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Warren Buffett: Accounting and Bond Investment of Insurers

July 08, 2011
In the letter to shareholders, Buffett has described the issue of accounting of insurance companies and how it relates to the action of insurers, especially on bond investments. That would give us a lot of insight into accounting and insurance businesses.

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)

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


Rating: 4.5/5 (55 votes)

Comments

roke6362
Roke6362 - 3 years ago
This is another good article on valuing property & casualty insurance companies. One of the reasons CINF took a huge loss in market value in 2008 was because its claims surplus held an inordinate amount of stocks that lost value when the market tanked, most notably Fifth Third Bank.

When reviewing insurance companies, it is important to review the type of bonds the carrier holds. However, it is equally important to know the duration/turnover of the bond portfolio. Right now, I've been told by a CEO of a midwest insurer that an average duration/turnover of 4-5 years is appropiate in today's climate.

This will allow the carrier more flexibility to invest in instruments that will not lose value, either through claims, inflation, low yields, and market values.
salleeaz
Salleeaz - 3 years ago
Have the accounting rules changed to mark to market?
roke6362
Roke6362 - 3 years ago
According to Buffett, mark-to-market doesn't apply to bonds, but I believe it does apply to equities. Either way, it will have an impact on premium-to-surplus ratios.

It is also especially important if the carrier is forced to prematurely sell bonds to fund claim payments in a disaster scenario.

Another area to review is the concentration of risk in a particular product line and geographic area. For example, STFC has had to tweak its business model because it had developed a larger concentration of property risk from the gulf of mexico up the Mississippi River. When the storms and hurricanes of from 2008-2010 occurred, its results were adversely affected.

Consequently, they filed to sell insurance in states where storms were less likely, and provide more competitive pricing in commercial insurance.

STFC also renegotiated some of its reinsurance agreements to assume more up front risk inreturn for more assistance for its cat loss exposure.

salleeaz
Salleeaz - 3 years ago
Thanks. I own FRFHF and MKL because both have great value investors: Watsa and Gaynor respectively. I would love to see FRFHF do something to improve its combined ratio.
ken_hoang
Ken_hoang - 3 years ago
Generally, there are three type of financial investment, applying to any corporations:

1. held to maturity: It applies to debt maturity, so in the balance sheet it record at amortized cost, the fluctuations in the market place does not affect the income statement.

2. Available for sales: it is record at fair value. Change in fair value between periods is not recorded as income statement but it is adjusted in the item called "comprehensive income" in the equity section.

3. Trading: It records at fair value, the change in fair value record in the income statement. (it is mark-to-market)

The bonds of insurers are in the section one, that is in order to avoid any pain of recording any losses, the insurers avoid selling their bonds to keep the financial statements look good.

Totally agree with Roke in terms of diversification, the concentration in P&C insurance is very dangerous. And the premium should be efficient in accordance with the probability of loss and the magnitude of potential losses.

@Salleeaz: MKL seems to have good performance over the long period of time, I haven't looked at the company in details yet. Please share your knowledge on those 02 (MKL and FRFHF)
rgarga
Rgarga - 3 years ago


Please note that FAIRX did adjust its muni bonds value mark to market and hence it book value came down from approx 390 to 354...
rgarga
Rgarga - 3 years ago
Sorry I meant Prem Watsa and FFH
salleeaz
Salleeaz - 3 years ago
I tend to buy the jockey not the horse and I want the jockey to be an outstanding value investor. For Fairfax, it's Perm Watsa sometimes called the Buffet of Canada. For MKL, it's Tom Gaynor. Both companies use CAGR in book value as a measure of performance. For the last ten years, FFH had 9.9% and MKL had 12%. The management of each company has most of their money invested in their company which I also like to see. According to Morningstar, MKL has an economic moat because of the types of things they insure. Mkl consistently has a combined ratio less than 100. FFH is having a problem with getting their combined ratio under 100. We are in a soft market and these companies are doing well. In a hard market, they should do very well.
ken_hoang
Ken_hoang - 3 years ago
Thanks Salleeaz, the consistently rising stock price of MKL over the more than a decade has proved somehow the operating performance over the long time of MKL. Will dig it deeper then.

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