One of the big stories to watch for year end earnings will be how many companies will confess that their casualty reserves are still woefully short.
There doesn’t seem to be a whole lot of angst about this, even after the large Swiss Re charge last quarter.
Just because management teams are sounding cautiously optimistic doesn’t mean the problem has gone away. It likely means they’re in denial (or, if you’re cynically inclined, intentionally looking away).
Now, if one is in denial, the most likely outcome is they postpone their reserve charge for another year. This appears to be where the market consensus is. We will see if it holds up or not.
From my vantage point, year end seems like an obvious time to pad reserves. Most companies have had good years, so bonuses will still be intact if you take a medium sized Q4 reserve true up.
If a CEO is trying to maximize their own pay (and yes, many care about that more than the share price), it is better to exceed the bar by a little this year and a little next year, rather than have a great 2024 and a poor 2025 because you punted on addressing reserves now.
However, it doesn’t matter what I think. Companies will do as they please and many prefer to be optimistic and hope problems go away.
Everest On Deck
That brings us to Everest. They are the one company that has warned of a year end reserve review. Market expectations are for a meaningful charge.
My ear is not as close to the ground as it used to be, so I don’t have a great sense for consensus, but to pick a round number, let’s say the market expects $1B.
What really matters though is whether a charge in the $1B range will be the last charge or if they will need to address the issue again in the future.
Adding to the intrigue here is the decision by CEO Juan Andrade to leave for USAA. Maybe there is information here (is he running from a problem???) or maybe it’s just noise (unfortunate timing, but largely a coincidence).
Either way, a new CEO has some incentive to take a larger charge to put the issue to rest.
So what’s the biggest charge I could see Everest taking? There’s actually a way to estimate that.
Assessing The Constraint
The first thing to understand about when companies confess bad news (whether a large cat loss or a reserve issue) is there are many factors that go into what number they land on.
Yes, the actuarial indication is an input, but it’s no more than that. CEOs can decide whether to post that whole amount upfront or bleed it out over time (think of asbestos reserves as the most famous example of “bleed it out”).
What might impact that decision? External constituencies.
For example, there might be a concern clients will buy smaller lines from reinsurers perceived as having balance sheet risk.
In my old world, I know plenty of CEOs who were afraid to report bad news before their peers because their stock got punished worse by going first (while this was not rational investor behavior, it tends to be true).
But the bigger issue is the rating agencies. If you report an adverse event that is worse than the agencies expected, you could find yourself in ratings jail and that’s a bad place to be.
So, the number one constraint I look at for any company in this position is how big a charge can they take before they would get put on negative outlook or negative watch.
It is more important to avoid the latter. Companies will tolerate a negative outlook, but you really want to avoid negative watch if possible. Negative watch tends to mean you have to raise capital (or cut stock repurchase) to defend the rating.
This opens Pandora’s Box to unintended side effects such as the Board looking for a new CEO or CFO or competitors wondering if they should try to acquire your company on the cheap.
So how big a charge can Everest take without inviting a negative watch? Let’s try to figure it out.
Estimating Charge Capacity
This analysis would be a lot easier if I had a recent S&P or Best report that spelled out the precise triggers that would trigger a negative outlook.
Without those, I’ll try to provide some useful guideposts.
At year end 2023, Everest’s debt/capital ratio was 20%. This is well within normal for its rating and suggests they probably had $1B or so of debt capacity they could raise without impacting their rating.
Through the first three quarters, Everest earned about $2B. This reduced the D/C from 20% to 18%. However, the year end charge will likely result in a loss for the quarter.
One important trigger Everest wants to avoid is a loss for the full year. Fortunately, this doesn’t seem like much of a risk. “Normal” earnings for the fourth quarter would put the full year easily over $2.5B after tax.
That means it would take a $3+B pre-tax charge to wipe out the year’s earnings! I don’t think we have to worry about that.
Given earnings will still be positive for the year, that means the D/C at YE 24 will be better than YE 23 as shareholder’s equity will be higher (repurchases have been limited and offset by bond gains) on the year.
Thus, there is no particular concern about leverage ratios. Everest will probably have to agree to avoid repurchase this year as a safeguard against any bleed through of more adverse development in 25, but that’s not a significant obstacle.
Therefore, the biggest ratings risk is “surprising” the agencies. While a $2B charge would still leave positive earnings for the year, I suspect the agencies would find that amount concerning and, at a minimum, put a negative outlook on.
It is likely Everest has had conversations with the agencies about expectations and the eventual number will likely be consistent with those expectations.
So if we don’t have to worry too much about the ratings agencies as a constraint, where else should we look?
Executive Comp
Management bonuses!
I don’t have the exact pay plan for 2024 but we can use 2023 as a guide and it leads to some interesting conclusions.
2023 Incentive Targets | 100% payout | 25% payout | 0% payout |
ROE | ~14% | ~6% | <6% |
Book value growth | ~10% | ~5% | <5% |
So what does this tell us? Everest wants to be really sure they can still do at least a 6% ROE and 5% BV growth. Also, if they can squeeze past a 14% ROE and 10% BV growth, they will manage to do so.
Which is more likely? Let’s do some math!
Book Value
Let’s start with book. It ended 2023 at $13.2B and was $15.3B after Q3. Thus, 10% growth requires $14.5B and 5% $13.9B (assuming flattish share count). If we assume zero charge, book would probably end the year close to $16B.
That means management still gets a full payout if the charge is under $1.5B pre-tax and they could still hit the 25% payout even with a $2B pre-tax charge (note, I’m assuming zero investment gain impact which will obviously prove wrong).
ROE
ROE has more moving parts as the charge impacts both the numerator and denominator (assuming they use average, not beginning, equity).
I’m going to assume a $1B p/t charge results in year end equity of $15B. This would result in average equity of $14.1B and requires $2B of income to hit 14%.
Net income was right at $2B through three quarters but a $1B charge would likely leave it just below that level for the full year (without shenanigans).
It is certainly possible they resort to shenanigans if they are close (realizing some gains, releasing some short tail reserves, etc.) but it is more likely they will fall just short of a 100% payout at the $1B charge level.
At that point, the payout would drop to 25%. But could it drop below that level?
Let’s say the charge went to $2B p/t. Average equity would fall to something like $13.7B, so to beat 6% requires $800M of 2024 a/t earnings.
A $2B p/t charge is $1.6B a/t and, given they’ve already earned $2B and will have other “normal” earnings in Q4, would likely land them around $1B of full year net income, so above the 6% necessary to keep the 25% payout.
Predicting the Charge
So, unfortunately, we’ve come up with a pretty wide range. It’s hard to see Everest going above $2B as it puts bonuses at risk and would likely spook the rating agencies.
There is an incentive to come in a bit below $1B to max out incentive comp this year. That may leave risk for another charge in the future though, which isn’t something a new CEO would want to take on their watch.
So, I would suggest a reasonable middle ground is management makes sure to get the full payout on the book value growth but only hit the 25% on the ROE. I should note ROE counts twice as much in their formula as BV though, so the incentive is stronger to hit the ROE goal if they can manage it.
Thus, my very rough, non-actuarially based prediction is the most likely outcome is in the vicinity of $1.5B.
That’s enough to provide some cushion for the new CEO against another charge in twelve months, but not so much as to raise alarms with the rating agencies or endanger bonuses completely.
The next most likely outcome is management finds a way to manage the outcome to grow book value 5.1% and print a 6.1% ROE and decides to bleed through any remaining pain over time through lower ongoing earnings.
Of course, this analysis leaves out a multitude of other factors that will affect the decision and includes a lot of simplifying assumptions on my part. I also acknowledge hitting the bonus goals isn’t the only, or even primary, driver of the outcome.
However, history has shown that it often has a bigger effect than one might want it to, so it is an important element to consider if you are trying to predict the outcome.
$1.7bn
you were close
The $1.7B included $200M of AY24 true up. The actual reserve charge was $1.5B so I’d say I hit it on the nose! (even if it was as much luck as skill)
Well done.
Bravo