Amit Wadhwaney is a former key portfolio manager of Third Avenue Funds, who currently operates his on value-oriented hedge fund under the name Moerus Capital. At Third Avenue, Amit Wadhwaney led the upstart of the international business at Third Avenue and was the founding manager of the Third Avenue Global Value Fund, LP, the Third Avenue Emerging Markets Fund, LP, and the Third Avenue International Value Fund.
Fundamental Analysis
In the aftermath of the 2009 financial crises, Amit Wadhwaney wrote about how insurance companies hold up during financial crises. From the Third Avenue Funds 2011 Annual Report:
Insurance Company Investing During Financial Crises
As if the scrutiny to which financial services companies worldwide had been subjected of late was not intense enough, two events that took place during the most recent quarter have managed to place financial stocks ever more firmly under the microscopes of skeptical investors worldwide. The first event – though probably the less important one in the short term – was the much ballyhooed downgrade of U.S. federal debt by Standard & Poor’s in August. Secondly, the worsening of the European sovereign debt crisis and the ongoing, though to date, futile attempts of European governments to defuse it have exacerbated investor fatigue. Though nothing particularly new – the prospect of a default by one or more European countries has worried investors for more than two years now – these concerns intensified over the summer and turned into a full-blown panic by the end of August of this year. Market commentators launched into elaborate speculations about the impact of a sovereign default on the financial system. As wild rumors swept the markets, common stocks of financial institutions sold off indiscriminately.
We are often asked by fellow investors in the Fund about our exposure to financial institutions, particularly those in Europe. The first relevant point to make is that we have avoided investing directly in European banking stocks throughout the ongoing sovereign turmoil (and, truth be told, throughout the Fund’s history). However, our portfolio has, in fact, included holdings in European insurers (since 2008). Some of these holdings – most notably Allianz SE and Munich Re – have inspired questions and concern from market participants, perhaps understandably so, given the significant role that each of these institutions plays in Continental European and global financial services markets. However, lumping together insurance companies, particularly wellcapitalizedones like those that can be found in the Fund, with commercial and investment banks may very well prove misguided. Indeed, we believe – based on our experience in observing financial crises that have taken place globally over many years – that not only are insurance companies much more resilient than banks, but, in fact, they can become beneficiaries of disruptions in financial markets, with the related benefits ultimately accruing to shareholders such as the Fund.
In our shareholder letter accompanying the Second Quarter 2009 report (for the period ending April 30, 2009), we discussed in some detail the characteristics of insurance company investments that we find attractive, focusing particularly on safety and the preservation of capital. In summary, we seek out common stocks of insurance companies that possess the following attractions: they reliably generate cash from underwriting, use conservative reserving and accounting policies, do not take undue risks in their investment portfolios, have excess capital, and avoid borrowing money at the holding company level. Insurance companies that pass our selection criteria – which seem simple enough, but at times have proven to be a set of hurdles surpassed by few – tend to be far more resilient than their competitors. Moreover, our experience has shown that insurance companies fare better in financial panics than do banks, for the reasons outlined below. It is instructive that much ink has been spilled over the prospects and dangers of a European banking crisis, but the term “European insurance crisis” remains unknown to Internet search engines.
Insurance companies have a number of characteristics that support their resilience in a financial crisis:
1. Insurance Companies Do Not Need Acess to Liquity
The most important difference between banks and insurance companies can be found in the structure of their balance sheets. In general, banks borrow short term (via deposits or wholesale funding) and lend long term. The upshot of this fact is that many banks need recurring access to short-term funding to keep their business model chugging along. Their dependence on the health of wholesale financial markets may seem inconsequential while the good times roll (say, in 2006 or 2007). But, alas, all good things must come to an end, or to a temporary respite at the very least. And when they do, banks’ reliance on wholesale funding markets becomes a far more serious limitation. Indeed, any disruption of those markets, or concerns about the solvency of the particular bank in question, could quickly lead to liquidity issues. These liquidity issues, in turn, can ultimately result in a fate that very well might have been nearly unimaginable during better times: a permanent impairment of capital, perhaps via forced capital raising (perhaps with the bank’s hand forced by government, for example), or even the outright liquidation of the bank.
Such an outcome should, indeed, be frightening for investors. But, as compared to banks, we believe the business model employed by insurance companies, in general, is much more resilient, and it does not share this dependence on short-term liquidity in order to operate. Insurance companies tend to do a better job, consciously, of matching the duration of their assets and liabilities (if anything, their assets tend to be shorter duration than their liabilities). As long as they avoid excessive debt at the holding company level and remain well capitalized at all levels of the corporate structure, they generally do not need to access wholesale financial markets to fund their continuing operations. In short, the business models of well-capitalized insurance companies, such as those held in the Fund, are generally not dependent upon wholesale financial markets, whose notoriously fickle nature at times (such as during credit crunches) could threaten to bring capital market-dependent banks to their knees.
2. Asset and Liability Matching by Country as well as by Duration
Insurance companies have a well-deserved reputation for being exceedingly complicated. But as frustrating as it may be to encounter unnecessary complexity in life, at times it may be useful to heed the advice of Albert Einstein, who famously warned, (note: we are paraphrasing here) “Everything should be made as simple as possible, but no simpler.” In the case of insurance companies, we believe that, ironically enough, their complexity can provide not only protection and robustness, but, ultimately, opportunity for investors. A large insurance group, such as an Allianz or a Munich Re, which operates across multiple geographies and/or business lines, is typically organized within a publicly-listed entity. While the common stock of this listed entity is what investors actually trade on stock exchanges, functionally the listed entity acts as a holding structure for its collection of local, separate operating insurance entities. That each of these individual operating subsidiaries has its own balance sheet is a fact which is obscured by accounting consolidation for financial reporting purposes, which basically aggregates all of the subsidiaries’ assets and liabilities in the financial statements reported by the listed holding company.
While this fact may seem to be simply an accounting technicality, in actuality it has interesting implications for the robustness of the listed insurance holding company. Each of the aforementioned, individual local entities is compelled to satisfy its own local regulators that it has sufficient capital for its operations, and can be, in effect, ring-fenced from the rest of the group. This could prove to be a useful characteristic in times of stress. Suppose, for example, that there is ultimately a catastrophic failure of the “Euro Project,” perhaps resulting in the ejection of a country from the Eurozone. In this draconian type of scenario, it is worth noting that a local insurance subsidiary operating in the country which has been kicked out will likely havematched its assets in that country with its liabilities. That would not change the fact that, if a country were to be ejected from the Eurozone, it is likely that the assets of an insurance company operating there would experience some impairment. However, this asset impairment would be mitigated by a concomitant decline in liabilities.
To make this abstract scenario more concrete, take the German insurance company (and Fund holding) Allianz, which reports large gross exposure to Italian government bonds, a fact which from time to time elicits concern from investors for obvious reasons. But in fact, Allianz’s Italian subsidiary is the second largest insurance company in Italy, and it holds Italian fixed income securities to balance its Italian liabilities. The likely consequence of this is that any redenomination of Italian assets (e.g., from euro to lira) would be matched by the same redenomination of Italian liabilities, with a muted net impact on the consolidated group.
Furthermore, this concept of self-contained or selfsustaining insurance units would take on even greater importance in another, more draconian scenario. Suppose, for example, that a country were to institute capital controls. One might become concerned that the insurance subsidiary operating in that country might not be able to access capital from its holding company abroad, given said capital controls. But even in this case, the local insurance subsidiary operating there, with matched assets and liabilities, would be able to use the cash flow from its maturing assets to meet its local liabilities, without needing to access capital from the holding company outside of the country.
3. Sharing of Losses with Policyholders
European life insurance contracts are often based on the idea of policyholder participation: profits (and losses) from the insurer’s investment portfolio are shared between policyholders and shareholders, sometimes with a rigid ratio. Therefore, money defaults and impairments of investment assets do not fall directly to shareholders’ equity; the net impact to shareholders is smaller than the gross exposure might suggest.
Specific arrangements on policyholder participation in profits and losses differ greatly from country to country and from product to product, making it difficult to generalize. Local regulators have the final say on the allocation of profits and losses and on minimum guaranteed returns.
Insurance companies have built up reserves for investment losses (from excess profits in previous years), and are able to draw these reservesdown under adverse conditions. In effect, these reserves provide an additional cushion protecting the financial strength of insurance companies.
Although the encouraging attributes highlighted above might be considered to be theoretical, actual historical experience has, in fact, confirmed the greater resilience of the insurance model, versus the banking model, during periods of adversity. When insurance companies become impaired, it tends to be as a result of underwriting mistakes; it is relatively less common for an insurance company to blow up because of investment mistakes.
And as noted above, one of our criteria that the Fund’s insurance investments must meet is a demonstrated ability to underwrite profitably over a reasonable period of time. We believe that insisting on this attribute significantly limits the odds of being felled by the banana peel that has often been the culprit behind most insurance company impairments.
If anything, financial crises provide opportunities to insurance companies to take advantage of their excess liquidity, at times when their banking and investment banking counterparts might be paralyzed by distress.
A sterling example of such a maneuver was Munich Re’s acquisition of Hartford Steam Boiler from AIG in the depths of the 2009 financial crisis, at such an attractive valuation that it led former AIG Chairman and CEO Hank Greenberg to send an angry, open letter to AIG’s Board of Directors. More recently, Allianz has expressed interest in providing liquidity to the sovereign credit market by participating in a public/private bond insurance program, at the right price.
In conclusion, we will continue to monitor European developments closely. We believe that the companies in which we have invested are resilient and will emerge from the crisis unimpaired, while offering attractive prospective returns to long-term investors.
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