With the news that Exor is selling PartnerRe and exiting insurance, we have one more example of a high profile investor realizing that running an insurance business was harder than they thought.
While Exor got a reasonable return on its investment, certainly in comparison to hedge fund reinsurers, it clearly did not meet the ambitions it aspired to when they trumped Axis to acquire Partner.
A History of Investors Operating Insurance Companies
In the beginning, there was Buffett. I’m not going to teach anyone here about Buffett buying GEICO and figuring out the magic of cheap float. Over the years, we have seen other companies marry running an insurance company with a nontraditional investment portfolio from Cincinnati to Alleghany to Markel to White Mountains.
All of these efforts have met with success. One thing they all had in common was the insurance company’s behavior was independent of the investing decisions.
That changed with the next iteration, “Total Return Insurers“, most commonly referred to as “Hedge Fund Re”. Highly successful investors like David Einhorn and Dan Loeb started insurance companies enthralled by the idea of “cheap float” and, more importantly, sticky liabilities. They were soon followed by a number of others generally through a partnership with a traditional insurer.
All of these ventures have disappointed. Those who are public all trade well below book value. Why? Because there was no insurance strategy. Well, that’s not quite true. There was a strategy. It was to take as little risk as possible while generating as much float as possible. But there was no strategy for successful underwriting.
Exor was probably closer to a White Mountains or Alleghany approach. They bought Partner which was an established franchise with a clear identity in the market. The float would then be used to fund buying other companies. It didn’t necessarily fail, but it also, according to reports, was challenged by a tougher reinsurance market than expected.
One would have thought Exor would have realized when they bought in that reinsurance is a cyclical business and that there was potential for volatility. Recent results shouldn’t have been a surprise to them. It appears what happened was they realized running an effective “float” driven insurer isn’t as simple as Buffett makes it sound.
Doing Things Back Asswards
The key variable that changed over the time in the float driven model was the original versions were led by a strong insurance company which formed the ballast for the more aggressive investments. The more recent versions were enamored with the asset return potential and assumed they could “figure out” the insurance part.
While some of these companies have been hurt by poor investment results (particularly Greenlight), they have all underperformed on the underwriting side. They underestimated their weak distribution position (underwriters had no incentive to use them except on the worst business) and the inherent uncertainty in underwriting outcomes.
When I would see pitches for these businesses, the combined ratio assumptions were generally for a continuation of the last five or ten years’ results – ignoring that those were peak margin years! There certainly weren’t any stress tests showing what results looked like at the bottom of the cycle.
Given that the most float comes from longer tail lines and longer tail lines typically have higher combined ratios, the margin for error was slim to none. Companies were typically hoping for a 96 CR. It only takes small changes in trend for that to be 100 or 104 and often that is what they got.
The Allocated Capital Dilemma
There is no free lunch with a float model. If you are going to take more investment risk, you have to run with less underwriting risk (unless you are Buffett and you are allowed to skirt the rules with favorable regulatory treatment).
Thus, the model is only better than a traditional model if the return on the extra investment risk offsets the lost profit from lower underwriting leverage. It certainly can be, but it is not guaranteed.
The way the newer companies evaluated the optimal level of investment risk to underwriting risk was a) manage to the “dual stress tests” metric used by AM Best, which essentially looked at if you had large investment losses and underwriting losses at the same time and b) always max the investment risk if possible because this is where their “expertise” was (and because this is where they earned management fees!).
The problem was they never considered that insurance losses, especially in casualty lines, have more persistence than investment losses. In other words, if we head into a bear market, a savvy investor a) has the ability to recognize it early and sell out before losses get too bad and b) a bad year doesn’t suggest that the following year will also be bad.
Contrast this to insurance where you are locked into contracts that you can’t liquidate easily when things head south. On top of that, casualty losses tend to persist for several years in a row so unless you non-renew most of your book, you will continue to rack up losses.
This inability to react quickly to a worsening environment means there is a much greater chance of getting the insurance outcome wrong than the investment outcome.
While the lower underwriting leverage helps reduce the impact, the inability to build a steady franchise means the probability of things going south are high. And when that happens, you inevitably have to take down investment risk to re-balance your stress test.
Which brings us full circle to the premise that the first objective of a total return insurance company should be to have a strong, stable insurer that won’t force a margin call on the investments rather than try to attach any old insurer to a strong investment platform.
The Conflict Of Interest
While these newer total return entrants I’m sure did admire the Buffett float concept and wanted to emulate it, there was one other piece to the story that was just as important – permanent capital.
While being a famous hedge fund investor can pay very well in the good years, the equity value of the business is highly uncertain. Most hedge funds are two bad years away from closing. Institutional investors leave a lot faster than mutual fund investors do when performance hits a wall.
An attractive solution to this challenge is to find a way to lock capital in regardless of performance, like say by having the investments reside in an insurance company!
Now, the hedge fund has going concern value! The management fee (as well as potential performance fees) they collect off the insurance company assets can be valued like an annuity.
No wonder poor valuations haven’t prompted any of these companies to shut down. Sure, it sucks that their investment in the reinsurer is underwater, but that pales in comparison to the equity value created for the hedge fund from the permanent capital.
Note, Exor didn’t have outside investors. They didn’t value the permanent capital in the same way. That is probably why they could make the decision to get out easier than the hedge fund guys.
Conclusion
People continuously fall for the trick that if Buffett has succeeded with something they should copy it and will have the same success for themselves. That hardly ever works, whether it be individual investors who go on the pilgrimage to the Annual Meeting or sophisticated investors who consider themselves “mini Buffetts” (which is really just their own trick as it is a good method of raising capital).
I actually think total return insurance makes a lot of sense – but only if you have the humility and patience to do it the more old fashioned way. Build a strong insurance company with predictable results.
Then, instead of using your excess capital for dumb acquisitions or buying back your stock when it’s overvalued, deploy it into other investments where you have developed an area of expertise.
Footnote: Your Move, Scor
One natural consequence of the Covea deal could be that it motivates Scor to get bigger. In the last two years, we have seen AXA and Covea both get bigger, particularly in reinsurance. Certainly with the “national champion” culture embedded in French business, it must be hard for Scor to watch its neighbors surpass it in its core business.
Could Scor look to buy something next? I won’t speculate on names but I don’t think it is too hard to guess who the likely targets might be.