On Life Insurers, GAAP and Value Traps

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On Life Insurers, GAAP and Value Traps

 

 

I get good questions from readers.  Here’s one from this post:

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Is there a reason why life reinsurance companies are better positioned then life insurers?

Don’t they face the same problems that they won’t be able to generate as they roll their portfolios into lower yielding bonds going forward (since rates have come down so much)?

Basically just wondering why you think RGA is cheap at 84% of AOCI adjusted book but not the rest of the life insurance industry at 35%-75% of tangible book?

Is it mostly due to your opinion of management?

I started to leave a reply and the normally reliable software glitched, and I lost it. Dejected, I decided to make it a post.

First, life reinsurance is much less competitive than life insurance.  Globally and in the US, the top 5 life reinsurers have ~80% of the market share.  Life insurance is far more fragmented, and has a decent slug of mutual insurers who don’t have an explicit profit motive.  (Note: many of the large mutuals are exceedingly well run, which makes the competition even stiffer.

Second, life reinsurance is mostly mortality exposure-based, versus life insurers which are mostly investment spread based.  The law of large numbers favors the life reinsurers over the insurers.  Low interest rates will not affect reinsurers as much as insurers.  Hint to those who analyze life insurers and reinsurers: look in the statutory statements, which have a lot more data than the GAAP statements for odd reserves that indicate a significant chance of losses if interest rates continue to remain low.

Third, life insurers have weaknesses in reserving practices for variable products with secondary guarantees.  There is no good way to calculate what a proper reserve should be.  The implied options are odd, and have no natural hedges.

That’s why I only own one life insurance company; one that has simple products.  Aside from low interest rates, valuations are low at life insurers because of lack of certainty over reserves.

So, much as I like RGA management, they are not the main reason why I like the company.  RGA executes well, and has an excellent reputation in its industry.

Here’s another question that I received via e-mail:

Prices of financial services stocks are too cheap for me to resist these days.  I see companies like Citigroup as being just given away by Mr. Market.

 Within insurance, my equity exposure is limited to AIG, which I consider to be well managed, misunderstood, and priced attractively enough to continue holding.  Over the past month other insurers have started to grab my attention (HIG, MFC, MET, PRU).  HIG stands out as being the least sensitive to the possibility of a decade of financial repression.  Do you have any favorites that you would care to share?  This topic could make for a timely blog posting.

I responded:

Value trap.  Focus on sustainable ROEs that will validate book value.  The accounting of AIG is a quagmire, even after their disposals.

There is a further difficulty with life insurers at present.  The GAAP accounting standards do not fairly reserve for secondary guarantees on insurance and annuity policies; truth, as a life actuary and a financial analyst, the options offered are so complex and long-dated, that I’m not sure there is a way to value them.  Over the last 10-20 years, we knew that this could be an issue, but we are now seeing the issue creep in as stock performance ebbs.

But if you disagree, consider PNX, it has all of the issues, and then some.  Be sure to get the Statutory books of the companies you buy here, because that drives dividend payments to the indebted holding company.

And one more e-mail:

Hi David,   I have enjoyed reading your blog for many years (even before GGG recommended it)

I have two questions for you about insurance companies in general — I know you are very busy, I am just hoping you can point me to some websites where I can do my own homework.

(1) If I want to check the financials of a number of mutual insurance companies, is there a consolidated source?   Do I need to pull the annual statements of each one and are the different state accounting rules comparable?

(2) As I understand it (and I am quite new to this so I may have this wrong) — mutual insurance companies use “statutory accounting”, which is different from US GAAP.    Is there a website or library book that explains the differences between these two methods?     Does statutory accounting differ from state to state?

Again, I am sure you are very busy and I will have to do my own research / homework.  You seem to be more knowledgeable than most about insurance accounting, and I am hoping you can point me to some documentation that will help me gain a better understanding.

My response:

1a)  Consolidated source: https://eapps.naic.org/insData/ , but most companies will send it to you if you ask.  Haven’t been turned down yet, aside from Berkshire Hathaway… and I’m working on that.

1b) Generally, you have to pull each one.  Some companies will do a combined set of schedules for their investments.  When I got AIG 3 years ago, there were 60+ books…

1c) There are slight differences by state, but most of the time you can neglect that.

2a) Mutual companies use statutory accounting, but so do stock companies for the state’s analysis of insurance subsidiary solvency.  And, though stock companies use GAAP for reporting to shareholders, many mutual companies will have an internal pseudo-GAAP basis for analyzing long-term profitability, and for management bonuses, yeh.  Statutory accounting is in some ways more critical than GAAP even for stock companies, because that determines how much cash can be distributed to the holding company, which is crucial if the holding company needs to make interest payments, or wants to make dividend payments.  This is one reason why actuaries often price products by calculating marginal distributable earnings.

2b) I have attached what I think is a short primer on GAAP vs Stat accounting.  This is a big topic, and the NAIC sells all manner of resources at high prices with all of the gory details.  This should give you a good start.  I general, the volunteers from the actuarial societies put out some good summary stuff, but you have to hunt for it.

Keep fighting the good fight.  Bloggers are the conscience of Wall Street and DC…

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Life insurance is tough because there is uncertainty on claim payment on timing, and uncertainty of investment earnings.  The latter is usually more serious, because the law of large numbers does not help.  Add in the valuation issues, and now you know why a life actuary primarily invests in P&C insurance companies, life reinsurers, and simple life companies.

Full disclosure: long RGA

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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