I am in Omaha and have just been to the Warren and Charlie show. It has been on my "to do" list for my whole adult life and I am strangely disappointed.
It is of course blasphemous to be disappointed in Charlie and Warren. These octogenarians could teach me plenty - they just did not. It was annoying to be in the presence of people so smart and to learn so little.
I have read various notes from the meeting for almost twenty years so I had a fair idea what to expect. I could expect - questions on politics and economics, questions from young people wondering what to do with their life and questions from hedge-fund managers using 25 thousand rich people in a room as an opportunity for self promotion.
I got all this - and for the most part I got the usual homily answers. (The same questions were asked last year and the year before and the year before that. Answers can be got from meeting notes.)
This year we got multiple questions from hedge fund managers who were concerned about the stock price. Charlie Munger in frustration tartly observed that if one (nameless but well known) hedge fund manager was that concerned about short term matters he wasn't really welcome in this room. This got general applause but could (like many of Charlie's answers) be a little more diplomatic.
But with the above exceptions the questions were better than I expected. Much better. We had serious questions from competent Wall Street analysts who mostly asked about insurance, underwriting and regulatory issues - issues that cut to core of what Berkshire is and Berkshire's ability to route money to the parent company (where it can be used unencumbered) and to pay insurance claims. The detailed answers to these questions were largely squibbed.
One analyst for instance made the obvious observation that the organizational structure is "challenging" and wondered why the railway (BNSF) was owned by a regulated insurance subsidiary. Charlie and Warren squibbed it - arguing that BNSF provided more resources for paying claims - noting roughly $5 billion in pre-tax profits. But throughout the meeting Warren argued that one advantage of BNSF was that it was going to be allowed to invest vast sums (far in excess of depreciation) at acceptable regulated returns. In other words BNSF is going to absorb cash. How does this mean the insurance sub is going to have more cash to pay claims? Can claims be paid in steel rails or railway bridges?
This wasn't an atypical squibbed answer. Warren (correctly) argued that General Re was a good asset now but that previously it lost its way. Charlie wasn't going to let Warren get away with this - it was thoroughly lost when Berkshire purchased it (and paid a huge price). However the details of how General Re was brought back into order were simply glossed over. Warren observed that Gen Re had a very nice life reinsurance business. That surprised me. Swiss Re has a sort-of-OK life reinsurance business but life reinsurance is a business that has produced a few disasters one of which I followed closely*. I was struggling to understand what made the life reinsurance business a good business.
Warren also noted - as a throwaway - that they had a long term care reinsurance business that he wished they had less of. Again there was no explanation as to why. But this time it is inside my field of competence so I am going to explain myself.
The disaster of long term care insurance
Long term care insurance has bankrupted almost everyone that ever touched it. It is the insurance against the need to go into a nursing home and it has mostly been sold by insurance agents on commission.
Here is what a commissioned agent does.
They make friends with people who run nursing homes.
When the kids (now middle aged) visit a nursing home they might put their (elderly) parents into the insurance broker is notified. The insurance broker then sells them a policy for their parents.
Of course the policy is going to be used. The people who buy long term care insurance are precisely the people who are going to claim. It is a disaster.
Eventually the policies become so expensive (to cover the losses) that people who won't claim never buy a policy. Adverse selection becomes total.
Long term care insurance is the worst business I have ever seen.
Warren of course never told us that - but somehow he wound up re-insuring it.
I guess he did not want to explain his stupidity.
But then long term care doesn't need to be that awful. Indeed there is (at least) one company that does it well.
That doesn't make long term care a good business - but it might make it an acceptable business.
That company is (and this will be a surprise to many of my readers) Genworth. The same Genworth that was a spin-out of crappy long-tailed insurance businesses from GE Capital. It includes a mortgage insurance company (with what is probably a toxic Australian exposure) and a long term care business.
Here is what they do to make the long term care business acceptable.
They employ a sales force of 60-65 year old people on salary not commission. Because they are on salary not commission they have no incentive to write bad risks. They do not troll for business in nursing homes.
This sales force visits the home of leads and has a cup of tea or coffee and a social chat. They might spend twenty minutes having a chat.
They will find out what the lead's husband or wife is doing.
They will find out whether the lead is doing the New York Times crossword or reading sophisticated books.
And whether they play golf or do some exercise.
They will look for pictures of the grandchildren and ask questions about them.
They will observe and ask about the pile of toys and children's games in the corner.
And only then will they ask anything that looks like an underwriting question but they will have already decided whether to underwrite the business.
Here is what is going on.
People who have stable relationships into old age tend not to wind up in nursing homes. They look after each other. Singles are the biggest risk and asking about a spouse is the critical question.
Doing the New York Times crossword or reading sophisticated books indicates no Alzheimer's disease. That removes another major insurance risk.
Golf suggests some physical fitness - and removes more risk.
The children's toys however are - after a solid marriage - the next largest risk mitigating factor. If the grandparents look after the grandchildren that creates a reciprocal obligation. The children are far less likely to put granny in a nursing home if granny is a part of their own kid's lives.
Warren knows all this. He knows why some insurance businesses are better than others. He knows why their life reinsurance business is good (I have no idea). He knows why their long-term care reinsurance business is bad (and after this post so do you).
But Warren told us surprisingly little. And for that I am disappointed.
John
*I was once obsessed by the collapse of Annuity and Life Re.
Post script: in all except a very bad year or a very high cap-ex year the depreciation plus profits of BNSF will probably be less than cap-ex so there are likely to be distributable funds. One exception may be if a catastrophe removes many of the bridges or damages the rails or closes the line for an extended period. That however may well be a big claims year for the insurance company so the situation can still be problematic.
34 comments:
John, regarding BNSF, isn't there a distinction between investing more than the rate of depreciation and investing more than that depreciation plus profits? Only if it does the latter would it be consuming cash, correct?
Nice overview of the long term care business. Are there any sites or primers you would recommend where can I learn more about other insurance businesses and why some businesses are better than others?
How would you rank the best to worst insurance businesses to be in? I've developed a personal interest with the economics of insurance industry (I did a double take the first time I heard the commission rates on some of the policies agents sell to people).
I'm also in Omaha...don't disagree with your comments, especially the analysts' questions.
Yep, hard to see GNW not making a killing on LTC a few years out - especially now that UNUM, MetLife, and the Pru are out - and once interest rates rise. Now if they can just get the MI business in your neck of the woods straightened out...
Tanks for teaching us about long-term care insurance. It's so true though. My grand-mother was very involved in my upbringing when I was a child, and when she was old, I spent time looking, making sure she continued to live in her own home (and die there which for us was very important)!
Been a follower for a whilst and wanted to post to show my appreciation for your great blog.
Can you give more information on "probably a toxic Australian exposure"?
Because I am down here and would have to say its either incredibly bad luck or incompetence that would give that in this market...
John, thanks. That answers my question of how BRK could have lost so much in life reinsurance, which was one of my main questions two months ago.
The life reinsurance business is a good one if practiced well. Look at RGA, they manage it right. BRK bought some doggy blocks of business, and has now awakened to fleas.
LTC is a horrid business, because the insured knows far more than the insurer.
Full disclosure: long RGA, and I am a life actuary though inactive...
About my toxic Australian exposure: the last conference call referred to a surprising spike in losses in self-employed people in coastal Queensland.
The question: is this the thin edge of a property debacle or a one-off.
I am getting bearish. That is all.
Nice display of common sense.
When I read about Buffet investing in derivatives, an insurance company owning a derivative and the ever increasing unrelated businesses owned by Berkshire, I can't help but think that we're seeing a corporate structure that looks more and more like an imbroglio.
Sounds to me like your description of the long term health care business is the very reason why (long term) health care should be universal and mandatory.
As I see it, the main reason for BRK to own businesses like BNSF outright is to avoid the corporate governance / agency issues that arise when owning small blocks of publicly traded stocks.
The big risk I see with BRK is that of some rogue manager betting the company on bad insurance. LTC is just a slow leak that is dwarfed by profits elsewhere. But I'm sure there are places where the risks are much more significant. I care mind paying those insurance execs big salaries, but it should be paid in restricted stock--and restricted for as long as the insurance business they are writing.
Aha! Now I know the secret to getting LTC insurance with Genworth. It is difficult if not impossible to change the risk factors but now I can rethink the notion that we might need the insurance at all being in a stable marriage, reasonably fit, and mentally strong. No grandchildren yet, but now I can see that Genworth considers us an excellent risk so it would be a poor use of our funds.
Re: BNSF. You cannot pay claims with bridges or rails. But BNSF shares can be sold in a worst-case catastrophic insurance payout. As Buffett has observed, the BNSF right-of-way simply cannot be recreated today. The other Class I Railroads would also know this, and they would also be faced with the need to respond to what their competitors were doing. Thus, BNSF would be worth a great deal even in a fire-sale situation.
As for insurance, I'd like to know what's in the General Re run-off book that Warren Buffett keeps complaining about. Just for curiosity's sake. After all, Buffett liquidated most of the General Re derivatives, many of them at a loss. Thus, the General Re run-off book is filled with the ones that **nobody else wanted to buy**. Just how crazy do these derivatives get?
National Indemnity has liabilities that last for the next 50 years (Equitas' asbestos claims). Now National Indemnity has assets that last for the next 50 years (railway).
That's the reason why Buffett bought BNSF.
The reason why BNSF is a subsidary of National Indemnity is regulatory capital. National Indemnity's regulatory capital surplus went up by $30+ billion in 2010 when Buffett put BNSF under National Indemnity.
If BNSF gives out a dividend to National Indemnity --- it becomes part of National Indemnity's regultory capital surplus. If BNSF spends money on capex, that becomes part of BNSF's shareholder equity which eventually beomes part of National Indemnity's regulatory capital surplus.
I agree with your assessment of LTC insurance, but your analysis of Genworth as a winner in the group is way off. I hope you are not long GNW.
What you say about their sales force may be true, but it is just a matter of time before that block goes sour, and some would argue that it already has. That means the rate increases are just around the corner and they will have the same fate with LTC insurance as the other big boys (MET, CNA, CNO, Penn Treaty, Allianz,...)
Everything is alright, until it isn't.
Accountants will continue to publish balancing figures until they don't...
John,
Bravo! I learned more about the insurance business in this single post than a whole year worth of reading. Long Hempton, short Buffett! LOL.
Btw, wanted to ask you: (1) how did you find out their sales strategies? (2) how would you "short" the toxic Aussie house market?
I'm not familiar with how Genworth operates in Australia, but in the States, the company does not have a salaried sales force. They are all non-employees working strictly on commission.
Your otherwise correct. Genworth is the one company that has done a excellent job making LTCI work.
.
Hi Thanks for sharing your observations and experience.
Why didn't you ask the questions you wanted to ask? You make salient points.
I've never known an Australian to be shy, but I guess I would have been awed too. For some it's K-pop idols, and I guess for us, it's a couple of elderly gentlemen.
I love Charlie!! :D
Brilliant post John. Cheers
I love Charlie :D
Brilliant post John, cheers.
This was one of the most off based articles I have read in years. Most long term care insurance is sold by career agents. They help people who respond to marketing or went to websites. People understand they need a plan for the the physical, emotional and financial burdens long term care places on family and friends.
The risk is real. As medical science contiunues to improve we survive health events and accidents and we live to older ages. When you get old you have age related issues from memeory to physical.
Commission sales people are used since this is a hard product to sell because of denial. Insurance premiums would actually increase if you used salary folks which is why most insurance is sold by commssion sales people.
This is not unlike many products. Few people have the skills required to listen to a clients needs and help solve the problem the client might have ... no matter what the product.
The problem some insurance companies have in long term care insurance is underwriting since so many people do end up needing care. In the past many companies expected a large number of people to laspe the policy before ever using the product.
The actual lapse rates are very low. Some companies like Genworth have been doing this since the 1970's so they understand the real risks and price the product properly.
The other area companies have a problem with is they must reserve large amounts of money for claims. This is an expensive business to be in because of the reserve requirements. Now that interest rates are so low only the best will survive.
This is still a solid business. A huge marketplace exists (people aged 40 to 70) who have assets to protect and who need a plan for the the physical, emotional and financial burdens long term care places on family and friends.
Tax incentives and partnership products are available as well. A good place to look at this product is www.completelongtermcare.com
Ah Dr Robert Weed
I think they people who buy your policies get a better deal than those that sell them.
Also you did not short Conseco.
J
that was the silliest explanation of long term care insurance I have ever read. LTCi has been under-priced by insurance companies seeking to ramp sales so that the execs could pull out bonuses. When the company gets into trouble because the premiums collected were inadequate the execs are long gone living on a beach or on to the next scam. It is a similar problem that health insurance in America has, where execs have pulled more per premium dollar to their bonuses (which have tripled in the past 30 years, despite a low growth environment) while raising premiums and always looking for an excuse to blame- right now it is Obamacare that is the scapegoat. John, you make some good observations, but twist to some very wrong conclusions. Ulysses.
John,
oh, a few more things: Genworth does in fact have a small direct business unit, but the majority of their business is done by commissioned agents, many of whom are financial planners. Financial planners generally represent a fairly affluent crowd that will buy insurance at a younger age as a part of their overall retirement planning. The average age of a Genworth new client I believe is a shade under 60, which gives Genworth over 20 years to play the float.
I do agree that inflation is a concern for insurance companies in general, but the inflation rider for LTCi is expensive and thus not a problem. Insurance companies in general price policies pretty well, except, as mentioned previously, when sales and bonuses outweigh long-term corporate health.
An analysis of the sales strategy and insurance company management is the most important step in evaluating an insurance company. I was short Conseco for a time when I was first securities licensed after I saw that they would in fact take virtually anybody for their LTCi plans. Only Bankers Life survived that mess as they had tighter underwriting. The parent hurt them obviously, but I believe that is the surviving entity. A poker buddy of mine is now an exec with them.
Hancock and NML are the other good companies in this business btw. Omaha appears to be borderline, hard to tell with TransAmerica now that they have re-entered.
Ulysses
LTC has had the same experience as Disability Income Insurance.
Underpriced initially by insurance companies (no premium increase ever, lifetime benefits, etc), and gamed by the policy holders.
Throw in a bad economy, which always triggers claims, and the backdrop of lousy real life investment experience for the general public, is it any wonder that the policy holders would rather see a return on their premium dollars instead of touching their sputtering investment portfolio.
BTW John, married couples have always gotten huge discounts on premium compared to individual policies. This is no secret.
Hi Conscience of Conservatives,
Your point about derivatives in insurance companies is a little hard to follow.
You see, in many instances, derivative contracts are used as a form of insurance, albeit structured in a legal manner which neatly avoids all the tiresome regulatory issues involved in writing insurance contracts.
In principle, a good insurer, ie, one who has the ability to understand the risks and to price appropriately, is probably in a better position to write derivative contracts than anybody else.
However, the experience of AIG a few years ago provides a notorious example of how things can go wrong. How did that happen? Judging by the published material, it seems that the didn't understand what they were getting into (eg, they too thought that real estate price always go up) and, at least to some extent, they were gamed by their IB counterparties.
Cheers, Nemo.
Great post on incentives.
Funny that some insurance companies still don't get it. Surely losses should show up relatively quickly?
I thought Genworth was struggling with long term care insurance as well, that they admittedly had underpriced it, and were asking for price increases?
also, if Canada is in a property bubble, as some are suggesting, including Prem Watsa at Fairfax Financial, then Genworth's book of business in Canada may also be toxic.
I thought Life Reinsurance is a ok business. Certainly if you are reinsuring mortality risk- long term contracts, decent barriers to entry (you need the databases, expertise combined with giving primaries confidence that you will be around in 30 years means you don't get new startups forming just because they fancy it). Its a relationship driven business with 3-4 players dominant. You will know more about Life & Annuity Re than me, but I think they blew up because they took on investment risk and got it wrong. (A post on it would be welcome) Reinsuring mortality risk is a good business (trends in your favuor, reasonable predictability of what your risks are, etc). Reinsuring minimum interest rates or policyholder behaviour is a terrible business (punt on markets). I think that is what WB +(and the fellow talking abotu RGA) is getting at.
Slightly OT, but one's Apolipoprotein E's profile is a huge factor for Alzheimer's.
http://en.wikipedia.org/wiki/Apolipoprotein_E
Speaking of letters.
When's the next Bronte Capital performance letter going online?
Another Warren Buffet mistake:
Between the period 2004 and 2007, WB sold about US$37bn dollars of equity index puts (S&P500, FTSE, Nikkei, and Eurostoxx) maturing between 2019 to 2028 (European; 15 to 20 year contracts). This was a huge position as Berkshire Hathaway’s total investments in 2007 were $141bn (26% of the portfolio).
In 2007, he mentioned that he had received $4.5bn in option income from the sold equity index puts (S&P500, FTSE, Nikkei, and Eurostoxx). And in 2008, he had received a total of $4.9bn. He was obviously selling more puts as the markets were falling.
Unfortunately for WB most of his put options were sold close to the top of the market.
In 2011, because the sold puts are in the money WB said that if the indices remain where they were at year end to the end of the contract life Berkshire Hathaway would have to pay $6.2bn on their $37bn exposure. Note that he only earned $4.9bn in put income.
There are still many years before the sold put options expire and WB reasoning is that the $4.9bn option premium will be reinvested to earn the superior Berkshire Hathaway returns. Plus who knows all the indices may end up higher than their 2007 levels. If this happens then the put option income would be banked for free (even though capital was at risk during the tenure).
My comment:
The run rate on WB’s sold equity index positions is not great to date. He has earned $4.2bn (+11% return) to so far lose $6.2bn (-17%) on $37bn delta 1 exposure in 2011.
Things haven't improved mch better since the end of 2011. Between the 31 Dec 2007 to 21 May 2012 all the indices still have negative returns:
SP500 FTSE Nikkei DAX (my proxy for Eurostoxx)
-7% -16% -42% -19%
WB may be right that the option premium can be reinvested for the next 20 years. But
(i) He won’t be around when the position is closed (these are European options)
(ii) Its cheating to say that the income can be re-invested, because he could have easily bought the various indices and re-invest the dividends
The key to selling puts is to sell during market panics as the market will be on its knees and implied volatilities will be extremely high (as the market will be irrationally paying for put protection). Unfortunately, WB committed a large exposure prior to the GFC and had limited scope to increase his exposure further in 2008.
The $37bn sold put exposure on various indices may end up being a very ordinary investment for Berkshire Hathaway.
TJ
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