“So you’re the new investment risk manager?”
“Yes, I am,” I said.
CA: “Well, I am the Chief Actuary for [the client firm]. I need you to do a project for me. We have five competitors that are eating our lunch. I want you to figure out what they are doing, and why we can’t do that.”
Me: “I’ll need to get approval from my boss, but I don’t see why not. A project like this is right up my alley.”
CA: “What do you mean, right up your alley?”
Me: “I’m a generalist. I understand liabilities, but I also understand financing structures, and I can look at assets and after a few minutes know what the main risks are and how large they are. I may not be the best at any of those skills, but when they are combined, it works well.”
CA: “When can you have it to me?”
Me: (pause) “Mmm… shouldn’t take me longer than a month.”
CA: “Great. I look forward to your report.”
The time was late 1998, just prior to the collapse of LTCM. Though not well understood at the time, this was the “death throes” of the “bad old days” in the life insurance industry for taking too much asset risk. Yes, there had been bad times every time the junk bond market crashed, and troubles with commercial mortgages 1989-1992, but the industry had not learned its lessons yet.
The 5 companies he picked were incredibly aggressive companies. One of them I knew from going to industry meetings came up with novel ways of earning extra money by taking more risk. I thought the risks were significant, but they hadn’t lost yet.
So what did I do? I went to EDGAR, and to the websites of the companies in question. I downloaded the schedule Ds of the subsidiaries in question, as well as the other investing schedules. I read through the annual statements and annual reports. I had both my equity investor and bond investor “hats” on. I went through the entirety of their asset portfolios at a cursory level, and got a firm understanding of how their business models worked.
Here were the main findings:
These companies were using double, and even triple-leveraging to achieve their returns. Double-leveraging is a normal thing — a holding company owns an operating insurance subsidiary, and the holding company has a large slug of debt. Triple leveraging occurs when a holding company owns an operating insurance subsidiary, which in turn owns a large operating insurance subsidiary. This enables the companies to turn a small return on assets into a large return on equity, so long as things go well.
The companies in question were taking every manner of asset risks. With some of them I said, “What risks aren’t you taking?” Limited partnerships, odd subordinated asset-backed securities, high yield corporates, residential mortgage bonds with a high risk of prepayment, etc.
So, when I met with the Chief Actuary, I told hid him that the five were taking unconscionable risks, and that some of them would fail soon. I explained the risks, and why we were not taking those risks. He objected and said we weren’t willing to take risks. As LTCM failed, and our portfolios did not get damaged, those accusations rang hollow.
But what happened to the five companies?
Two of them failed within a year — ARM Financial and General American failed because they had insufficient liquid assets to meet a run on their liquidity, amid tough asset markets.
Two of them merged into other companies under stress — Jefferson Pilot was one, and I can’t remember the other one.
Lincoln National Corporation (NYSE:LNC) still exists, and to me, is still an aggressive company.
Four of five gone — I think that justified my opinions well enough, but the Chief Actuary brought another project a year later asking us to show what we had done for them over the years. This project took two months, but in the end it showed that we had earned 0.70%/yr over Single-A Treasuries over the prior six years, which is a great return. The unstated problem was they were selling annuities too cheaply.
That shut him up for a while, but after a merger, the drumbeat continued — you aren’t earning enough for us, and, in 2001-2, how dare you have capital losses. Our capital losses were much smaller than most other firms, but our main client was abnormal.
To make it simple, we managed money for an incompetent insurance management team who could only sell product by paying more than most companies did. No wonder they grew so fast. If they had not been so focused on growth, we could have been more focused on avoiding losses.
What are the lessons here?
Rapid growth with financials is usually a bad sign.
Analyze liability structures for aggressiveness. Look at total leverage to the holding company. How much assets do they control off of what sliver of equity?
If companies predominantly buy risky assets, avoid them.
Avoid slick-talking management teams that don’t know what they are doing. (This sounds obvious, but 3 out of 4 companies that I worked for fit this description. It is not obvious to those that fund them.)
And sadly, that applied to the company that I managed the assets for — they destroyed economic value, and has twice been sold to other managers, none of whom are conservative. Billions have been lost in the process.
It’s sad, but tons of money get lost through some financials because the accounting is opaque, and losses get realized in lumps, as “surprises” come upon them.
Be wary when investing in financial companies, and avoid novel asset risks, credit risk, and excess leverage.
By David Merkel, CFA of Aleph Blog