the analysis!
The market values P&C insurance/reinsurance companies as commodities and in most cases they are. But there are competitive advantages in underwriting/ organization standards (Berkshire's REs). Though, it is very difficult as an outsider to evaluate those. Even M&A due dilligence screws up on this though they have plenty of access to documents.
Check Aleph's blog and see its forensic analysis of AIG and how much much of the disaster could you have caught as an outsider. Read Buffet's letters, they are eye opening. And that comes from someone that has worked in the industry and concurs on how difficult is to organize Insurance/ Reinsurance companies to maintain underwriting standards
Do you think that maybe, one of the errors of your investment involved piggy backing on Martin Whitman's coattail?
ReplyDeleteAt the time you invested in Ambac, Bill Ackman made a very convincing bear case. It seemed imprudent, to say the least, to ignore that argument.
When being a contrarian, it's often important to pick your spots well by going after understandable situations. I believe you instead chose to be a cowboy and rush into a situation that was too complex and blindly deferred some of your investment analysis to Whitman's decision making.
Re: Watsa.
You say that Watsa's investment acumen is suspect, but if you look up HWIC's track record you'll see it's very strong over a long period of time.
Deferring judgment to Jim Chanos (who gets a lot of PR but reveals less about his long term track record) seemed to be a failure.
What's interesting is at the time of your investment in ABK, you could have invested in Fairfax, an insurer trading below book with a large portfolio of credit default swaps and profited handsomely. What a no-brainer.
Viktor: "<span>Do you think that maybe, one of the errors of your investment involved piggy backing on Martin Whitman's coattail? At the time you invested in Ambac, Bill Ackman made a very convincing bear case. It seemed imprudent, to say the least, to ignore that argument. "</span>
ReplyDelete<span>Martin Whitman gave me higher confidence than I otherwise would have. However, I became interested in Ambac independently of Whitman. I probably wouldn't have made as large of an investment if Whitman wasn't bullish.</span>
<span>Interestingly I would disagree with you and say that the ultimate outcome did not depend on anything complex. If anything, it was very simple. Ambac's fate depended largely on mortgage defaults. I don't think there was anything complex about that. Ambac didn't blow up because it wrote complex CDS on CDOs. Rather, it blew up because the loss estimates were way off. Keep in mind that companies that did not engage in anything complex--say banks owning straight residential mortgages or even "prudent" companies like Wells Fargo which supposedly doesn't chase risk--also suffered massive losses to the point of insolvency, in some cases.</span>
<span>I didn't believe William Ackman's views as much as you did. I still think even he didn't really forecast the magnitude of the problem. Remember, he was short-selling MBIA back in 2002 or 2003 if I remember. The mortgage problems didn't exist back then. Sure, there were going to be losses but the really crazy stuff happened after the peak in 2005. Perhaps one can call housing in 2003 a bubble but it wasn't that big. His original thesis still seems shaky.</span>
<span>Ackman ended up right simply because we ended up with a credit bust on a massive scale. If Ackman actually saw a credit bust on the scale that we did, he clearly wouldn't have gone long retailers like Sears and Target; companies like Borders also would have been questionable under that scenario.</span>
Viktor: "You say that Watsa's investment acumen is suspect, but if you look up HWIC's track record you'll see it's very strong over a long period of time. Deferring judgment to Jim Chanos (who gets a lot of PR but reveals less about his long term track record) seemed to be a failure. "
ReplyDeleteI don't know much about either of those two. Prem Watsa is good but I don't know how good he is (you definitely have a better idea.) You are dismissing Jim Chanos, and I don't know much about him either, but I do respect him. From what little I have read or seen of him, I wouldn't be so quick to dismiss him. After all, he basically discovered the flaws at Enron. It doesn't appear--I haven't done any deep reading of Enron--that Chanos really knew the exact details but he did detect some serious issues. It would have required a lot of investigative work and skilled financial statement analysis to unmask Enron. At that time, Enron was the poster boy and no one really questioned it. People always questioned companies like MBIA and Ambac (there were some stories after Eurotunnel default and Katrina about the bond insurers) but Enron was perfect--too perfect.
Maybe Chanos was just fishing and caught Enron by fluke; whereas Fairfax was a mistake. Whatever it is, it's hard to say.
Viktor: "What's interesting is at the time of your investment in ABK, you could have invested in Fairfax, an insurer trading below book with a large portfolio of credit default swaps and profited handsomely. What a no-brainer."
Oh, I don't know about the no-brainer part. I wasn't familiar with Fairfax but it seemed like it had serious issues with ethics and the legal system. The SEC was still investigating them from the past (although I'm not sure if the investigation was completed without any charges--I wasn't following Fairfax.)Getting involved with a company with an SEC investigation is a totally different risk. If you did your homework and figured out the SEC investigation was bogus then, yeah, it was an attractive investment.
In any case, even without any legal issues, you really had to believe in the bust scenario to have invested in it. Since I didn't believe in that scneario, hence I invested in Ambac, I don't think it would have been as attractive (I don't know for sure though since I wasn't following the company.)
To me, Fairfax, particularly a few years ago, was, in a simplistic sense, sort of like Greenlight Capital Re (GLRE), David Einhorn's insurance company. David Einhorn is a good investor but how good is he? Some consider him one of the best young investor out there, and if so, GLRE may be an attractive opportunity. But it's easy to be skeptical and avoid investing in GLRE as well.
I agree with the first Guest's comments on short-tails. While all insurers, whether their risks are long or short, must price risk, those insurers with long-tail risks seem to be at a disadvantage because they do not get data about the frequency and severity of claims very often, so they cannot engage in 'course correction' based on that data. A short-tail insurer will know if he has mispriced his risks quickly, and if he survives, he can fix his pricing. In effect, the short-tail insurer has a more robust data set from which to draw conclusions.
ReplyDeleteA long-tail writer may have no new data on frequency and severity of claims for YEARS, all the while writing policies based on past data, with no updates from current experience because claims are few and far between. And even the past data is made up of just a few data points. A short-tail writer has better past-data to work from (more data points to extrapolate from) and is constantly getting new data because claims occur frequently, so he can recalibrate his pricing as necessary and his original pricing seems (to me) to be less likely to be off.
Thanks for the supporting point Jim, that is exactly what I was thinking about. After watching several insurance companies from the inside, organizational the pressure from the commercial areas little by little erodes the underwriting standards. I have seen no insurance/reinsurance company, except Berkshire, that reduces the retained premium when prices go bubbly.
ReplyDeleteIt is too easy for public companies too loose the underwriting culture. Most of them have incentives bases based on premiums instead of COR and even some go so far as to incentivize the technical areas too. So I much rather invest in companies that can change course before things get so big that are threat to survival.