Tag Archives: financial markets

Dinner With Warren Buffett (Part 1)

Recently, we received an amazing email from Warren Buffett, the Oracle of Omaha himself, congratulating us for InsNerds.com, confessing that he’s a big fan of our efforts and inviting us on an all expenses-paid trip (on NetJets, of course) to have dinner with him to discuss the industry. We had an amazing time over the three-hour dinner at Gorat’s Steak House. The best part was being able to pick his brain about the awesome industry we work in…

Sadly, then the alarm clock went off at 5 am, and I realized I was dreaming. There was no email from Warren Buffett, no invitation for dinner and no flight on NetJets.

alarm

 

But all is not lost. Uncle Warren has written extensively about the insurance industry through letters to the shareholders of Berkshire Hathaway, which he has published every year since 1977. All this wisdom is available to anyone online for free, or you can even buy a printed copy. All you need is the nerdiness, dedication and patience to read through all 763 pages of material.

Because we know you’re busy, and don’t have the time to do this, we did it for you. We went through all 38 years of Warren Buffett’s letters, and we extracted everything you need to learn about insurance from the Oracle of Omaha himself, largely in his own words, with some of our colorful commentary. There is a lot to learn from Omaha’s Oracle, so instead of overwhelming you with all 38 years worth of knowledge, InsNerds will be publishing a series of articles sharing his wisdom.

The letters contain a lot of the history of GEICO, Gen Re, Berkshire Specialty Insurance and his other insurance companies in the letters; we chose not to include that and instead focus on insurance knowledge that can be useful to today’s insurance professionals. Uncle Warren keeps hitting many of the same points over and over; in those cases, we generally chose the wording from the newest letters, because, like good wine, Uncle Warren’s writing got better with time. Our first article will share three insights on the fundamentals of insurance:

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1. At the core, insurance is nothing but a promise, and being able to fulfill that promise is key:

“The buyer of insurance receives only a promise in exchange for his cash. The value of that promise should be appraised against the possibility of adversity, not prosperity. At a minimum, the promise should appear able to withstand a prolonged combination of depressed financial markets and exceptionally unfavorable underwriting results. ” 1984 letter, page 10.

Buffett is indicating that a company must be cognizant of the promise that it is making to its customers, which is that the company will have the funds to indemnify its customers after a loss. The company must manage its reserves and investments wisely to be able to fulfill its promise when there is a claim, so the investments must be able to withstand a down market and a year of catastrophic losses at the same time. One of the main things that makes insurance interesting is that, contrary to most other businesses, we don’t know the cost of our product when we sell it.

2. Uncertainty is okay, as long as it’s priced appropriately:

“Even if perfection in assessing risks is unattainable, insurers can underwrite sensibly. After all, you need not know a man’s precise age to know he is old enough to vote nor know his exact weight to recognize his need to diet.” 1996 letter, page 6.

The purpose of insurance is to manage risk. When taking on a given risk, it is not possible to know if you will see a positive or negative outcome. In choosing risks, one must make informed decisions, but if a company waits to make a decision it may lose the business. Insurers must determine how much uncertainty they are comfortable with. The company will likely not be able to attain every single bit of information that it would like before making a decision, but a decision must still be made.

3. Always remember the big picture:

“[…]any insurer can grow rapidly if it gets careless about underwriting.” 1997 letter, page 8.

Finally, in the business of insurance, a company should take on smart risks. It can be tempting to grow rapidly by writing any piece of business that comes your way. A company may take shortcuts in underwriting to put business on the books. However, if this practice becomes a habit, the profitability of your book will be unsustainable. Playing the long game is necessary in our business. This is something Uncle Warren is constantly talking about in his letters: Underwriting discipline, especially when the market gets soft, is his top priority.

These are three key observations about the basics of insurance that we found in reading Mr. Buffett’s letters. There are many more to be discovered, and we look forward to writing about some additional themes.

Cracking the Risk Code: A Trifecta Win Is Finally Possible

It is clear to me, as it seems to be to many others, that we have some work to do to improve the functioning of the core systems of our nation’s government and finance. The meltdown in U.S. domestic and global financial markets that began seven years ago brought to light critical issues that require transformational thinking and effective implementation.

I am familiar with the issues plaguing the federal government, having spent 15 years on the front lines, spanning four presidential administrations and including nearly a decade as comptroller general of the U.S. and head of the U.S. Government Accountability Office (GAO). The federal government has grown too big and promised too much and needs a fundamental restructuring. But that is unlikely to happen anytime soon. 

After 10 years of full-time commitment to promoting truth, transparency and transformation in connection with government fiscal policies and operational practices, I recently decided that it was time for a personal change.  I left the public sector to tackle those precise challenges.  Realizing this objective will, of course, require determining the proper role of both government and the private sector in a variety of markets, including credit and capital markets and insurance.

A big problem in financial markets is the severe illiquidity and low trading volumes in most public bond markets for seasoned securities, including the $6.6 trillion-plus corporate bonds and the $6.35 trillion Fannie- and Freddie-backed residential mortgage-backed securities (RMBS), to name just two large product areas.  Various insurance carriers invest more than 40% to 70% (call it about half) of their assets in bonds with a current outstanding value of about $1.5 trillion, more than pension funds and mutual funds combined.  However, the profound illiquidity in the secondary markets for corporates and RMBS leaves insurers hard-pressed for current or real-time, fair-value assessment of their portfolios.  This creates significant risk management issues.

Consider the scope of the problem:  Despite record-setting volume in new issues in the primary market for corporate bonds, only an estimated 2% of all outstanding issues trade annually.  The Federal Reserve has bought in excess of $3 trillion in bonds since the start of the quantitative easing policy, creating holdings of more than $4 trillion.  By comparison, the Fed owned less than $900 billion in bonds when the crisis began.  In the very thin market of today, prices are not readily available for trades in excess of $500,000.  Average bond volumes in the corporate bond market have dropped from a pre-crisis average of $700,000 to about $400,000 now, according to published reports last November. An important measure of secondary market liquidity has fallen much more.  The same source notes that block trades, a focus of institutional holders, have fallen from 4% of outstanding U.S. corporate bonds to less than 0.5%.  (Source: “Mile Wide, Inch Deep, Bond Market Liquidity Dries Up,” [12/2013] marketwatch.creatavist.com/story/7571)  At the same time, the dollar volume of mortgages guaranteed by FNMA and FHLMC, numbering into the multiple trillions of dollars, represents roughly half of all mortgages outstanding.  This is an obligation that the government would like to privatize if only there were a viable market.

Historically, the dealer community on Wall Street has been the market maker and intermediary for these sectors. But, for a whole host of reasons related to new capital rules, the role of the dealer in these markets has changed dramatically.  Dealers are out, with some holdings reportedly down as much as 82%.  Market-making activity, the lifeblood of a market, is a fraction of what it used to be.  The result is illiquidity of a magnitude that cannot be ignored and that is literally reshaping these markets.

Valuation and associated liquidity problems represent a risk for individual issuers and holders of securities as well as a potential systemic threat to the entire insurance industry. They pose a particularly serious challenge in light of increased capital and reporting requirements for almost all financial institutions.   Transparent resolution of valuation issues is a necessary first step to all other progress.

Add to this problem the economic impact of losses from recent storms and other environmental risks, particularly in the context of new Federal Emergency Management Agency (FEMA) flood maps, and the pending federal legislation that will require all of us to recognize the full cost of updated flood risk pricing: One can easily imagine that this will present yet another significant financial challenge for many individual property owners and for municipal, state and federal governments.

These are just a few of the insurable risk market sectors that need to be addressed. And each sector involves risks that run into the trillions of dollars and touch the lives of millions of Americans.  There is incalculable benefit for all of us, especially insurers, in reestablishing robust, healthy financial markets.

An effective solution to restore the secondary markets for corporate bonds and for asset-backed securities must be predicated on today’s information-based technology and the ubiquity of communication networks and needs to be designed to adapt to emerging technology.  The solution, a framework for risk assessment, will require new tools to observe, measure and manage all kinds of risks in credit, capital and insurance markets, and do so in real time.  Any solution must not be captive to the past, but must be oriented toward the future.

Markets are driven by both observed data flows and facilitated by emerging asset classes of information.  (Approximately six years ago, the World Economic Forum identified two evolving trends, “Personal Data: the Emergence of a New Asset Class” and the “Convergence of Insurance and Capital Markets.”)  To be both successful and sustainable, the solution to the market problems cited above must reposition data mining and transaction fees in ways that actually increase transaction and new business volumes.

But can we find such transformational thinking in financial and insurance markets today?  Does the technology exist with which we can develop these tools, and can it quickly be adapted to resolve these critical market issues?  If so, the result could be like winning a trifecta of truth, transparency and transformation for all of us.

The answer is “Yes.”  The transformational thinking and the necessary information technology do exist.

For one, a Connecticut-based company that develops innovative solutions for financial markets has developed new forms of transactional, enterprise-risk management methodologies and features with a focus on the maintenance of healthy, liquid markets.  The company’s proposed system offers a comprehensive and dynamic framework for risk detection, tracking and valuation spanning the life of any financial contract from its first inquiry (pre-trade) through its final disposition or maturity (all post-trade). Continuously updated risk and transaction data is displayed as it occurs. Traders and investors can view and assess all available pricing data, pending orders, executed trades (although, currently, these may not be available in a uniform format).  As a result, price discovery is opened up.

Through the grant of incentives, each market participant is further encouraged to transact and to contribute updated disclosures and information. This information and data is aggregated in the data repository of any system participant to earn the provider more credits that apply to other transactions.  Each participant can apply those incentives either to offset the cost of future transactions and/or to access system-generated analytics and other data. Participants can interact directly with one another or through intermediaries.  Traders and investors also have access to the system's independent validation of the displayed real-time pricing — continuous revaluation of financial contracts, a transparency index and a risk-differentiated ticker tape.

In addition to internal cross-references of data provided, external sources of verification are also used to protect against false information being introduced into the system.  “Portals” can be created for all market participants including buyers, sellers, brokers and regulators.  As a result, all participants have the best available information on which to make decisions, negotiate and manage risk.

The use of time-sensitive incentives serves to directly infuse liquidity into the primary and secondary market sectors of any financial product.   Not only does this advantageously reposition data mining and transaction fees to increase transaction volumes, it supports the continuous revaluation of financial contracts, individual or pooled, throughout the term or maturity of the product.

What does this mean? How does it occur?  In part, it is as simple a concept as banks or insurers giving away toasters to attract new clients.  Today’s version is an exchange of risk-detailing information between market participants that secures the relationship between the two, in exchange for a time-sensitive financial or strategic benefit.  The incentive generates the risk disclosure that leads to the right match or risk transfer; the time sensitivity of the benefit lets the grantor actually direct business volumes to products or sectors of choice.

Any insurer (or any risk taker) needs to guard against the informational asymmetries and adverse selection that bedevil financial results and can cripple markets.  The solution is a drill-down into “granular market information.”   To the extent that a prospective insured (or any market participant) does not choose to supply requested information, the price of their risk goes up.  This is a transparency-generating mechanism combined with a transaction engine that increases security for everyone.

How might this benefit the risk manager at an insurance carrier? The risk manager has a buy/sell/hold question to be answered at all times and in different circumstances.

Risk managers are unconcerned about their holdings of newly issued liquid bonds, for which price discovery is not a problem. However, the portfolio is largely composed of seasoned securities, which require a secondary market for price discovery and risk transfer.  In today’s market, the risk manager who needs to liquidate large positions  (i.e. in excess of the average $450,000) cannot do so except at significant discounts to an uncertain market value.

Through the proposed new system, there is historically driven and contemporary pricing information, real-time market information and counterparty discovery.  This can enable or improve immediate fair-value price discovery and appropriate risk matching.  As part of due diligence on the market, the risk manager can obtain verified pricing information on the securities in any portfolio and access information about market activity, including pending orders and offers.  The risk manager can observe the market for “color” and obtain answers to questions about other participants’ offerings, their size, condition and other risk details.  Such exchanges of information add transparency to a market that is currently too opaque.

As the risk manager purchases, for example, a highly liquid corporate new issue, the incentive granted in that transaction can be applied to offset transaction costs in the sale of less liquid, high-yield corporate bonds or an RMBS security.  The data from these transactions and interactions are aggregated in the data repository of each participant,, adding to the richness and accuracy of the market and pricing information displayed on the ticker tape and transparency index, enabling the continuous revaluation of financial contracts.  This adds value to each incentive granted.  In effect, the time-sensitive incentive actually narrows spreads; transactions are facilitated; and, liquidity is enhanced.  The risk manager has based decisions on the most up-to-date market and transaction information, verified price discovery and at reduced costs.

This approach, described in the proposed system, offers what I think may be an excellent, profitable and market-based means to achieve the key objectives of proper risk management, market health, growth and prosperity.

These same results, presented electronically as continuous revaluation of financial contracts, would fully support Solvency II’s “Own Risk and Solvency Assessment” (or “ORSA”) and U.S. ORSA mandates for a modern enterprise-risk-management system. A system as described above actually can lower the regulatory costs for carriers, as the disclosures are “traded” for benefits that lower cost for all participants.  A unified process can actually help turn the cost of regulatory compliance into profitable businesses and databases, as data mining expands the possibilities of risk-differentiated products.  This, in turn, drives more business to intermediaries and can be a significant stimulus for growing a market.  A unified process such as this also enables the identification and tracking of risks throughout the markets, “connecting the dots,” so to speak.  Such a large-scale approach, a new system architecture using private-sector incentives, seems to offer a comprehensive and easily understood solution.  The benefits seem clearly to outweigh the costs.

It is urgent and essential that the current dysfunction in secondary markets be resolved. The role of finance and insurance is to provide the orderly transfer of risk for both the public and private sectors.  Properly functioning secondary markets are essential to the efficient clearing of risks throughout the system.  Without them, the system breaks down.

At the beginning of this article, I stated that what is needed is transformational thinking and effective implementation.  It is a fact that the transformational thinking and requisite technology for implementation exists – as is evident in this proposed new system by a small private sector company.  All that is needed is the will to implement these solutions now.

Implementing any solution to restore liquidity in these and other financial markets will require cooperation between potentially antagonistic factions and will undoubtedly require some discomfort as compared to the status quo. However, it is essential that these markets be restored for the sake of our nation. Doing so can also facilitate a smaller and more effective government in the future.

We can achieve a trifecta of truth, transparency and transformation that will have the effect of a unified and massive economic stimulus – if we so desire.

The time to act is now.

Authors

Dave Walker collaborated with Michael Erlanger in writing this article. Michael Erlanger, founder and managing principal of Marketcore.com, Inc., spent the first 30-plus years of his career on Wall Street, where he consistently ranked among the top credit market revenue producers as a corporate bond broker, trader, institutional salesman and department head. Subsequently, he cofounded two profitable Wall Street boutiques, including IPEX LLC, an institutional whole loan brokerage that is the predecessor firm to Marketcore. At IPEX and before, orders ranged as high as $5 billion across some 60 different asset classes.