Flavors of Insurance, Part II

Includes: ANTM, FAF, FNF
by: David Merkel, CFA

<< Return to Part I


Commercial purchasers of insurance often hire insurance brokers to search for the best coverage from a price and quality standpoint. In return for their services, insurance brokers receive a commission that is a percentage of the premium. Insurance brokers bear no underwriting risk; the primary risk of an insurance broker is that margins get squeezed when P&C rates go soft. This has the countervailing advantage for investors, that after a major catastrophe, the brokers will always do well, because rates rise, and the brokers have no risk of getting tagged for claims.

Part of the story for the insurance brokerages has been the continuing acquisition of small “Mom-and-Pop” insurance brokerages. Twenty years ago, the insurance brokerage space was fragmented. There is still a decent amount of fragmentation today, but now there are major firms that define the sub-industry.

Among the biggest firms, there are sometimes other business lines that form a significant part of the total enterprise. Human resources consulting, benefits consulting, risk management consulting are common ancillary enterprises. Less common are asset management services, and owning insurance companies, but some of the bigger firms do those.

Expense control and discipline in acquisitions are critical aspects of a successful insurance brokerage, as the lack of either one will impair long term earnings power. Our biggest concern with acquisitions is that the prices paid to “roll up” smaller insurance brokerages will eventually rise to levels that make their purchase uneconomic, but the purchases will continue in a foolish attempt to gain market share.

The insurance brokers had a great run of growth through the nineties. Since 2000, their performance has been flat for a number of reasons: underperformance of non-insurance brokerage operations, and slowing organic growth. With P&C premium rates moving from slow positive growth to flat at present, flat performance from the sub-industry for the near term is what we would expect.


Bringing It to the Present:

Some things I got right here, and others wrong. On net, the group didn’t do much since I wrote the above in 2004. But almost all of the little companies got acquired, often by private equity, even a few that I thought were garbage. The big players suffered through the scandal of contingent compensation, while the little players ignored the threat successfully, because the threat from Spitzer and other AGs would not stand up in court. The big players buckled under the load of bad PR.

So, among the publicly traded companies five remain: Marsh & McLennan (NYSE:MMC), Aon (NYSE:AON), Willis Group (WSH), Brown & Brown (NYSE:BRO), and AJ Gallagher (NYSE:AJG). I own none of them, and looking at the valuations and soft P&C insurance markets, I have no interest at all. Short them if you like, though I won’t.

One closing note, contingent commissions have returned. In any sort of business transaction where there are multiple parties at the table, be aware of who is allied with whom. Do not assume that there are neutral parties. Who is paying whom? If buying from someone, be skeptical about trusting the opinions of “neutral parties” that are paid by them.



Health insurers have changed over the past thirty years. Thirty years ago, health insurers were strictly indemnity-based, and there were many of them. Many multiline insurers had health insurance subsidiaries. The creation of HMOs and Preferred Provider Organizations (PPOs) were innovations that helped lead to a consolidation in the sector. Today few health insurance providers are part of multiline insurers. Health insurers are specialists.

Another trend among health insurance is the slow but steady demutualization of Blue Cross/Blue Shield affiliates. The greatest expression of this is found in the merger of Anthem and Wellpoint (WLP), where the combined entity covers thirteen states, and makes it the second largest health insurance provider in the US.

Health insurance only became a profitable venture on an underwriting basis recently. If you added up underwriting profits and losses from health insurance through the 1990s, the profitability was breakeven. Since then, expense control on medical providers and at health insurers helped bring the group to sustained profitability. Part of that might be attributable to larger health insurance companies gaining additional bargaining power. The increase in market share of the major health insurers has helped to raise barriers to entry in the space. It is difficult to replicate the advantages of the largest health insurers in terms of buying power, or in terms of the ability to service national accounts.

People in the United States want the best of two incompatible worlds with health care. They want it to be inexpensive to users, and yet be available “on demand” with services of the highest-tech nature. Individuals and firms want it to be socialistic if their own costs are heavy, and “free market” if they are small. Add onto this the demand of perfection of results, enforced by tort attorneys, which drives up costs. Doctors practice defensive medicine in order to avoid malpractice claims, which is costly.

Because of their buying power, government-related purchasers of health care also tend to be price-sensitive purchasers of health care, leading health care providers to shift costs to private purchasers that are price-insensitive in the short run. Health insurers are middlemen in this situation, attempting to deal with the conflicting goals of controlling costs, while providing an amount of services that keeps users of the system happy.

Because of the foregoing, costs have been rising at rates in excess of the inflation rate in the general economy. There is consistent political pressure against the profits of health insurers, but it has not affected profit margins over the past three years. The health insurers have been able to pass through their cost increases so far, but the possibility of government actions makes future results less predictable.

The stock performance of the health insurers was fairly flat through the end of the nineties. In the 2000s, return improved dramatically, due to the advantages of scale and expense control. The advantage of scale is not going away, but the above average profits of the last four years may prove difficult to maintain, as the government will find it difficult to not increase regulation in response to complaints over high health insurance premiums in the face of what are viewed as high profits.


Bringing It to the Present

After fighting off federal regulation 2004-2008, health insurers did a deal with the devil, deciding that it would be better to be health utilities than dead. At this point, I do not know how things will go:

  • Will ObamaCare be ripped out two+ years from now?
  • Will ObamaCare be defunded?
  • Will ObamaCare persist?
  • And if there are changes, what will replace the current system?

The one thing presently in favor of the health insurers is the graying of the Baby Boomers. There will be increased need, but how will it be filled?



Financial guarantee insurers insure creditworthiness in a number of related, but different areas. They insure home mortgages for lenders who accept low down payments. They insure the debt of municipalities, who often find it cheaper to sell insured debt. In structured finance they guarantee the senior-most debt branches of residential mortgage (RMBS), commercial mortgage (CMBS), and asset-backed securities (ABS). In the corporate credit arena, they guarantee the senior-most debt branches of collateralized debt obligations, and occasionally, single issuer project finance.

There are generally two types of companies in this sub-industry, with a slight overlap of business between them. One group guarantees low down payment mortgages for lenders. The other group engages in the rest of the businesses listed above. Financial guaranty and mortgage insurance are regulated separately from other types of property and casualty insurance. For the most part, companies that engage in these lines of business are specialists, though their continued high profitability is attracting new entrants.

Financial guaranty insurers have a primary function of credit enhancement for the corporate, municipal and consumer credit. In this function, securitization both competes with and facilitates their business. RMBS, CMBS and ABS can be structured as insured deals, or as deals where the senior bonds are protected by subordinated bonds sold to institutional investors at yields appropriate to compensate them for the risk. Even so, insured bonds trade with greater liquidity than uninsured bonds. The financial guaranty insurers are vital to the smooth functioning of structured finance.

The mortgage insurers have faced problems in the recent past. Loss experience on subprime borrowers has been disappointing. There have been bulk loan transactions that have also had poorer loss experience than ordinary transactions that flow one-by-one from lenders. Mortgage insurers are adjusting their pricing to reflect the differing loss costs.

In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.

There are yet other threats that mortgage insurers face. Fannie and Freddie could get their charters adjusted to allow them to accept uninsured mortgages with lower down payments. Large lenders could decide that they don’t need insurance for loans that they keep on balance sheet. Second mortgages compete with mortgage insurance. Inflated appraisals inflate the true amount at risk to the mortgage insurers. Finally, refinancing makes it difficult for the insurers to retain business on their books.

Aiding the mortgage insurers is the continued price appreciation of housing, which lowers the incidence and severity of claims. Homes are critical to most people who own them; it usually is the last thing that people will miss a payment on. Finally, there are significant barriers to entry for new competitors in the mortgage insurance business.

With the financial guaranty insurers, the issues are different. The amount of leverage is huge; the face amount of debt insured at a AAA financial guaranty insurer can be more than one hundred times greater than their surplus. Financial guaranty insurers underwrite to a zero loss tolerance. In other words, every transaction is expected to produce no losses; anything less than that would make the ratings agencies downgrade them severely.

Balance sheet complexity is large in terms of the many contingencies insured. Remember our phrase “too smart for your own good risk?” That may apply here. The rating agencies consistently affirm that these insurers are AAA, but we will argue that the rating agencies are co-dependent with them. The financial guaranty insurers indirectly generate a lot of revenue for the rating agencies. If an insurer begins to slip, initially it would pay the ratings agencies to delay the recognition of that, and work with them to lower leverage; the damage to the ratings agencies and financial guarantee insurers from a downgrade of a financial guarantee insurer to less than AAA would be huge. It would throw into question many of the fundamental underpinnings of the structured securities markets. It would also lead to turbulence in the AAA-only portion of the fixed income markets, which are quite large, but can’t deal with any degree of uncertainty.

Against this, the financial guarantee insurers have the following big advantage: they only guarantee the timely payment of principal and interest of obligations. If it is to their advantage to pay off the obligation immediately, they will do so. If it is to their advantage to string out the payments, they can do that as well. In a time of financial stress, the financial guaranty insurers can pay off claims slowly, and reduce the writing of new business, which would allow them to delever rapidly.

The twin engines of the rise of structured finance and low down payments on mortgages amid a rapidly growing housing market have fueled the performance of this sub-industry. The stocks in this industry have performed well. Valuations today are not outlandish, but they are kept low by the concerns that we have listed above.

In general, we believe that the future will be more risky for this sub-industry than the past. Both engines of growth will be slower in the future. In addition, the mortgage insurers have to contend with borrowers that are reliant on the low interest rates on ARMs in order to continue making payments on their homes. Consumer credit is overextended, and that will affect the loss experience on RMBS and ABS.


Bringing It to the Present

I wish I had screamed louder. Yes, I told the party line story back in 2004, but I tried to highlight the risks involved.

When I went to work for Hovde, I had a hierarchy of trust for reserving:

  1. Life
  2. Personal lines / Health
  3. Commercial Lines
  4. Reinsurance
  5. Title
  6. Financial

Financial insurers and mortgage insurers have proven less than sound. They are just another example of what happens when leverage collapses.

As a bond manager, I never trusted the rating agencies on structured finance. I wanted my AAA bonds to be AAA without support.

The financial insurers were too critical to the system. We needed them to work. That should have been the signal that something was wrong. When something has to work, we are in big trouble, that is a sign that things are out of balance.

As it is now things are broken, and we are in an intermediate state where we are waiting for guarantors to be created. The system needs third parties to take risks for pay.



The title insurance industry is small. How small is it? If you added together the market capitalizations of all title companies, it would be smaller than half the market capitalization of the largest life company. It would be less than 5% of the size of AIG.

Most people view title insurance as a necessary evil, or even a pseudo-tax, when they purchase or refinance a home. The main reason for that is that few people ever experience a fraudulent conveyance of a title to a property. Loss ratios are mid-single digits in percentages. There is no underwriting cycle in title insurance because claims are not a big enough part of the business.

Most of the economic challenge of running a title insurer comes from expense control. Distribution expenses are big; they range around half of premiums. Profit margins are typically a mid-single digit percentage of premiums as well. General and administrative expenses absorb the rest of the premiums.

Title insurers exist to protect purchasers of homes and their lenders from fraud in the conveyance of the title to the property. Title insurance is different, because it protects against events that have happened prior to the inception of the policy. Title insurance allows the gears of buying and selling homes to grind smoothly in the US. If our local governments did a better job of tracking property transactions, perhaps title insurers would not exist, as is true in most of Europe.

Because a large number of title policies are originated because of refinancing, and refinancing comes in waves, expense management is a priority for title insurers. Today, most title insurers employ temporary workforces that they grow substantially during refinancing waves. It is more costly to have temporary employees, but it makes responding to large changes in demand possible.

That interest rates have fallen so much has driven many of the title insurers to seek avenues of diversification, because opportunities to originate policies because of refinancing will likely not be as big in the next ten years as it was in the last ten. Most of the diversification is taking place in real estate related industries, thus leveraging off of existing competencies and relationships. Other efforts have been into other financial businesses including asset management, trust services, and credit verification services. The jury is still out on whether these diversification efforts will pay off; still to this point, no major company in the space has less than 75% of profits coming from lines of business other than title insurance.

For a business that sounds so marginal, why have the stocks done so well over the past ten years? A combination of three factors made it so: first, valuation levels were low back in 1994, as refinancing slowed down marked when rates began to rise. Second, there are barriers to entry; creating a new title insurer would involve creating or purchasing new databases of property records, which would be prohibitively costly. Third, falling interest rates since 1994 created three major refinancing waves that allowed for the issuance of many additional policies. Because interest rates are low now, and valuations considerably higher than where they were in 1994, we are less optimistic on high returns for the sub-industry for the immediate future. It is also possible that new title products, such as lien protection products, may eat into gross margins. That hasn’t happened so far, but it is another thing to watch.


Bringing It to the Present

The big four became the big three. LandAmerica died, which was the company I thought was the most reckless (note my comments at RealMoney). The two large companies, First American Corp. (NYSE:FAF) and Fidelity National Financial (NYSE:FNF) went through transformations, selling off their arms that did everything except title, unlocking a lot of value in the process.

Lien protection products ended being a big zero. Perhaps that could have been a way for the GSEs to justify their existence, but no.

And yet, title insurers took some real losses from the financial crisis. Not surprising, given the open-ended nature of title claims, and the degree of potential for fraud when real estate is sagging dramatically.

Just as residential real estate will take a while to settle, so will it be the same for title insurers.

>> Continue to Part III

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Disclosure: Author long ALL, SAFT, CB, PRE and RGA