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.