On Mistakes Admitted

“Expensively purchased knowledge should help us avoid future errors.”

Bruce Berkowitz, Fairholme Funds

Something special happened in the last Markel conference call. Something that rarely happens in a corporate sponsored conference call: humor. Not just humor, but humor on mistakes.

In the first quarter, Markel’s total investment return was negative .3% (+.9% on fixed income and -5.4% for equity). That’s not very bad considering most other insurance investment returns were disappointing. Even more interesting, the Current allocation to equities stood at lower than normal 66% of stockholders equity. Typical exposure is 80%. Lowest ever? In 2000, at 50%.

This is a number I will be paying a great deal of attention to going forward. After about 3 years of getting to know the company, it’s finally on my radar. At times, it felt like an opportunity lost. It was always on the watch-list and I always admired the company. In fact, I would say they are in the top 5% at doing what they do.

Here’s what Mr. Berkowitz had to say about Markel, “The company’s accounting is conservative and management has a record of generating excellent returns for owners…compensation to employees is fair and management spends significant time discussing past mistakes and future risks when communicating to shareholders.”

Here’s what Markel has to say about themselves. In every annual report, at the very beginning you will see the “Corporate Profile” it states:

“Markel Corporation markets and underwrites specialty insurance products and programs to a variety of niche markets. In each of these markets , we seek to provide quality products and excellent customer service so that we can be a market leader. Our financial goals are to earn consistent underwriting profits and superior investment returns to build shareholder value.”

Sure seems to satisfy the Fairholme insurance investment checklist.

After the “Corporate Profile” you will see a section titled “The Markel Style.” After reading it, you want to own a piece of this wonderful business, immediately. It states:

“Market has a commitment to Success. We believe in hard work and a zealous pursuit of excellence while keeping a sense of humor. Our creed is honesty and fairness in all our dealings”

“The Market was is to seek to be a market leader in each of our pursuits. We seek to know our customers’ needs and to provide our customers with quality products and service.”

“Our pledge to our shareholders is that we will build the financial value of our Company. We respect our relationship with our suppliers and have a commitment to our communities.”

“We are encouraged to look for a better way to do things…to challenge management. We have the ability to make decisions or alter a course quickly. The Markel approach is one of spontaneity and flexibility. This requires a respect for authority but a disdain of bureaucracy.”

“At Markel, we hold the individual’s right to self-determination in the highest light, providing an atmosphere in which people can reach their personal potential . Being results oriented, we are willing to put aside individual concerns in the spirit of teamwork to achieve success.”

“Above all, we enjoy what we are doing. There is excitement at Markel, one that comes from innovating, creating, striving for a better way, sharing success with others…winning.”

If Markel was a brand of toothpaste, Dentist would be out of business, If it was an engine, you would never need an oil change. And if it was a significant other, you’d be marrying up no matter what your financial situation was.

If you don’t believe in owning a business with a partner who has a commitment to success, a sense of humor, who is honest and fair, respecting of customers and always looking to improve. You have problems, and I can help, send me an e-mail and I will find the closest mental institute.

Rewinding back to the beginning of this post, regarding the conference call and why it was special.

Mr. Tom Gayner, the Chief Investment Office at Markel found humor, in a good way.

Here are a couple of quotes:

-“We are in a number of wonderful businesses at attractive prices.”

-“We have chosen to participate in this worldwide growth through companies with intangible brand values, manufacturing networks, and intellectual expertise.”

-“Our goal is always to have reserves established at a level that is more likely to prove to be redundant and deficient”

-On Reserves “Imprecise science.”

-Meyer Shields, Stifel Niicolaus “I guess, Tom, I know verly little about analyzing banks, but I would think…”

-Tom Gayner, “It turns out so do I, but go ahead with your question.”

-“Well clearly, when you make mistakes, you need to admit it, recognized it, and figure out what you can learn from it and move on.”

-“We are at an unusual time in the markets where the highest quality things that you have the highest degree of confidence in are also selling at bargain prices.”

-“There’s more capital in the P-C industry than there are premium opportunities.”

-“We are managing the business as if they are not going to change quickly.”

-“Our underwriters, with the help of our actuaries, have a keen understanding of where we drive that line in the sand and we just simply don’t go past that point. And consequently we’ve lost some premium volume because of it.”

I mentioned last week that I had written this weeks post already, because I don't think I will get a chance to purchase Markel at book, I had talked myself into 1.25X. I have not yet purchased the equity in question, but it is getting close...

Here are a couple links worth looking at:

-On Moral Hazard

-Anyone that attended the Berkshire Annual should recognize this lighthearted British humor that was shown to shareholders before the meeting started.

-Finally, a person in the blogosphere is in the process of painting the value worlds Sistine Chapel. I will be paying very close attention to this over the coming weeks and months as well as take part in the discussion.

-Lastly the obituary of Mr. Templeton. While your presence will be lost, your ideas and thoughts will not.

In the meantime, take care. Not sure what I will write about next week and that's where the fun begins. If you have any ideas, I'm all ears.

Regards,

S.K.

Worse Than Ours

“At least 95% of the insurance business in the world are worse than ours.”
Charlie Munger, Wesco Annual 2008

That is a remarkable statement coming from a person with an even more remarkable reputation. Whether it is or isn’t true, the statement stands on it’s own for the sheer reason of bluntness. Not to suggest it isn’t true, in fact it may very well be an accurate assessment.

Sure would be great to be invested alongside the top 5%, or even the top 10%.

If you haven’t had the time or chance to read the Fairholme annual letters, you should. They are short and to the point. You could read all within a 2-hour time period and in the end, you will feel smarter. Mr. Berkowitz’ record is astounding in relative and absolute terms. Further, their intimate knowledge of the insurance business allows the ambitious Intelligent Investor to understand in layman terms what to look for.

For example: “Property and Casualty companies have three ways to make money: 1) Underwriting Profit, 2) Investment income (Equities and Bonds-but mostly bonds), and 3) Investment Appreciation (Mostly Equities).” (Parenthesis mine)

Because with “The right management, these streams can generate a torrent of free cash flow.”

Part of a great investment thesis is not the stream of information from one direction, but from multiple sources. Relying on what makes sense (to you!), and making a purchase at prices you feel comfortable based on your appraised value of the business. In the value investment world, relying on different models is attributed to Mr. Munger.

In 2000, 50% of Fairholme fund was in Property and Casualty businesses. Why? Because “Such company have earned 20% returns on Book, and we paid near book.” (Emphasis mine)

During Fairholme funds existence, they have purchased Markel, Alleghany, Berkshire, and a couple of others. With insurance, the triple waterfall that comes from: “1) Improving underwriting results, 2) Growing Float, and 3) the Redeployment of capital from low to high return investments” makes for a great investment model.

Putting 2 and 2 together, and searching for the 5% of insurance businesses that have the same model as Berkshire, the focus on underwriting profit, investment income and capital appreciation is pretty hard. This insurance industry and the three factors mentioned by the folks at Fairholme doesn’t happen in syllogism fashion in the insurance industry. You can find an insurance company that underwrites profitably, but doesn’t have the investment acumen to find solace in the latter two. In which case, you are with the other 95% of insurance business worse than Berkshire.

So be careful. Be strict with these guidelines. They are only qualitative factors and with the right checklist, you can easily scratch off a potential insurance investment in less than 24 hours.

Comment on Comment

I devoting a new section to comments posted on specific posts for two reasons:

1. Sometimes very good points are made that other readers may be interested to know, and
2. If a reader dedicates a portion of his time to read something of interest to me, the least I could do is make note of it.

Last week, a reader asked if I have made any recent purchases in ORH. I have not, most recently I’ve been a consistent Fairfax buyer. All in all, about three months ago ORH was 3X more than FFH, within the last 2 months, FFH is now 1.5X ORH position. At the same time, not one share of ORH has been sold. The decision to sell other positions to raise cash to subsequently purchase FFH was all too simple.

I’ve already penned next weeks post and with lower market appraisals, it may be perfectly timed.

Until then, take care.

Buyers Delight

Good to be back and dusting off the keypad to write again feels pretty good. My grammar may be a little off, but writing a post is the equivalent of a grammar jog.

I have to say, my Seven-One Insurance Cherry was popped recently and with increased work assignments, blogging became "Cleaning out the Garage" type of work. For that, I sincerely apologize.

Now onto more topics of substance and less self-sorrow.

Insurance businesses are Cheap. Not just cheap, but utterly cheap. From a long-term perspective, you have to love the prices offered for certain insurance businesses. And make no mistake, this is not an endorsement for the plain-vanilla shops like XL or AIG, readers of this blog can use the search function to understand my distaste on the two.

As we look back 3-years ago, XL had a market cap of 10.4B and at 1.34 P/Book and AIG has a market cap of 142B and a P/Book of 1.77- my have the mighty fallen.

Today, AIG has a market cap of 65B and .84 P/Book, making comparisons worse, XL has a market cap of 3.56B and .41 P/Book.

Some vulture buyers in the insurance industry are about to go on a feast soon. The best part is some of these blood-smelling sharks are flush with cash and are trading at book. Cost of capital is the oxygen to an insurance business, with swift credit rating downgrades, cost of capital has the same type of damage as pulling a boat on a Miata. Even better, it's not insurance losses that is destroying the cost of capital structure, it is their investment portfolios. Which means, most insurance company's with valuable franchises are very much profitable as stand-alone shops.

Usually, the vulture buyers buy an under performing insurance franchise/sub because of their belief that having the right management could turnaround the operations. With the most recent investment portfolio problems of certain company's, some profitable insurance franchises look rather unprofitable.

Take for example, Alleghany Corp. (Y), last Monday a purchase was made in the unknown-untold-unreported section, Allied made a purchase for Darwin Professional. Alleghany owns 55% equity position in Darwin worth approximately 300million based on the Allied purchase price. The terms were fair (P/Book 2) and in a market where a bird in a hand is worth two in the bushes, I was pleased to see Alleghany with extra bullets.

These guys were purchasing Burlington Northern in the teen's and have started to sell their position in the last two years. The chances of Alleghany making an imprudent capital allocation decision are low. Not zero, just low. They were already well capitalized and based on the Darwin sell, now over-capitalized in a market full of purchase potential. Needless to say, the 55% Darwin position at the beginning of the year was a little more that 45% less than the 300million Alleghany will receive once the deal closes.

Another reason why I have a favorable view of Alleghany is the tax/shareholder friendly dividend. For every 50 shares you own, you get 1 share. Wall Street doesn't know anything about Alleghany conference calls, management doesn't like them. And our other friend Uncle Sam, the worst capital allocating pseudo hedge fund doesn't need to know.

With that in mind, I think you have to evaluate and make your own decisions based on what works best for you. Alleghany makes a lot of sense to me and most recently I've increased my position. There's a funny story actually, a few weeks ago, I was talking to a friend about how I missed a fat-pitch. Earlier this year, I purchased a 1/10th position at 340. For four months, I wasn't willing to pay a higher price than my estimated book value (345) at the time. Why?

Simply because valuable insurance franchises with equity centered investment portfolios and outstanding qualified management at book is a damn good deal.

Take for example the paragraph you see when you go to the company website:

"Alleghany's objective is to create stockholder value through the ownership and management of a small group of operating businesses and investments, anchored by a core position in property and casualty insurance. Alleghany is managed by a select company staff which seeks out attractive investment opportunities, delegates responsibilities to competent and motivated managers, defines risk parameters, sets management goals for its operating businesses, ensures that managers are provided with incentives to meet these goals, and monitors their progress.

The operating businesses function in an entrepreneurial climate as quasi-autonomous enterprises.

Conservatism dominates Alleghany's management philosophy. Alleghany's philosophy shuns investment fads and fashions in favor of acquiring relatively few interests in basic financial and industrial enterprises that offer the potential to deliver long-term value to the investor."
(Emphasis mine)

If that statement doesn't peak your interest in any way, I'm sorry to have disappointed you.

I don't think there is a 50% margin of safety here, however I also don't think there is zero margin of safety. Once they report their latest results, I'm all ears.

That's it for today. Next week, I'll take a shot at looking over some highlighting/underlining marks I made for the most recently reported numbers by insurance company's (of interest).

Until then, hopefully everyone had a safe 4th of July weekend. We live in a great country. Although I'm not the owner of patriotic boxers, I share with you a story that rings loud to the great tradition of this country.

I moved to the states at the age of 7 from overseas. My first language was Farsi, some now confuse Farsi being my second language. In fifth-grade, one morning, after saying the Pledge, my teacher asked me to stand up.

When I did, I was asked: "Are you a citizen?"
The answer at the time: "No"
Next question was: "Do you have a green card?"
Again, the answer was: "No"

My teacher then proceeded onto making a comment I have come to love and respect throughout the years: "Well Shahin, every morning you are the first one stand up for the pledge, and I respect that very much."

Fast forward to now, and I share a great affection for this country and the people whom have greeted me with open arms.


And so it goes, we live in a great country. Happy 4th.


S.K.

Back Soon!

Evening,

I am still alive and well. Thank you for your e-mails! Unfortunately, this is the time of the year when our business unit is busy for the 7/1 renewals, too much insurance! Worst part is this is also the time of the year for new annual reports, and quarterly cc's from company's of interest. Never thought a blog would take a life of it's own, I was wrong.

During this time, I did attend the Berkshire Annual and a weekend trip to Lost Wages. All in all, it has been eventful to say the least.

Hopefully I can find time for some posts starting next weekend.

Thank you,

S.K.

Three Wise Guys, Making Money from Desperate Crack-heads

“Too much of a good thing can be Wonderful.”

-Mae West

Depends who you are, if you are a crack head, too much of a good thing (crack) can be wonderful in the short-term, and if you are a business partner of the three wise guys (FFH, ORH, NB.TO), too much of a good thing (increased position) can be wonderful in the long term.

The reference to crack-heads is actually to the whole financial institution spectrum that the Three Wise Guys profit from through their CDS portfolio. Why so harsh? Not a day goes by where so and so institution doesn’t get capital infusion from foreigners, and they don’t do it because they are sincere, they do it at the cost of massive dilution. So just as how crack-heads and druggies need one last high before they are “sobered up or quit” (so they say!) and willing to sell valuables (family jewels) to pawn shops (foreigners) at dirt cheap prices, which the pawn shop will gladly buy and resell at a higher price later on in the future, the Three Wise Guys profit.

So go to your local bar and order the drink Three Wise Guys to start the night, it is composed of:

Johnnie Walker® Scotch whisky (Fairfax)
Jim Beam® bourbon whiskey (Northbridge)
Jack Daniel's® Tennessee whiskey (Odyssey)

Just a rundown on FFH, NB.TO, and ORH, I have been meaning to do this for a while, thanks to a rolled ankle from playing basketball, I can afford to now…

Fairfax 2007 Results were the best in 22 year history, 1.1 billion after tax, Book value increased by 49% to 230 (Currently I think it’s at least in the 260-270 range. 2007 Combined Ratio was 94%, 2006 CR was 95.5%. No CDO’s, or ABS, 80% hedge of equity portfolio.

-Refinanced common debt to 2017 maturity, resulting in lower interest rate. Consolidated debt to capital ratio to 27%, net-debt to net capital to 17%.

-Counterparty include 3 large international banks. For year 2007, sold 1 billion notional value for 199 million, cost of 25 million, profit of 174 million. In accounting terms, realized 185 million!

-From January 1- February 15, sold an additional 2.7 billion notional value for 651 million, realized gain of 591 million, cost of 60 million.

-Purchased an additional 2.2 bilion notional value for 51 million. Now totals 18 billion notional value. Value had increased by 596 million since the end of 2007.

-If Q1 ended Feb. 15, total gain of 747 million (150 on contracts sold, 596 increase in market value.) As of February 15^th, maket value of 18 billion notional was 1.3 billion. In summary, sold 3.7 billion for 850 million approximately 10 times original cost of 85 million and more than two times total cost of all CDS contracts ever bought.

-Not only has Mr. Watsa recouped total cost of the CDS portfolio, in effect he has a total 100% gain, even if all the remaining contracts expire. Further, they continue to be protected from a 1 in 50, and 1 in 100 storm in financial markets. I’m not a historian, but if now is a 1 in 50 storm, rest assured; Mr. Watsa has 10 people carrying bags to the right side of the balance sheet. Cumulative investment gain of over 5.5 billion since 1986.

-Fourth quarter earnings of 563 million were outstanding, but that’s more attributable to a relatively disaster-free year. 4Q07 underwriting profit was down 39% YOY, and that’s fine, if business is not profitable why be the village idiot, let AIG play their role.

-Fairfax also noted, “Deterioration in rates and pricing, intense competition for accounts, renewals and new business.” Again, this isn’t a surprise, astute readers of the Utterly Unknowable have noted this price deterioration when we chronicled the reports of 15 or so PnC insurers.

Now for the Subs:

For Odyssey,

-“Underwriting pricing is dropping, costs are going up. Property Cat- pricing continues to subside, remains relatively attractive…Primary level is more severe, Surety continues to perform very well.”

-“Picked up several new accounts in Europe.”

“In London, reinsurance for 1/1 is competitive, rate down 5%.”

-“Medical malpractice at Asian marketplace and Asian marketplace have been growing.”

-“May see net premium in 2008 decline up-to 10%. Competition on renewal will increase, margins will compress.”

-Net income, 4Q07 243 million (3.48 per share), 4Q06 84 million (1.16 per share)

-Operating Income, 4Q07 59 million (.85 per share), 4Q06 65 million (.91 per share)

-Combined Ratio (Quarterly), 4Q07 93.7%, 4Q06 94.8%

-Combined Ratio (Annual), FY07 95.5%, FY06 94.4%

-2007 underwriting profit of 94.7 million, versus 2006 underwriting profit of 77 million.

-Gross Written Premium was down 2%, In America down 10%, London up 3%

-Premium Composition 52% U.S., 48% international

-Business Composition, Casualty 53%, Reinsurance 68% of total.

Regional

-Euro-Asia, Gross Premium Written up 3%, CR of 81.5%

-London, Gross Premium Written up 26%, CR of 38.5% (49.2% of favorable development)

Losses?

-30 million- Flood in Tabasco

-10 million for potential D&O subprime losses

-Asbestos survival ratio reserving 10.7 years

AM Best estimate for Combined Ratio for the reinsurance line was 95%, ORH notched a spectacular 95.5%

Why spectacular? Because rating bureaus always underestimate true market vibes.

Investments

- Investment Result of 595 million in 2007, 507 million in 2006.

-CDS, rise in value when credit spreads widen

-As of Dec 31^st, carrying value was 308 million, up from 130 million as of Sep. 30, 2007

-Notional Value of 5 billion, term to maturity 3.6 years.

-In 1Q08 up to Feb 15^th, sold an additional 670 million notional for 161 million

-Remaining- total earnings thus far have benefited by 179,4 million, carrying value of CDS portfolio was 327 million.

Finances

-Debt to Capital 16%

-Purchased 770,000 shares or 1.1% of outstanding for 28 million, since Sep. 30^th

-Full Year- 2.6 million (3.7% of outstanding) for 94 million

-Since Dec. 31, 2007 to February 21, 2008- Purchased an additional 329,000 shares

-Total 3 million at cost of 109 million (36.33 average)

-91 million dollars remaining,

Economic Interest

-26% economic interest in Fairfax Asia

-6.5% share of ICICI Lombard

Book value of 36.78, up 31% for the year, in the 4^th quarter 12% or 3.87 per share

Since 2001, grown book value at 20%

For Crum & Forester,

Best’s estimate was 94% and C & F bested that with 93.5%. 2007 underwriting profit of 77 million, 86 million in 2006. Gross written premium was down 7%, and net premium written down 8%. Net Earnings of 293 million in 2007, 312 million in 2006.

For Northbridge, Canada’s leading Commercial insurance group

-Underwriting profit of 78 million in 2007, 20.5 million in 2006. There was some “Frequency and some severity in its Commonwealth and its Markel books.”

-2007 combined ratio of 92.3.

-Net earnings grew to 295 million in 2007, 167 million in 2006

-1.7 billion of premiums written across the four company’s (Lombard, Markel, Federated, and Commonwealth)

-Net investment income was 89.9 million

-Shareholder equity rose to 1.42 billion

Across 4 company’s:

-Lombards- CR 93.7% for 2007, 90.1% in 2006

-Growth in specialty

-YOY decline in underwriting profit because of increased frequency

-Favorable reserve development contributed to about 18 million underwriting profit

-Markel- CR 95.2 % in 2007, 91.2 in 2006

-Net premium written down 15% YOY

-Competition in mid to large accounts

-15.5 million benefit from favorable exchange movement on U.S. Claims

-Long haul trucking, “returing to the darker days of the last stock markets.”

-Federated- CR 94.1% in 2007

-Premiums written flat

-Common Wealth- CR of 77% in 2007, 153.7% in 2007

-Underwriting profit favorable development of 31.3 million

-Book value of 28.59 (22.89 in 2006), up 25% for the year.

-Investments

-Carrying value of investments of 3.3 billion, 2.9 billion in 2006

-Includes (+136 million in CDS gains, +100 million in Hub Gain, +12 million improvement on short sales of S&P, -23 million write down, -21 million in foreign exchange loss)

-Already 85 million in gains on CDS in 2008

-26% in cash and shore term, 54% in government

-Buybacks

-30 million for 840,000 (35.71 average)

-Allow repurchase of 2.5 million shares before Nov. 5 2008 (watch this date! Why? Well because Northbridge averages a little over 92k shares a day, if they wanted to take advantage of the full 2.5 million share buyback, that would take 27 full days of NB.TO being the only buyer of stock, obviously that’s not going to happen…here’s the perfect scenario, for the stock to go down, average 100k volume, and NB.TO to take advantage of the full 2.5 million share buyback).

-Future

-“We think there is going to be considerable consolidation in this industry over the coming decade as markets soften and who knows how much of the foreign owned parents will get into capital problems over the coming years.”

For Fairfax Asia,

-Underwriting profit of 20 million, up 40%, Combined ratio of 70.4%. Gross written premium of 171 million, up 27%, net premium written 70 million, up 16%.

-Growth in Singapore, introduced Falcon Thailand.

-For India (26% owned ICICI Lombard), the largest general insurer by market share in India.

-Group Re had an underwriting profit of 11.3 million, with combined ratio of 95.6

For Runoff,

-187 million pre-tax income due to investment of 291 million, 241 attributable to CDS. Year to date gains on CDS of 160 million pre-tax.

Cash is over 1 billion, paid down 100 million in debt, debt to capital ratio declined from 35.7% in 2006 to 27.1% in 2007.

They have a 19 billion dollar investment portfolio:

-Bonds represent 10.5 billion, duration of 7.5, last year was 8.5

-cash and Short term securities represent 4 billion

-Equities represent 3.3 billion, we now know that 10% of their equity portfolio is in JNJ.

-Derivatives represent 1.2 billion

They have no intention of selling any run-off business. New CDS positions have exposure to “Auto, Credit Card, Private Equity, Bank loans, all sorts of things.”

Why?

Because, “The idea of tranching loans, be it mortgage loans, credit card loans, the structure was applied all across the credit markets, and that has led to moral hazard.”

Who?

If you somehow come across a guy with the last name “Bradstreet” congratulate him, even if his first name isn’t Brian. The guy will forever be remembered as the brains behind the very profitable CDS portfolio. Rest assured, Mr. Watsa says “We like where we are.” And who wouldn’t?

Just to conclude: I hold positions the three wise guys (FFH, ORH, NB.TO) and I actually treat it as one position. Why? Well management philosophy is pretty much the same, investment portfolio is the same, and if I like those two qualities and want to be a part owner in Fairfax Asia, and the largest Canadian insurance company, would it make sense to just hold ORH? It does to some people and I don’t want to step on any toes, but I think too many people own one and not the other based purely on metrics. I own all three because I want specific exposure to certain business operations that I wouldn’t get with only ORH, or only NB.TO. I believe that treating all three as one investment position will allow you to hold an outstanding insurance business portfolio. For example, if you only hold ORH, you are not getting any of the Runoff business or Crum and Forester business, your best bet is to buy FFH, then add ORH and NB.TO.

Anyways, those who hold one, likely hold two, and if they hold two they probably do own all three. So I am probably preaching to the choir.

Enjoy your week, I will be heading off to Houston, TX this weekend. A friend that works in the insurance industry as an underwriter has an annual meeting should be fun. I’ve been trying to convince him to write for the Utterly Unknowable for some time now, don’t hold your breath!

As always, until next time,

Take care,

S.K.

I'm Not Selling

Good evening, just thought I should write since a couple of family members and few friends have asked me if I am selling my long held gold position. In short, obviously by the title of this post, the answer is no. I first shed light on this position in the post Random Rants:

I remember when I made my first purchase. It was 2004, I held an internship at J.P. Morgan Chase, the Credit Card Division, not the I-Bank. It was late in the afternoon and my mentor, Mr. Hancock, 15 year veteran instant messaged me saying, "Kudlow & Cramer just said they would short gold at 394." This of course was music to my ears only for the fact that my father spent 20 years as a jeweler in Iran. Much of the West doesn't understand the importance of Gold in Asia. The majority of the Middle East only trusts the yellow metal as a true store of value. In fact, to this day, anytime there is a wedding, there is a transaction of Gold between the two parties. Further, 80-90% of the gifts received are gold! With one of the more youthful demographics, Gold will continue to be in circulation.

Now to India, same story as above. There is just massive amounts of Gold that is treated as a currency. Men wear Gold as a symbol of wealth and it's not the 14 K material! I just find it hard to believe that anytime Gold is talked about in the media it is talk of inflation. And don't get me started on that, as inflation is the most wrongly used word today. Inflation is not rising prices, rising prices are the result of inflation. Inflation is just the increase in money supply/credit.

So within a week of Kudlow and Cramers great investment idea of shorting an asset class that I personally have "inside info" through my father, I made my first purchase of the yellow metal. Physical gold of course, at the price of $396 an ounce. I still hold it. In addition the next year I purchased premium gold coins, the Saint Gaudens, MS-63 and the MS-65. Consequently, late 2005 I purchased physical silver, at around $7.15 an ounce. I saw a cheap asset class and my reasoning is 100% fundamental and there will be a time to sell. Call it a liquidity crisis, solvency, whatever you want, but as Mr. Coxe says, "Gold is the only asset that is no one else's liability."

Buying gold at $396 an ounce and silver at $7.15 an ounce wasn't always the easiest or most popular statement back in 2004-2005. In fact, I remember a guest who came to our house for dinner one night, MBA background. He asked what I was buying and my response wasn't met extreme ridicule. Shortly after, I excused myself from the table because my mannerisms and attitude had become slightly immature relative to my age. I remember vividly that one night.

Nowadays, most people don't believe that I hold these precious metals. So either way I'm at a loss of words. And I'm not selling, I can wake up tomorrow and gold can be down 200 and silver down 4 and it wouldn't bother me. People don't understand these commodities nor their respective mining process. Quite frankly, I don't care.

Often times, I save an article here and there just for memory. Relating to gold, earlier this year I saved this one, dated January 3, 2008, titled: "India housewives rush to sell trinkets as gold soars." This was at $868 an ounce and while I'm not the genius who will sell the gold at the exact top, my sign to sell will be when India's housewives buy their gold trinkets back at much higher prices. What will gold do tomorrow? that is Utterly Unknowable.

Thank you,

S.K.

The Genius of Watsa/Buffett/Simpson

"Seize the moment of excited curiosity on any subject to solve your doubts; for if you let it pass, the desire may never return, and you may remain in ignorance."

-William Wirt

Quick one tonight.

I was curious about recent positions taken by Berkshire/Fairfax, more specifically the one's in the pharmaceutical area. It actually drove me nuts, because we have heard numerous times about Sir Buffett's lack of understanding of the pharmaceutical industry. Now we know he is being humble. And we don't know for sure whether if the Glaxo/Sanofi purchase was Mr. Simpsons, but we can at least assume the JNJ purchase could have been Sir Buffet's. It really doesn't matter who purchased it and for a man (Lou Simpson) who never receives any credit, well he is a genius in his own right.

Fairfax of course also has made some recent purchases in pharmaceuticals, namely Pfizer and Abbott Labs.

Doing what little reading I could do this weekend considering my younger brother was in and out of the hospital, I had a chance to look over the W.R. Berkley Corp. conference call. In it, there is a nugget that had somewhat of a "hmmm, I sorta 'get' it if indeed it is true."

The quote:
"In general medical costs overall in the whole industry have been the real risk for cost inflation...medical inflation has been 6%, 8%, 10% depending on where and what."

Take it for what it's worth, because for clarification purposes, Mr. Berkley was talking about California workers compensation medical trends. However, I figured that for most liability lines, especially in auto for PIP (personal injury protection), the medical inflation wouldn't necessarily just apply to WC, it would apply to almost every other line.

Later on, Joshua Shanker of Citi stated in a wordy question, "You [Mr. Berkley] made an assumption on claim inflation but clearly one goes back one, two or three years on the liability side and the claims inflation has been much more modest than what you talked about."

It's indeed claim inflation as a whole that's increasing, and what the "Genius" at the head of Fairfax and Berkshire are doing is hedging claim inflation. Again, I don't know if this is their true intention and I'm very curious about these purchases in the pharmaceuticals. What do you think?

Until next time,

Take care,

S.K.

Insurance Rundown, Part 4

"I think we have an embedded risk management system that is everyone who works for us and who runs the company is scared to death of being stupid."

William R. Berkley

What better quote to conclude the "2007 Annual Insurance Rundown" for the Utterly Unknowable blog than by Mr. Berkley. I think the final consensus is: a continued soft market with price declines of 5-7%, that may get more aggressive as the year goes on.

There are many questions that cloud the insurance industry that may stay the same or get worse. I didn't see anything that could change that may improve the softness. Let's discuss a few:

1. Investment income- we have negative yields in the bond market. Those who stay conservative or have invested conservatively thus far will eventually get the credit they deserve. There were four insurance company's (XL, RNR, CNA, and AIG) that have stated investment losses. Although AIG's is not total yet, they will report their earnings soon and we should get a better picture. Two of these company's (XL, CNA) are currently priced at below book value. I've heard a few voices here and there about how AIG is cheap and I think the answer to that is utterly unknowable. I have a strong case against an investment in AIG.

Investment income and the portfolio are equally important to insurance company's underwriting standards. In this case, the PnC industry is coming of off a two-year catastrophe hiatus and entering a soft market that may/will get softer. Further, you would think that most PnC company's would have pristine balance sheets going into this soft market. That's where the striking difference will be in my opinion of which company's will receive a premium to book or a discount. The one's who stayed conservative, didn't do anything fancy, will set themselves apart.

I'm not going to specifically outline who the good and the bad are, but with enough research I think there are some consensus answers!

2. Reserves- again, we are coming off of consecutive years in reserve reductions because of reserve redundancies. I think we will be entering a couple of years in reserve increases because claim inflation is more apparent.

What does this do? Well, there are many variables involved, but the ultimate effect is lower bottom line numbers, especially if it is long-tail. I think we'll see the IBNR number trend higher as well.

3. Systemic Change- Mr. Fishman hinted at it:

“I’ve been talking for a couple of years now actually at some risk to my perceived sanity, that there’s lots of factors that could cause one to believe that the traditional cycle that we’ve seen in the business may be somewhat different this time. We’ve talked about terrorism. We’ve talked about the management of various companies and how much that’s changed. We’ve talked about the tools and analytics that are available universally in the industry now and the fact that people are not running the business by the seat of their pants but in fact the analytics are really very much improved."

Then, the folks at RLI hinted at it, "Information is better...."

Lastly, the quotable Mr. Berkley said

"I don't think the business itself is any different, I think how it's reported and how people are reacting is a bit different. I that there is a lot more people looking at things with mathematical models which creates their own problem."

So the question is...we have three very smart managements (TRV, BER, RLI) talking about how information is better...this isn't anything that I really have a comment on (at least not yet!). However, I do think we should keep an eye on it.

4. Acquisitions- This could relate to the systemic change, or not; but think about it, we have gone through a quite period with little to no purchase activity. Instead, cash has been used to repurchase stock (more on that later). What does that tell you?

I imagine that once the separation of good and bad happens that I talked about earlier, things will become clearer. Until then, you have to think cash will be used to repurchase.

5. 60% of questions/comments- every transcript I read (over 20 now) had a mortgage crisis theme to it. On the investment side (portfolio), D&O and E&O, and Litigation. The investment side more recently because of the AIG hiccup.

On D&O and E&O- there is some major confusion. Mr. Greenberg said "Someone is not telling the truth." Let's talk about the knows and the unknowns:

• We know the estimated premium for this line is somewhere between 3 to billion
• We know there is a lag, just like how economists insist that there is a lag from the unemployment numbers and economic upturns and downturns; the same is true for the insurance industry. There is going to be an up movement in claims for D&O and E&O once all the mess is figured out. This actually takes a long time.
• We know someone (insurance company's) will pay, we just don't know who:
• "I think a lot of people have said that we have no exposure and if you'd listen to everyone in greater composite that means there'll be no losses in the insurance industry for sub-prim which is not what we think. But we think that losses will be focused on financial institutions. They will be focused on mortgage brokers and real estate agents." -Will R. Berkley
• And we know someone is not telling the truth according to Mr. Greenberg of Ace.

Now try figuring out this mess, because...

• We don't know who was messing around with the coverage’s Side A, B.
• We don't know where exactly the total premium number is 3 to 4 billion has quite a margin of error. 3 to 4 dollars doesn't, 30 to 40 dollars may, 300 to 400 dollars sure does, and you get the point!
• We don't know if the company's that wrote these lines have pristine balance sheets.

So if you are keeping score, depending on who is the sole benefactor of these policies, this may be a larger than anticipated issue. Further, Chubb talked about the litigation side of this line of insurance very well. Basically, recent Supreme Court decisions have favored the insurance industry, but how many threads are on this rope that the insurance industry is holding onto? I don't practice law, but I know lawyers who have made a career out of fighting for the common good get quite the initial reception.

But just in-case you’re curious, this is the two most asked questions, in my words of course:

• How much professional lines exposure do you have?
• How much CMBS, RMBS, CDO's etc. exposure do you have in your portfolio?

So, by now you are guessing at what I could have possibly hinted at in segment 2 that could change the insurance industry landscape. And this is just a hypothesis, one that I will be examining to prove just as I did with the hypothesis I posed on the very first segment.

I personally believe that buybacks and repurchase of stock work well in some industry's and not so well for others. For insurance, I'm not so sure. Think about it, you own an insurance business, on a daily basis you sell a promise for a price (premium), you don't realize that income until a certain time has passed (policy period), and that's just a very simple view. It gets much more complicated based on coverage’s, period (claims made or occurrence), etc. Further, you have headwinds and sometimes they could be tailwinds (litigation, capacity, etc.). Basically, you sell a good where you don't know what the cost of goods sold is and that is a very tough industry to be in.

In August 2007, in a post titled "Financial Engineering" I briefly mentioned Procter & Gamble and their decision to purchase $30 billion dollars worth of their stock back. The difference between Procter & Gamble and an insurance company is that at the end of the day, PG knows the cost of what they sell and an insurance company has a clue. One company can make a better assumption of their respective intrinsic value than the other and this allows more informative capital allocation decisions.

I think this is what separates an industry where buybacks and repurchase of stock have the ability to increase intrinsic value or not. Further, I don't have any rough numbers, only estimates, I think it's quite a bit however and I think a couple of years from now on an industry so flush with capital can be not so flush. And that's a good thing, because those who were conservative, have prudent management, and exercise diligence will fair very well in the next hard market. Here are the links to the previous segments of the "Insurance Rundown."

Insurance Rundown, Part 1

Insurance Rundown, Part 2

Insurance Rundown, Part 3

This week should be interesting, I've been anticipating it for some time, the three amigos (FFH, ORH, NB.TO) on Friday will release their earnings and before I can comment, I'll need some time to decipher the expected unbelievable-ness.

Just to give you a little clue on what I will write about next week:

"Anyone in this room who thinks they can open a new mine in a third-world country in less than 5 years is a menace to (their) stockholders, and industry. Figure 8 to 11 years, to build schools, hospitals, community relationships, so that you can get to keep what you get and you are welcome to the country."

-Don Coxe quoting Chip Goodyear of BHP at the mining conference

If you guessed Uranium based on my previous posts, you were right! Here are previous posts that talk about Uranium:

Successful Investors

Bull Markets and Bear Markets, Uranium Part Two

I hope you enjoyed reading the "Insurance Rundown" as much as I did working on it. All in all, it was fun.

Until next time,

Take care,

S.K.

Insurance Rundown, Part 3

“Someone is not telling the truth…”

-Evan Greenberg

Did I get your attention?

Good evening, tonight we will glance over The Travelers Companies, Aspen Insurance, and Ace Limited, two are very interesting to say the least! But before I start…

Yesterday was an interesting day in insurance to say the least. By now everyone has heard about Warren Buffett’s supposed proposition and everyone is asking, well why would the mono-lines go through with this? Because right now it’s head’s I go bankrupt, tails I go to run-off. At least that’s is what I think. Some smart value investor will be able to extract some value out of each by taking one or another into run-off. The smart folks at PICO holdings have done this before, of course with other types of insurance lines. Mr. Whitman did hint at possible run-off situations, so sure it makes sense.

In fact, Mr. Buffett’s thesis makes a whole lot of sense, right now the mono-lines are too busy trying to distinguish and pay damages for toxic waste they hold in their portfolio. This puts the Municipal bonds (they insure) at the end of the payoff diagram. If Mr. Buffett takes control, he will be able to guarantee what the word insurance entails as opposed to a promise that will go unfulfilled if these mono-lines hold onto them.

The Travelers Companies (TRV)-

-Operating income of $4.5 billion full year, 1.1 billion 4Q2007

-$6.71 per diluted share full year

-Return on equity of 18%,

-NWP increased 3%

-CR of 88.4% in Q4, and 87.4 full year

-$1 billion share buy back in Q4, 4.1 billion since 2q2006

-Repurchased 19 million common shares in Q4, and 8.3% of outstanding shares as of beginning 2007.

-BV at 41.23, Debt-to-Captial ratio 19.4% compared to target of 20%

-Investment portfolio realized gain of 937 million FY

-Commentary

-“D&O, E&O and Fiduciary products are issued on claims made policies which dramatically reduce the latency tail on the business and the ability to stack limits.”

-“On a policy level basis we see it approximately two-thirds above a $5 million retention which reduces our net exposure per loss to $12 million up to an annual aggregate of approximately $375 million” (“Any potential issue would be frequency not severity”)

-“Given that we view this as fundamentally a frequency issue, we think a material variance from our assessment would require systemic changes to the insured litigation environment expanding our exposure to segments that currently appear to have low correlation to the sub-prime environment.”

-“In summary we have thought in a comprehensive fashion about the evolving implications of financial sector stress on our management liability and surety industry exposures. The net conclusion of our in depth exposure analysis at year end 2007 are that the issues are very manageable for us and we’re comfortable by both our diversity and profitability of business in the management liability and surety lines.”

-“90% of construction portfolio is public works spending”

-“Our experience shows us that recessions in and of themselves don’t necessarily cause surety losses. But they do tend to expose the underwriting that took place when times were good, when the economy goes into a recession and I think our position on that is that even in robust economic times our underwriting has not changed and so in a recession it’s not necessarily going to follow that our losses will increase.”

-(Interesting)- “When we refer to a systemic change, we’re really talking about a class of risk not currently identified in any way, not currently associated with in some way being dragged into it…Brian’s comment about frequency versus severity is driven by our limits profile. We have low limits, relatively small limits I think compared to other people who underwrite the business, and so on individual account won’t change much of anything. It would actually take a systemic change in the class of business that was associated with this and for there to be litigation which our policies would respond to…Ultimately, there has to be litigation to the insured for our policies to respond. So that’s what we think could trigger a worst case scenario, but so far there’s no evidence of that.”

-“It’s very important first to remember that in claims made policies defense costs are contained inside the limits unlike tradition occurrence policies where the obligation to defend run outside the limits and so the obligation to defend can simply run on, in effect forever, at least theoretically.”

-“To the extent that defense costs emerge, they emerge first at the primary level. Those who have the primary policy will provide defense. I think one of the things that we take some comfort in – and it’s in the analysis of the 30 claims and notice of claims that we’ve got – is that only five of them are primary, 25 of them are excess so at the moment you see the average attachment points there. It sure feels good in this case to be an excess provider rather than a primary provider.”

-On Acquisitions: “I think it would be irresponsible for a management team to say in the broadest sense that it would never consider an acquisition. I think we have a responsibility to be thoughtful, to see how we can create shareholder value and to use all of the tools that are available to us to do that.

Having said that, our instinct about it is really no different than it was which is that the risk of any transaction is very high. There’s culture risk and balance sheet risk, reserve risk, people risk, financial risk; it’s significant and we recognize it. We’re experienced at it and we recognize that those risks are real. Any transaction that we might evaluate will inevitably be compared to the very high hurdle of the risk assessment that we put into any transaction.

So then I go back to, can we create shareholder value? Can we complete our mission with the tools and skills and the assets that we have? The answer is we’re absolutely convinced we can. So you take a transaction, you evaluate it in the context to accelerate the growth of shareholder value, again evaluating against the risk.

So I think it’s all on the table, Larry. I don’t think that’s any different than it was three months ago or six months ago. Risks are high. They are difficult to do. We have a lot of experience doing them so we feel pretty good about it but the risks are nonetheless high.

There’s nothing in our capital profile that’s driven towards accumulating capital in anticipation of a transaction. We are returning capital as aggressively as we think prudent in the marketplace that we’re in. To the extent that we feel comfortable doing more we will do more.

I think it would be nice to be AA straight with both agencies. We are on watch on upgrade from Moody’s from AA3 to AA2. I don’t know if that will occur or when. We’re currently rated AA minus with Standard & Poor’s I think it would be nice to be AA rated and the financial targets that Jay sets and the ways in which we measure our business are geared to doing that.

But we’re not sitting on $0.05 of capital without a good reason and a good reason is not sitting on it to create a war chest for an acquisition. That’s just really a silly way to run a business and we just don’t do it.” (I just love that response!)

-On EVERYTHING, and I mean EVERYTHING “I’ve been talking for a couple of years now actually at some risk to my perceived sanity, that there’s lots of factors that could cause one to believe that the traditional cycle that we’ve seen in the business may be somewhat different this time. We’ve talked about terrorism. We’ve talked about the management of various companies and how much that’s changed. We’ve talked about the tools and analytics that are available universally in the industry now and the fact that people are not running the business by the seat of their pants but in fact the analytics are really very much improved.

We’ve talked a little bit about the Sarbanes Oxley process that all companies, I believe certainly as we do go through; I mean there are so many people internally here that certify the financial statements that any concern about loss trend or reserve development gets evidenced very, very early and filters up to senior levels of management. I think you can make thoughtful decisions about risk-taking.

I think it’s interesting that virtually every company in the business of any size has been involved now in share buybacks or dividends. If you look back in the ‘90s, that was not the case. There were companies that had programs but there were precious few who were actually in the market returning capital.

The fact that we are this long into the cycle and our guidance would translate to a 13% to 14% return on equity range, even before the impact of any development I think is an indication of the fact that we are believers that it may not necessarily be as dramatically bad as it’s been before. I think there are lots of signals; and again, I’ve said this before. Look at the retentions. The retentions and ours are exceptionally strong but there are other companies that also have had strong retentions. That is a counter-indicative signal with respect to a highly competitive, as you say, stupidity environment.

We were looking at middle-market retentions in the ‘90s that were in the high 60s, and now we’re talking in the mid ‘80s. These are very dramatic differences. Although I’ve worked for people who said don’t ever assume it will be different this time so I think we look to next year and assume that it will continue to be somewhat more competitive than it was this year but I still think there are lots of indications out there that it may indeed be a little bit different. So we’re hopeful.”

-“There should be no confusion by anybody on this call about our aggressiveness with respect to returning capital to shareholders. It’s not transactional, it’s strategic. It is strategic. We do it consistently. It’s part of our philosophy, and it is not limited or driven by any particular dynamic. It’s just the right way we think to run a business.”

My Take: I think Mr. Fishman is a very smart person, very quotable, very informative and they seem to be doing all the right things for a company their size. Moreover, for a big company to stay out of much of the mortgage crisis regarding bonds is even more amazing. Kudos to the management team here and continue doing what you have been doing, because obviously it is working!

Next:

Aspen Insurance Holdings Ltd. (AHL)

-ROE for the quarter of 23.2%, for year 21.1%

-CR for the quarter 79.4%, for year 83% 2007, 82.4% 2006

-Full year net income was $489 million

-BV per share increased by 25% to $27.95

-Net investment income for the year was $299 million, up 46% on last year.

-Asset under management grew from $5.2 billion at start of the year to $5.9 billion at year end.

-Increased allocation to funds of hedge fund from 3% to just over 9%, (These alternative investment produce an 11.4% return for the year.)

-Less than $51,000 of fixed income investments wrapped by financial guarantors.

-GWP for 2007 $1.8 billion was down 6.5%, NWP down 4%

Commentary

-“Towards the end of 2007 our new lines including Excess Casualty and Professional Liability started to contribute to the top line, and we look forward to the contributions that all of our new teams will make in 2008. The property book in particular was reshaped lowering gross written premium by 20%.”

-“Energy Physical Damage insurance- Rate reductions here are averaging 16% and we have non-renewed a number of accounts as a result.”

-“Marine liability account, the experience was similar. Rates were down and in spite of this we achieved an average increase of 5% on our book reflecting loss experience on certain accounts and some exceptionally strong client relationships.”

-“In our new Excess Casualty insurance unit, rate declines of about 5% especially reinsurance division experienced reductions of approximately 3% in average was bigger declines in certain clusters”

-“Moving on to the property reinsurance segment, we are experiencing rate softening in both the U.S. and international markets. There are significant differences in rate movements in the U.S. cap market. On average, U.S. coastal exposed business saw arte declines of around 15%, which still allows for acceptable margins for us.”

-“On U.S. regional cat accounts, the rates fell by 20% or more rendering many programs uneconomic.”

-“On our facultative reinsurance book, we’ve seen U.S. primary carriers reduced rates by 10% to 25% with a less pronounced decrease in Europe over 10% to 15%.”

-“Casualty Reinsurance business, we saw rate reduction of just between 2.5% and 10%.”

-“In U.S. Casualty Reinsurance, rate reductions of between 10% and 15% are not in prominent marketplace. However, we were able to achieve an average reduction of only 4.5%, reflecting our focus on risk selection. We are seeking increasing competition in our U.S. Casualty Treaty business overall with particularly aggressive pricing and workers’ comp class covers or a number of contracts in the market were being renewed by some of our competitors with the rate reductions around 40%.”

-“I am also pleased to announce today that we have entered into the financial institution insurance market and have hired a highly respected underwriter to lead our efforts…We anticipate that we will write around $60 million to $70 million of GWP in this line by the third year. The emphasize will be on smaller and medium-sized financial institutions with limited exposure to major investment banks. We also tend to avoid the global 100 players. We think we’ve got the timing right on this one given the current market.”

-“We also think there will be some E&O exposures and we think there may be some crime, financial crime involved ultimately as well. Those are all lines of business that historically we have not been writing. So we miss the issue altogether. We’ve taken a pretty conservative approach here. So I would be surprised to see any adverse development. Last thing…I’d say that it is claims made cover and this problem isn’t over yet. Every few weeks we find another interesting headline. So there may well be more claims in the future. I don’t think Aspen is particularly exposed to those as to say, simply not the business we are in, but as a word of warning, the problem hasn’t ended for the industry as yet”

My take- Interesting warning by the CEO that the problems are just about to begin for the industry regarding D&O, E&O and even more interesting that they are about to enter the business soon. Overall, can’t say I know this company very well, however their info was great regarding rate changes. So, I will definitely keep an eye on their calls just to get to hear what exactly is going on in the marketplace. CEO seemed pretty candid.

Next up: Ace Limited (ACE)

-Operating income of 2.7 billion, net income of $2.6 billion.

-CR for year 87.9

-Per share book value grew 16% FY

-ROE up 18% for year

-Reinsurance net written premiums declined 31%

-Duration of 3.5 years

Commentary:

-“Inflation and recession can have an impact on property and casualty results, both revenue and claims. Finally the financial and economic conditions are deteriorating in the face of a soft and softening global property and casualty market. In a soft market underwriters tend to minimize or rationalize away risk.”

-“We are not getting paid to take either duration or credit quality exposure. We have kept our power dry for a time we believe we will have the opportunity to take increased risk at attractive returns. In that regard we are entering a period of greater opportunity.”

-“We estimate the size of the US exposed financial institutions market for D&) and E&O to be around $3 billion to $4 billion in premium terms. Ace writes $143 million of net premium. Our average net limit is about $7.7 million for D&O and $3.2 million for E&O. All of the businesses claims made and defense is with the limits.”

-“Prices continue to decline around the world and the rate of decline is accelerating in some classes and staying relatively flat in others. Overall the market continues to be more competitive. For instance, in US insurance property rates were off about 15% for the quarter while for the full year they were off about 7%. General casualty was off about 8% for the quarter and that varies by class and 7% for the year.”

-“For professional lines D&O is off in the quarter 10% to 15% and 10% to 12% for the year and E&O was off about 13% for the quarter and 9% for the year.”

-“We found the reinsurance market to be more competitive that some of the public commentary we’ve been hearing that would lead one to believe.”

-“For AGO our loss represents our 24% share of AGO’s recently reported $300 million negative mark to market loss on derivatives for the fourth quarter. Our relationship with AGO is limited to our equity investment recorded at $392 million…They have emerged as one of the strongest of the financial guarantors.”

-Analyst: “If you pull back big picture is there any other type of D&O or E&O event you can think that parallels this historically in terms of how we may think about it, whether its mutual fund market timing, S&L’s, IPO related stuff, investment banks, is there anything?”

-Evan Greenberg, “You said them all. They are all what you would look at but each one is so specific and so different that this one will have it’s own size and shape to it and it’s own emergence pattern and each one is distinct from the other because it is so fact specific.”

-regarding Financial Institutions “My sense of this is it’s going to play out over the next two to three years, in reserves in the loss fully developing and payments will occur over even a longer period of time. I think ’08, ’09 and depending on the contentious nature on whether it goes to court between even the insured’s and the grieved parties and then the insurers get into it. Those play out over a long time, think of laddering, and maybe give you a good sense. Look at Enron that continues to play out.”

-“In the E&S casualty areas we’ve reduced our exposure significantly because just the pricing and terms are crazy to us.”

-“Here’s what’s happened, we need more price, need more rate. If we are paying to take the risk, we are in the business of taking risk, we are not shying away from it and we are not changing that playbook and as long as we are paid to take it and the terms make sense then we will do that. In the FI world that means rate and that has to be recognized and so far it is ticking up a little bit but the market is very slow to react and us and another, I know a major player, have been attempting to push the market in that regard and others have come into sort of fill the breach because the market has been slow to take it up. We’ve been pulling back a little but we get paid for it we’ll take it.”

-“Our new business writing in the quarter were down about 43% from the prior year and our new business for the year was down 20% from the prior year”

-“Keep in mind the answer is really more the financial institutions and the large ones can buy side ‘A’, they can’t buy ‘B’ and ‘C’, not available to them. They buy it because that’s what they can buy and that’s what’s protects their individual directors and therefore they’ll serve on the board of those FI’s. I think that’s more of the answer from everything we know. Someone is not telling the truth…”

-“The higher the risk the greater the volatility and the more uncertainty the more we want to get paid for that business.”

My Take: I’m starting to like Mr. Greenberg a lot, I think he comes from the perfect genes to run a sound and successful insurance company. He is very candid, he makes sense, he understands the concept of getting paid for risk. New business in the quarter was down 43% from prior year, well that makes perfect sense if you are not getting paid enough for the risk! ACE will be a force if the elder Greenberg has had any influence on the younger. I wouldn’t be surprised.

In conclusion, I decided against talking about Markel even though I have the CC transcript sitting right in front of me. I think I’ll devote a whole post (they deserve it) to them sometime in the next two weeks or so, once I get a glance of the three amigos (FFH, ORH, NB.TO) when they report next Friday (that should be interesting!). Further, I will also write the conclusion to the 2007 Insurance Rundown sometime during the week. Having a full time job really humbles you in relation to finding free time. On Friday, I head to Houston, Texas to get a taste of Texas Tea (oil) while visiting a very dear friend. Until next time…

Take care,

S.K.

Insurance Rundown, Part 2

Good evening, as promised, we will look over The Chubb Corporation, RenaissanceRe, and Harford Financial Services conference calls to see if the market is really softening. However, for comedic purpose I want to highlight a line from today’s Bloomberg article titled: “AIG Falls on Concern Losses May Have Been Understated.”

In the article there is a truly wonderful nugget by Wall Streets Finest:

“Today’s announcement ‘will leave investors worrying about other skeletons in the closet,’ Nigel Dally, an analyst at Morgan Stanley, said in a note to clients. ‘Investors should brace for mark-to-market loss of roughly $5 billion in the upcoming quarterly results.’ He rates the New York-based company ‘Overweight.’”

Look to purchase AIG when Nigel goes “Underweight” on this insurance business. I did look at AIG, and will look at it in the future if the price is right, but something bothered me last week about the company. It was the headline: “AIG to Buy Stake in Chinese Motorcycle Maker.” This crossed my monitor about a week and a half ago, and if there was ever a time when hindsight is 20/20 it would be now. They (AIG) had to know that their derivatives weren’t priced right, yet they made a decision to make a purchase under their asset management sub. If anyone wants to make a case for this purchase, please do because my first reaction is: Don’t Lose Focus.

And so it goes…

RenaissanceRE Holdings Ltd. (RNR)-

-Growth in tangible book value per share of 19%

-45% CR for Reinsurance Segment, 89% for Individual Risk

-Gross premiums were roughly flat Reinsurance segment, down 19% in Individual Risk

-Net Investment income of $402 million

-Q4 results negatively impacted on investment in ChannelRe and losses in casualty book of business

-Net income for the quarter of $62 million or $.88 per share and operating income of $186 million or 2.64 per share.

-On a full year basis, net income of $570 million or 7.93 per share, and $735 million of operating income $10.24 per share.

-Top line declined by about 7% for the full year, driven primarily by our disciplined approach in the softening market.

-Purchased approximately $112 million of stock, bringing year-to-date to just over $200 million. Since January 1 we have purchased an additional 186 million of our stock. Since 1Q2007, 6.8 million shares for $386 million, 9.5% of our total outstanding shares.

-Managed cat premiums are expected to be down around 10%, specialty down around 25% and Individual Risk down around 5%.

Commentary-

-“We are never quite clear if the chatter predicts the fall or if it causes the fall, but either way we did see softening at year-end.”

-“Unfortunately at 1/1 this year this trend stopped and the reinsurance market did not grow for the first time since 2005. The lack of growth in the market and once again, increased appetite for cat risk and prices to reduce.”

“Exposure-based reductions approaching 20% and programs with flat or reducing exposures were seeing exposure adjusted reductions of between 7.5% and 12.5%..”

-“UK and Continental Europe, and those were down about 5% and 7.5% respectively.”

-“Commercial property that is hurricane exposed continues to present opportunity for us in 2008. The market prices for California commercial property earthquake coverage had decreased dramatically in 2007. In 2007, our written premium from California earthquake coverage declined more than we had anticipated at the beginning of the year. We do not see a growth opportunity in the segment under current market conditions of 2008.”

-“We have no CDO’s and no CLO’s in our portfolio, and also we have not indirectly invested in any securities that are wrapped or enhanced through financial guarantees.”

-“The in-force premium for our California earthquake book in 2007 declined by approximately 75%, and that doesn’t mean that we won’t do any California earthquake going forward, but certainly less of it is just based on picking the once that we want at right prices.”

-on Channel Re,

- Analyst Question- “Do you think that the business model is broken because people talked about the notional risk for year and years, and this time around it really the investor confidence has been shattered. So do you think that there is still a business there?”

-Neill A. Currie- CEO- “Well, apparently some people think so, And yes, I know the erosion of confidence, there is a problem, but there is an ebb and a flow in these sorts of things. And there is still a need for a product along these lines, and so we think there will be opportunities of one sort or another going forward.”

My Take: I like the fact that they separate business they write into three categories: 1) Acceptable businesses, 2) Negative returning businesses, and 3) Low returning businesses. That view makes sense to me, I enjoy separation of risk that aren’t based on market weightings of S&P 500 (sorry I had to take a shot at XL). Further, Mr. Currie did say “Acceptable business is shrinking by 5% to 10%.” That also goes with the flow of the 5% to 7% rate reduction in premiums that we have heard over and over. Lastly, they did write down their Channel Re investment to Zero, now hate him or love him, Mr. Ackman has to get credit for this. He stated his displeasure with MBIA reinsuring policy’s through Channel Re who apparently Renaissance thinks is a zero. Overall, I don’t think I would invest in RNR only because one the best holding company’s who has a reinsurance sub, WTM is at near book.. I’d much rather prefer WTM whose investment process is conservative as opposed to RNR whose investments are through hedge funds and private equity. That’s not to say that RNR is a bad investment, just not one for my risk tolerance.

Next we go to….

The Chubb Corporation (CB)-

-Operating income per share of 1.60 up 10% for 4Q2006.

-CR of 83.3

-Investment portfolio market value of $18.6 billion.

-Fixed income portfolio remains heavily weight in tax exempt bonds, average duration of 4.6 years.

-Book value of 38.56 at end of 2007 compared to 33.71 at end of 2006. Increase of 12%

-Purchased 9.8 million shares at an aggregate cost of $525 million. In all of 2007, 41.7 million shares at cost of $2.2 billion

-ROE of 18.7%, 5-year average of 16%

Commentary

- “From Chubb’s standpoint the credit crisis currently has the potential to impact principally three types of policies we write in our specialty business; Errors & Omissions, Directors & Officers and Fiduciary. The types of insured’s we now expect to be impacted include home builders and developers, lenders, other financial institutions such as [REITs] mortgage brokers, mortgage insurers, bond insurers, rating agencies, investment managers and hedge funds. As we’ve done in the past on the investment banking, mutual fund and stock option back dating claims, we have been diligently monitoring case developments and claim filings relating to the credit crisis to ensure that we stay on top of the potential claims. For the reasons I’ll discuss I think we are well positioned to manage the exposures arising out of these events.”

-On the E&O side so far, things have been fairly quiet for us. In large part we contribute this to our underwriting strategy and prudent risk selection. In 2004 and 2005 we made a number of specific decisions that are now working to our benefit. We avoided writing insurance for the major sub-prime lending specialists. We got out of writing E&O insurance for almost all of the largest global investment banks and the top 30 global commercial banks and we exited a program of mortgage broker E&O insurance that we had been writing profitably for some time. As a consequence to date we largely have avoided the primary E&O exposures arising from these events particularly regulatory investigations involving allegedly deceptive marketing practices. Instead the few E&O claims that have been reported to us to date largely involve individual claims against investment managers that invested client funds in securities adversely impacted by the credit crisis.

-We have had relatively more activity on the D&O front but there also we benefited from strategic underwriting decisions, prudent risk selection and our limit and attachment profile. The majority of the claims we’re seeing under D&O policies are securities fraud class actions against directors and officers of companies that have either had to take a charge against earnings, revalue their investment portfolio or report disappointing financial results due to the affects of the credit crisis. Once again our conscious decision to avoid writing D&O insurance for large sub-prime lending specialists and to limit our exposure to investment banks and global commercial banks has helped us to avoid some of the highest profile cases. Of the Chubb policies under which D&O claims have been reported many are Side A only policies which can only come into play if the company is not able to indemnify its Directors & Officers. A significant majority of the policies are excess only and a great majority of the policies involve limits of $10 million or less.

-“Finally although it is far too early to predict how these cases ultimately will pan out it is noteworthy that plaintiffs are going to have the stricter requirements for pleading [inaudible] that the Supreme Court established last year in the {Tellabs] case in order for them to move forward with their claims. In fact the first reported decision in one of these cases granted the defendant’s motion to dismiss.”

-“We have received notice of only a couple of such suits under Chubb fiduciary policy. The policies potentially implicated have been either Side A or excess only. This also appears to reflect our decision to reduce our exposure under fiduciary liability policies for large risks. In sum, based on what we’re seeing now the underwriting actions I’ve just referred to lead us to believe that the volatility inherent in Professional Liability lines has been reduced but certainly not entirely eliminated in Chubb’s own book of business. That is borne out by our analysis of claims received by us to date. At the same time we recognize that the full contours of the credit crisis impact on insurers are not yet defined. It is an evolving process that has to be closely monitored and managed as we proceed.”

-“The second item I’d like to discuss briefly and happily I might add is the latest of a series of favorable decisions from the US Supreme Court affecting Federal Securities Litigation. On January 15 the court issued its decision in another closely watched securities case, Stoneridge Partners. Once again the court came down on the side of defendants holding that private plaintiffs could not sue a company’s vendors for securities fraud. Even if those vendors have knowingly engaged in transactions that the company used to falsify its earnings. Because the plaintiffs could not establish that they had relied on any conduct or statements of those vendors. In so holding the court refused to extend the reach of private causes of action under the securities laws and reaffirmed that there is no private right of action against alleged aiders and abettors of securities fraud. Obviously the primary beneficiaries of the Stoneridge decision are the so called secondary actors, the vendors, suppliers, banker, lawyers, accountants, even customers who may be involved with companies that commit securities fraud. The decision provides them a measure of protection against liability for alleged securities fraud perpetrated by those they serve or with whom they do business.”

-“As such its primary favorable insurance impact is likely to be on E&O claims including those asserted against investment banks and accounting firms in cases like Enron Securities litigation. We think the decision is much less likely to significantly impact a D&O claims environment because the typical securities fraud claim under a D&O policy usually involves directors and officers public statements regarding their own company for which they can be held primarily liable. Nevertheless even on the D&O front the decision is a positive development in that it reflects the Supreme Court’s continued rejection of attempts to expand the scope of liability under the Federal Securities Laws.”

-“In an attempt to identify some positive development in this opinion the plaintiff’s bar has been pointing to a couple of dangling comments in the opinion that left open the possibility that the secondary actors in the investment sphere might still be open to liability. The Supreme Court curtailed that speculation last week when it denied outright the petition for [surserary] in the Enron case. Importantly it did not remand the decision to the Fifth Circuit for further proceedings consistent with the Stoneridge decision instead it left the decision below stand and affectively put an end to the securities fraud claims against the investment banks who were all major participants in structuring transactions that Enron used to misrepresent it’s financials. In that context it’s safe to say that the circumstances under which a secondary actor can be held liable in securities class actions are now quite narrow and that is very good news in the litigation arena for defendants and guarantors.”

-“There was competition for new business and it was particularly strong and some competitors actually moves outside of their typical appetite in search of that new business. There was also pressure to reduce deductibles and increase some sub limits. We also found that CAT prone property came under rate pressure. So we believe that the rate declines that we say in 2007 and that competition for new business will carry over into 2008. Rates are off mid to high single-digits depending on the line of business. The credit crisis might have a favorable impact on D&O pricing going forward; we’ll have to see about that.”

-“The favorable judicial climate has just been remarkable over the last three or four years. The United States Supreme Court has taken consistent positions which raise the level of pleading requirements and make it more difficult to establish class action securities certification and I venture to say if we were redoing the corporate abuse estimates today in the light of the developments in the law since the exposure both to the principals and to their insurers would have been substantially lower today than it was in the climate in which tey were experience.”

-“On our CAT program specifically we think the traditional market will be down 10%.”

My take: I thought this was one of the more informative CC’s thus far. Why? Well because they pretty much gave a lesson on D&O and E&O. Something I’ll touch on in the conclusion is really the landscape of how for 3 to 4 years the Supreme Court has been on the insurance side. Could the tide change? Well sure, you get some new politicians in office who want to get votes and points from the “working man” who has been “used and abused” by the “big bad insurance” company, and suddenly a line or two of business might not be as profitable as it was three or four years ago. Again, I’m just making a simple assumption, but an easy one that can change. I’ll comment more on Chubb in the conclusion.

Next up:

Harford Financial Services (HIG)-

-Net income for 2007 came in at $2.9 billion

-Core earnings rose to another full year record $3.5 billion

-Core earnings per share were up 21% over 2006 to $10.99

-Since the end of 2006, book value per share excluding AOCI is up 11%

-Return on equity topped 15%.

-Written premiums were $2.5 billion in fourth quarter, 4% below last year.

-4Q CR 91.1%

Commentary

-“We benefited from favorable weather, our underwriting profitability was healthy and investment income was strong. PNC competition has been and continues to be intense with new difficult to come by.”

-“We think competition will remain tough in the coming year, but we do not expect pricing to become broadly irrational. That is why we believe we can achieve modest growth in 2008.”

-“Even though our top line has declined, we grew policies in force in personal lines, small commercial and middle market over the past year.”

-“We have seen more competition in personal lines of small commercial, but these lines remain largely rational. Loss cost will trend in slightly higher are still quite manageable.”

-“In middle market, we are seeing the effects of several year of moderate pricing declines on a written premium in combined ratio. State mandate reductions in workers’ compensation rates are also dampening premium growth.”

-“We are competing aggressively for new business in select classes and regions.”

-“In general, we would say that for investments where underline credit is single-layer or better the wrap is not getting much value in today’s market. The bonds are already trading close to the underlying credit. This process had already started in the fourth quarter and is partially reflected in our year end marks.”

-“Historically, life insurers have always been major holders of commercial mortgages and we are no exception. We hold a balance portfolio of $22.4 billion. Versus our peers The Hartford does hold the larger portion of its investment in the CMBS format and we provide extensive disclosure about these holdings in our appendix. The CMBS format has pluses and minuses. While in most market condition, they are more liquid than other loans, this liquidity means they are accounted for at market value, while whole loans are carried at amortized cost. CMBS also benefits from diversification and if you buy the senior trunches subordination, though in today’s market, structural protection often does not get the highest value from investors.”

-“On the fundamental, the commercial mortgage business is still in very good shape. Delinquencies remain near historical lows. Property values, while down in the last 12 months, never experienced the hyperinflation of residential property over the last 5 years. At this point in the credit cycle, I much rather be overweight commercial mortgages than high-yield corporate. You may have noted that roughly $1.9 billion of our commercial mortgages are held in commercial real estate CDOs. I would like to stress of that roughly $1 billion are not CDO in the sense you might remember them from residential mortgages.”

Ok, nomination for one of the best exchanges:

-Eric Berg “I understand that this is all about hedge ineffectiveness and about certain hedges that do not qualify for hedge accounting but how should we think about these losses, are they economic? Should we ignore them in your opinion, David? How do you think about this because they are running through your P&L so clearly the SEC feels they are meaningful. They are hitting your book value, what is your view on these $165 million and similar charges and previous periods?”

-David Johnson, “Eric, the vast majority of what you saw in the fourth quarter was loss as associated with credit derivative position that is what is recorded in that line and I look at that in two different ways depending on the credit derivative strategy. Portion of that loss is the credit derivative strategies where we did effectively replication trade and took credit risk, very similar to the risk we would take by owning a corporate bond, by assuming credit risk through buying or selling credit derivative and then also getting other fixed income investment associated with it.”

My take: I’m not that savvy with life insurance, not that I’m savvy with PnC, but I understand it better, at least that’s what I think. There wasn’t too much great info from this CC, just very basic info, just as we have been hearing, the PnC market is soft and may be getting softer. I think life insurers are in more trouble because of their investment portfolios and limitations they have.

So overall, the consensus is that the market is soft and that seems to be a reoccurring theme. However, I think there is an ace up the PnC sleeve that may change markets and I haven’t heard anyone talk about it yet. I’ll share that with you in the conclusion. The next post will cover Travelers, Markel, Aspen, and Ace Limited.

Until next time, take care,

S.K.