Summary:
Year-End Reserve charges are coming.
Companies need to “spin” why they took a charge after claiming their reserves were better than peers.
Hence, the “Position of Strength” reserve charge!
The Three Rules of Pain Management
For those who don’t remember, let’s recall the three rules of when companies admit a reserve problem.
- Companies know more than investors.
- Companies only raise price in response to bad news (known or pending).
- Nobody wants to admit to bad news
first second!
Part of the reason we haven’t seen widespread reserve additions yet is because…we haven’t seen widespread reserve additions yet. That’s what the three rules predict.
Nobody wants to go first. Until more companies are willing to admit pain, the reserve holes will get bigger and the risk to balance sheets will expand.
Travelers has done everyone a favor by attempting to cross the river first (reminder you can see the TRV wildebeest braving the waters at the 1:20 mark). The problem now is nobody wants to be the second one alone in the water. Everyone wants to jump in at the same time. How do we reach an equilibrium that allows this to happen?
Making It Acceptable
When is a reserve charge not a reserve charge? Well, never. OK, when can a reserve charge be explained away as not indicative of a broader problem? Ah, that’s an interesting question.
Let’s try it this way. What if I can find a way to say that I didn’t really need to strengthen reserves, but I did it anyway to put investors at ease that I’m ahead of the problem? Is such a scenario feasible?
Imagine this: I am the CFO and I know I have to address my GL reserves at some point. I’m not too exposed to the cats this Q and, because I haven’t taken any reserve pain yet this year, we are ahead of plan for the year. For argument’s sake, say we are $75M ahead of plan for the year.
What do you think happens next? Let’s play “Choose Your Own Adventure”!
- Option 1: I don’t want to go second, so I take no charge and keep kicking the can.
- Option 2: I take a $65M charge so the executive team still gets full bonuses.
- Option 3: I rip the band aid off and take a $250M charge so I can truly get in front of things and hopefully put the issue behind me.
Let’s get the easy one out of the way. I’m not taking door #3. My stock is down 15% on that news! I’m not crossing the river while that’s croc’s still hungry!
My guess is most CFOs are taking door #1. Keep kicking the can. Wait til everyone is in the water and hope the croc doesn’t think you’re weak.
However, some I bet will go for door #2. They’ll risk that they can execute the messaging so their stock doesn’t get hit while still getting paid.
Waiting for the Tooth Fairy
Oh, so before I get into the spin, I’ll take a minute to address the vocal minority reading this and proclaiming “how dare you suggest management would manipulate earnings like that? Don’t you know they could go to jail for that?”
Nobody is going to jail for an arbitrary decision on reserves, just like nobody is going to jail for refusing to admit they have a reserve hole and sticking their head in the sand. I would argue the latter is the greater violation.
And if you think most companies let the actuaries decide the reserves on their own, you probably still believe in the tooth fairy and the Easter Bunny (sorry, if any young kids are reading this and just found out the spoiler).
Also, to be clear, I endorse option #3. Tell the truth and deal with the consequences. Cross the river first and emerge stronger in the long run. But most people I talk to don’t think Travelers is being more honest; rather, they think Travelers has a bigger hole and “couldn’t hide it any longer”. Which is why I refer you back to the Three Rules above.
Position of Strength!
OK, so back to option two. How do I thread the needle and take a small charge without hurting my stock?
In my earnings call script I say something akin to what follows:
“While earnings in the quarter didn’t meet our expectations, we are proud that we produced another record year in 2019. Our underlying results for the fourth quarter remained strong and signify our momentum heading into 2020. We expect improved accident year margins as we earn in recent price increases.
“Given the pressures we are seeing broadly across the industry, we thought it prudent to increase IBNR in several lines of business at year-end, even though we didn’t see compelling evidence that indicated our own reserves were inadequate. Nevertheless, since we are operating from such a position of strength given our overall results, we felt it was good practice to fortify our balance sheet by adding $65M to our reserves and remove any doubt that further action is needed.
“We will remain vigilant in monitoring social inflation and will report back to you if we see a deterioration in our results.”
I am going to file for a copyright on that faux script (I took it from the Eastern and Southern conference call) so for any company who likes it, please come up with original wording rather than plagiarize, OK?
If anyone hears something like this on any of the conference calls over the next month, feel free to report it in the comments. And if any company actually uses the term “position of strength” yes, you are free to take a shot!
Isn’t This a Dangerous Game?
Yes and no. If you mean, isn’t there a risk companies who take a PoS charge (yes, you can read the double entendre into that if you like) are going to have egg on their face later when they have to take another charge? Yes, that is a risk, but that’s easily managed around. “The environment has gotten significantly worse than we expected since year end“. I mean that’s easy. Who can argue with that?
The only real risk is – back to the Three Rules – do they have to go back to confessional before or after everyone else? If everyone else starts taking bigger hits say in Q2, then they can wait til Q3 before saying the PoS charge was, well, a PoS. But it won’t matter anymore because everyone will be in the river.
Not only will their stock not be overly impacted once everyone is in the water, they may be rewarded with outperformance if investors perceive them to be ahead of the curve and thus have lower risk of future disappointments. They will have wished the Position of Strength into a Perception of Strength!
Yes, investors are surprisingly easy to manipulate unfortunately. So a skillful management team can spin their reserve hole into a premium multiple which will eventually allow them to raise capital on advantageous terms to pursue future growth once the pain has passed.
Let’s Review
What can a well-executed PoS charge do for your company?
- Everyone still gets full bonuses.
- You can begin addressing your reserve hole earlier than peers.
- Your stock doesn’t get slammed like the other fools who are more honest than you about their mistakes.
- You get a premium multiple to help you grow faster on the back end.
So, there you have it. Get ready to see some PoS charges over the next month. Now that I’ve let the cat out of the bag, I’m sure some IRs are furiously re-writing their scripts, but don’t be fooled if they call it by a different name. If it looks like a PoS and it smells like a PoS, it is most definitely a PoS charge. Be vigilant!