Buffett on Reinsurance

Just a post to keep some notes on reinsurance to self.

The Berkshire Shareholders meeting had little in terms on new content though it was good to see that both Charlie and Warren razor sharp as ever.

Probably one of the most interesting insights came in the initial parts of the Q&A. Reinsurance. Berkshire Hathaway had sold down its position in Munich Re and Swiss Re in 2015. When asked a pointed question about it, Buffett was very articulate and gave two key reasons for it: a. Low to negative yields in Europe b. Surplus capacity in reinsurance industry.

In a way, Buffett was alluding to the fact that with hedge funds like Greenlight Re and Thirdpoint Re entering the reinsurance business and being hungry for float, it is likely that too much competition will make (or has made) pricing softer in the market. Supply up, demand is the same. This should raise two questions: a. Buffett is reducing exposure to the reinsurance business by reducing his stake, Greenlight Re and Thirdpoint Re are going long at the same time. One must thoroughly consider the consequences of betting against the man who built the most profitable reinsurance business in the world and has constantly reminded us that the insurance industry is survived the longest by those who walk away when pricing is not adequate to the risks taken. b. If there is going to be softer pricing in the market, investors in companies like Greenlight Re and Third Point re, not only have to tide over the cost of float but also the rich fees that the hedge funds rake in.  The two net cost adders might make the economics very difficult for investors to make meaningful returns unless the reinsurance companies have many home runs on the investment side.

With the low to negative yields, float becomes less valuable as the capital structure of many of the reinsurance business like Swiss Re and Munich Re allows them to invest float in only certain types of securities. Buffett is essentially betting that it will be tough for reinsurance companies to invest float in positive returns instruments for quite sometime to come. Unless of course, you are Prem Watsa and assume that deflation is going to take over in which case the bonds become very useful. Time will tell. Time to increase watch on the insurance holdings.

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Greenlight Re and Third Point Re

We had written about the structural advantages of re-insurers before here. We ran through some numbers and here is what we found.

Both Greenlight Re and Third Point Re are structured similarly with Greenlight Capital and Third Point LLC running the investment books. Both follow 2% management fee and 20% incentive agreements with high watermark. Currently unearned premium is around 50% of equity (actually close to 40% of equity) for both the insurers. We have assumed cost of float as 2% for both the insurers. We tried to model the returns to the shareholders under various circumstances of underlying returns from the hedge funds. The shareholder equity varying as a function of float net of the cost of float.

Underlying Equity  $100.00
Float Leverage  $ 50.00
Total Assets  $150.00 102%
Underlying Rates of Return $150 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity
-30% $105.00 $102.90 $102.90 -31.4% 1.0% -48.1%
-20% $120.00 $117.60 $117.60 -21.6% 1.0% -33.4%
-10% $135.00 $132.30 $132.30 -11.8% 1.0% -18.7%
0% $150.00 $147.00 $147.00 -2.0% 1.0% -4.0%
5% $157.50 $154.35 $153.48 2.3% 1.0% 2.5%
10% $165.00 $161.70 $159.36 6.2% 1.0% 8.4%
20% $180.00 $176.40 $171.12 14.1% 1.0% 20.1%
30% $195.00 $191.10 $182.88 21.9% 1.0% 31.9%

Over a period of time, if one assumes that the insurers grow their float to get a structure where they have $100 of float for $100 of equity (which is still conservative as reinsurers typically write 5X of capital) However, given the general risky nature of where the float is invested, 1X is a more proper allocation for this strategy.

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 102%
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity
-30% $140.00 $137.20 $137.20 -31.4% 2.0% -64.8%
-20% $160.00 $156.80 $156.80 -21.6% 2.0% -45.2%
-10% $180.00 $176.40 $176.40 -11.8% 2.0% -25.6%
0% $200.00 $196.00 $196.00 -2.0% 2.0% -6.0%
5% $210.00 $205.80 $204.64 2.3% 2.0% 2.6%
10% $220.00 $215.60 $212.48 6.2% 2.0% 10.5%
20% $240.00 $235.20 $228.16 14.1% 2.0% 26.2%
30% $260.00 $254.80 $243.84 21.9% 2.0% 41.8%

One thing is very evident here, if the re-insurers are not prudent and conservative, it will wipe out equity fast as float functions exactly how leverage does. Companies like Berkshire own whole companies where earnings are less volatile compared to stock market instruments and they also own a lot of fixed income instruments. Third point returned -32.6% in 2008 and Greenilght Capital returned -22.6% in 2008. The above table clearly shows what would happen if another such year were to occur for these two insurers whose investment books are managed by the insurers. As the investments are starkly different from other insurers, it might be worthwhile to consider the volatility of the instruments.

How would Berkshire or Markel look with a similar capital structure? Remember, they do not charge 2% and 20%. However, they have taxes to drag them down and both of them have great historical performance to their back on running a reinsurer and its investment books. Markel lost 16% of their book value in 2008 which is remarkable considering that they were leveraged 2.2:1 on their float largely thanks for their fixed income instruments which was up 0.2% and equities were down 34%. Berkshire was down (9.6)% in 2008 thanks again to the fortress balance sheet and the fixed income securities that Berkshire owns.

If Markel or Berkshire had a similar structure, this is how they would look.

Underlying Equity $100.00
Float Leverage $50.00
Total Assets $150.00 100% 35% Full Tax
Underlying Rates of Return $150 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Before Tax Net Underlying Returns of Shareholder Equity After Tax
-30% $105.00 $105.00 $105.00 -30.0% 0.0% -45% -45%
-20% $120.00 $120.00 $120.00 -20.0% 0.0% -30% -30%
-10% $135.00 $135.00 $135.00 -10.0% 0.0% -15% -15%
0% $150.00 $150.00 $150.00 0.0% 0.0% 0% 0%
5% $157.50 $157.50 $157.50 5.0% 0.0% 8% 5%
10% $165.00 $165.00 $165.00 10.0% 0.0% 15% 10%
20% $180.00 $180.00 $180.00 20.0% 0.0% 30% 20%
30% $195.00 $195.00 $195.00 30.0% 0.0% 45% 29%

With $100 of Float to $100 of equity

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 100% 35% Full Tax
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
-30% $140.00 $140.00 $140.00 -30.0% 0.0% -60% -60%
-20% $160.00 $160.00 $160.00 -20.0% 0.0% -40% -40%
-10% $180.00 $180.00 $180.00 -10.0% 0.0% -20% -20%
0% $200.00 $200.00 $200.00 0.0% 0.0% 0% 0%
5% $210.00 $210.00 $210.00 5.0% 0.0% 10% 7%
10% $220.00 $220.00 $220.00 10.0% 0.0% 20% 13%
20% $240.00 $240.00 $240.00 20.0% 0.0% 40% 26%
30% $260.00 $260.00 $260.00 30.0% 0.0% 60% 39%

Markel at the end of 2014 had $145 of float to $100 of equities. Remember the fixed income securities and why Markel will not be very volatile and probably the returns will not exceed 10% on assets invested.

Underlying Equity $100.00
Float Leverage $145.00
Total Assets $245.00 100% 35% Full Tax
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
-30% $171.50 $171.50 $171.50 -30.0% 0.0% -74% -74%
-20% $196.00 $196.00 $196.00 -20.0% 0.0% -49% -49%
-10% $220.50 $220.50 $220.50 -10.0% 0.0% -25% -25%
0% $245.00 $245.00 $245.00 0.0% 0.0% 0% 0%
5% $257.25 $257.25 $257.25 5.0% 0.0% 12% 8%
10% $269.50 $269.50 $269.50 10.0% 0.0% 25% 16%
20% $294.00 $294.00 $294.00 20.0% 0.0% 49% 32%
30% $318.50 $318.50 $318.50 30.0% 0.0% 74% 48%

When one takes a closer look at the economics of the business models, it looks like third point and Greenlight re have managed to replicate a capital structure that replicates similar economics to Berkshire or Markel while getting much much better deals for themselves in the process instead of the taxman.

However,  things get interesting further. Greenlight Re is trading at 0.87 book and Third Point Re at 1.07 times book. Berkshire is trading at 1.46 book and Markel at 1.64 times book.

Underlying Equity  $ 100.00
Float Leverage  $ 50.00
Total Assets  $ 150.00 GLRE 3Re
0.87 1.07
Underlying Rates of Return $150 Invested Net Underlying Returns of Shareholder Equity P/B =1 P/B =1
-30% $105.00 -48.1% -41.8% -51.5%
-20% $120.00 -33.4% -29.1% -35.7%
-10% $135.00 -18.7% -16.3% -20.0%
0% $150.00 -4.0% -3.5% -4.3%
5% $157.50 2.5% 2.9% 2.3%
10% $165.00 8.4% 9.6% 7.8%
20% $180.00 20.1% 23.1% 18.8%
30% $195.00 31.9% 36.6% 29.8%

If the re-insurers grow the book to have float to 1X of capital.

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 GLRE 3Re
0.87 1.07
Underlying Rates of Return $200 Invested Net Underlying Returns of Shareholder Equity
P/B =1
P/B =1
-30% $140.00 -64.8% -56.4% -69.3%
-20% $160.00 -45.2% -39.3% -48.4%
-10% $180.00 -25.6% -22.3% -27.4%
0% $200.00 -6.0% -5.2% -6.4%
5% $210.00 2.6% 3.0% 2.5%
10% $220.00 10.5% 12.0% 9.8%
20% $240.00 26.2% 30.1% 24.4%
30% $260.00 41.8% 48.1% 39.1%

A good comparison would be Markel today. I have just included what Berkshire would do with a similar capital structure.

Underlying Equity $100.00
Float Leverage $145.00
Total Assets $245.00 35% Full Tax Berkshire MKL
1.46 1.64
Underlying Rates of Return $200 Invested Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
P/B =1
P/B =1
-30% $171.50 -74% -74% -81.8% -83.8%
-20% $196.00 -49% -49% -65.1% -68.9%
-10% $220.50 -25% -25% -48.3% -54.0%
0% $245.00 0% 0% 0.0% 0.0%
5% $257.25 12% 8% 5.5% 4.9%
10% $269.50 25% 16% 10.9% 9.7%
20% $294.00 49% 32% 21.8% 19.4%
30% $318.50 74% 48% 32.7% 29.1%

Clearly given the valuation difference between Third Point, Greenlight Re’s with the Markel’s of the world, the risk-reward points clearly towards the former.

However, one must be very mindful on how the volatility is handled within the books. Markel and Berkshire have their fixed securities helping them manage well through a downturn. Will Greenlight and Third Point be able to replicate with their long / short strategies and event driven value investing?

Will the shareholders want the comfort of the Berkshire balance sheet at expensive valuations and a size that kills performance or the risk / reward of the newer re-insurers with seasoned hedge fund managers like David Einhorn and Daniel Loeb who have been lackluster of late and are still new to the re-insurance business. Or is there a place for both categories in one’s portfolio?

Disclosure: Own BRK.B, MKL; Evaluating GLRE and TPRE

Daniel Loeb’s hedge fund and the original Warren Buffett hedge fund structure

Recently, Third Point’s Daniel Loeb launched a scathing attack on the Oracle of Omaha and his hedge fund structure. “I love how he criticizes hedge funds, yet he really had the first hedge fund. He criticizes activist investors, yet he was the first activist,” says Loeb.

It was must be recalled that Warren Buffett ran one of the original uber-successful hedge funds in the industry. Today, hedge funds are dime a dozen in the US. A closer look at the original ‘hedge-fund’ partnership of Buffett reveals the following:

  • The ‘Buffett Associates’ structure was a partnership. Not a limited liability partnership, just a plain partnership which meant that Warren was exposed to unlimited loses. His obligation to pay back was not limited to his capital. I think this was a very gutsy move. The confidence that Buffett shows on his own abilities is amazing. This does align his incentives with that of his partners.
  • No management fee.
  • To boot that, he also paid 4% interest on the capital. If the performance exceeded the 4% hurdle, Buffett got paid 25% of the profits. Now, consider this. If the partnership just broke even, Buffett had make good the difference to the tune of 4%. With liabilities not limited to his capital, on a base of $105K capital that Buffett raised, he had invested only $100. His potential losses would have been high. However, Buffett did have other money that he had accumulated. In a bad year, if the partnership was down 40% (say), Buffett would have to pay 4% and the partnership would lose 36%.
  • in 1958, Buffett amended the partnership further in favour of his partners, where he agreed to take 25% of all downsides. Which mean, if the partnership was down 40%, Buffett would pay 4% interest and 10% of the losses from his own capital. Buffett’s hedge fund structure was onerously favouring the shareholders in bad years and limiting their downside while leaving them with a sizable upside as well.

Compared this to Third Point’s 2 and 20 structure is in stark contrast where Loeb’s stands to make money of 2% even if the partners lose money with very limited liability. It is a classic screw the clients in a bad year and scoop their profits in good years. I think the difference between the two structures are night and day, a far cry from the shareholder orientation that Warren Buffett had in his partnership.