The problem at that time in the industry from the decline in bond prices and the accounting convention for insurance business had allowed the companies to carry bonds at amortized cost, regardless of market value.
“Insurers own long-term bonds that, at amortized cost, amount to two to three times net worth. If the level is three times, of course, a one-third shrink from cost in bond prices – if it were to be recognized on the books - would wipe out net worth. And shrink they have. Some of the largest and best known property-casualty companies currently find themselves with nominal, or even negative, net worth then bond holdings are valued at market.”
The accounting convention has a difference in recording the value of the stock portfolio and the bond portfolio in financial statements of insurance company.
“An insurance company’s survival is threatened when its stock portfolio falls sufficiently in price to reduce net worth significantly, but that an even greater decline in bond prices produces no reaction at all. The industry would respond by pointing out that, no matter what the current price, the bonds will be paid in full at maturity, thereby eventually eliminating any interim price decline. It may take twenty, thirty, or even forty years, this argument says, but as long as the bonds don’t have to be sold, in the end they’ll all be worth face value.”
That is why under those situations, many investment options disappear for a long, long time. Buffett suggested that when large underwriting losses are foreseen, it would make excellent business logic to shift from tax-exempt bonds into taxable bonds. However, an unwillingness of recognizing losses on the financial statements has prevented the insurers from doing so.
In addition, the unrealized bond losses recognition avoidance is more serious than that. Buffett continued: “For the source of funds to purchase and hold those bonds is a pool of money derived from policyholders and claimants (with changing faces) — money which, in effect, is temporarily on deposit with insurer. As long as this pool retains its size, no bonds must be sold. If the pool of funds shrinks, which it will if the volume of business declines significantly — assets must be sold to pay off the liabilities. And if those assets consist of bonds with big unrealized losses, such losses will rapidly become realized, decimating net worth in the process.”
That is why insurance company had two options. One is to keep pricing according to the exposure involved — “be sure to get a dollar of premium for every dollar of expense cost plus expectable loss cost.” That would leads to the decrease in premium volume as insurance company is more selective in writing policies.
That would lead to several consequences: “(a) with most business both price sensitive and renewable annually, many policies presently on the books will be lost to competitors in rather short order; (b) as premium volume shrinks significantly, there will be a lagged but corresponding decrease in liabilities (unearned premium and claims payable); (c) assets (bonds) must be sold to match the decrease in liabilities; and (d) the formerly unrecognized disappearance of net worth will become partially recognized (depending upon the extent of such sales) in the insurer’s published financial statements.”
So in order to avoid the severe loss on its books, an insurance company chooses to sell stocks that are carried at market values or recently purchased bonds. It sounds less painful in the short term, but selling the better assets while keeping the biggest losses will be unlikely to be the winner in the long term.
The second option that an insurance company can choose is to keep writing business for any rate levels to keep the present volume, assets and liabilities and “pray for the better day, either for underwriting or for bond prices… The second option might properly be termed “asset maintenance” underwriting — the acceptance of terrible business just to keep the assets you now have.”
Clearly, companies will not sell bonds at price levels that would recognize the major losses, “for any number of reasons, including public reaction, institutional pride or protection of stated net worth”. Those companies would find themselves frozen for decades or longer as the maturity of those bonds maturity might be 10,20, 30 or even 40 years. And Buffett noted further, “That’s only half of the problem. Companies that have made extensive
commitments to long-term bonds may have lost, for a considerable period of time, not only many of their investment options, but many of their underwriting options as well.”
In the series of insurance business and analysis, please see two past articles, one on valuing the insurance business (http://www.gurufocus.com/news/136885/valuing-insurance-companies) and second is the deep value analysis on PartnerRe, one of the outstanding players in the reinsurance business. (http://www.gurufocus.com/news/136777/partner-re-pre--a-conservative-stock-in-reinsurance-industry)
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