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Harry Long is the inventor of Structural Arbitrage and Hedged Convexity Capture and is the Managing Partner of Zomma, the world's most innovative strategy index creator. Mr. Long is a globally recognized expert on the research and development of quantitative investment strategies. Zomma's... More
  • Adventures at the Frontier of Corporate Governance: Part III 0 comments
    Aug 14, 2009 5:17 AM | about stocks: FMMH
    [Continued from Part II]

    In the interests of brevity, I will summarize the meeting's issues by importance, not chronological order:

    I. Dick did not offer any explanation or apology for not bringing Kent or Skip. He denied that he had agreed to bring them, then stated that he and Kevin usually handle investor relations.

    II. Examining the issue of underwriting in personal lines seemed to be very emotional for Dick. Even though the meeting’s agenda was about losses in personal lines, it was hard to keep Dick on track. He kept blurting out that the company made money last year as a whole. It was very hard to keep him on track examining the issue at hand. To me, it seemed like he couldn’t bear to hear criticism about personal lines.

    III. Dick seemed very upset about my blog. He told me that it was “hurting the company” and the share price. I told him that was ridiculous. Losses in personal lines were hurting the share price, not the fact that I noticed it and offered strong solutions to fix it.

    Furthermore, I gave him the example of David Einhorn, who Lehman brothers had disparaged and ignored (and also had accused of hurting the share price) when he pushed Lehman to deleverage its balance sheet. Lehman ignored him, with disastrous results. I told him that Fremont’s profits had decreased for two years and that’s why his stock price was down. Later in the conversation, he expressed that he wished I had brought my concerns to him privately, rather than writing about it in articles and blogs. I retorted that it was impossible to do so, since he had not returned my calls for months. He looked embarrassed. I asked him if he took responsibility for the communication breakdown, and he said, “I take responsibility for that.”

    IV. During our conversation, Dick expressed that insurance was cyclical and that there would be losses in certain lines from time to time. I told him that I understood that, but the problem was not losses, but management’s response to losses, which was to grow premiums and put its foot on the accelerator, not the brakes. I expressed that if you’re a General and your forces are getting decimated, you have to retreat and regroup and live to fight another day, not push forward and get your men killed (potentially destroying shareholder capital).

    I expressed to Dick that if he wanted to do a management buyout and practice cowboy risk management with his own money, and increase risk when he ran into losses, that was fine, but doing it with shareholder capital, which he has an ethical and legal fiduciary duty to protect, is unacceptable. In addition, I pointed out that he reminded me of a leveraged oil trader who refuses to reduce leverage as his position moves against him, thereby risking ruin [has Dick ever studied the natural gas trades at Amaranth?]. I commented that even though Fremont’s balance sheet is very clean, that due to the premium to surplus ratio, that he is in a similar position in economic essence, and must reduce risk exposure in the face of losses, not increase it.

    Every single time I brought up the point, Dick responded in myriad ways with essentially the same answer: we may be losing money, but I think growing premiums in personal lines will ultimately pay off. I told him that risk control systems were designed to counter people’s natural tendency to continue to believe they are right, despite evidence to the contrary. I said, I hope you are proven right, but (until you are proven right) when you lose money, reduce risk, get smaller. Until you are proven right, you have to assume you miscalculated. Losses should give you pause. You need to be modest. Humans make mistakes all the time. That’s why risk control has to be a firm set of rules which are strictly adhered to.

    Losses should trigger a cooling off period of no growth, or contraction, followed by an evaluation of the problem and the implementation of solutions. Only when an insurance line becomes profitable for two years running should premiums be grown again. At one point he questioned whether or not I understood insurance, and I said, “my management is not at issue here. Yours is. The burden is on you to prove that your personal lines strategy is right, given that it lost money last year, not on me. My management didn’t make the company lose money in personal lines.” At this point, he went off topic again and kept repeating that the company as a whole made money. Eventually we got back on track.

    Then, Dick just kept repeating in various ways that he thought he was right. I responded that it sounded like he would rather be “right” than make money and that he was in denial. Again, I challenged him to give one example of it ending well at one financial firm over the last 100 years which increased risk when a product line lost money, and he replied, “I can’t think of one off the top of my head.” I told him that it had been many days since I had first asked him. Kevin couldn’t think of an example either since.

    I said that it was rather arrogant to think that management could engage in a strategy (growing a line in the face of losses) which they had no example of ever working and win. I told them that they could not afford to ignore time-tested disciplines, and again gave the examples of AIG, Lehman, Bear Stearns, Wachovia, Banc of America, etc which had doubled down on disastrous bets and lost. Dick looked unimpressed. I told him the fact that he could think of no examples which supported his strategy absolutely terrified me as an investor.

    I asked Dick if he had read the Berkshire Hathaway shareholder letters, and he said he had. I reminded him of what Warren Buffett said about premium volume. Insurance is the only business where growth can be deadly. Unlike a product company, in insurance, you often want to contract. You can’t control pricing, but you can control whether or not you will accept bad rates. When rates are bad, keep your wallet zipped and preserve your capital. As competitors lose money and go out of business or are forced to pull back in the face of losses, capacity exits the industry, prices come back to rational levels, then you grow [I thought to myself, it is rather like waiting for mouth-watering valuations in stocks, rather than chasing around dot com shares with 100 P/E ratios which always lead to disappointment. Didn’t Dick remember, “be fearful when others are greedy, and greedy when others are fearful.”?]

    V. Dick didn’t seem to understand that the relationship between the variables had changed in personal lines. He pointed out that some years back, personal lines were very profitable. I said that was before the Governor had declared a price freeze, essentially declaring war on the Michigan insurance industry and setting a precedent that the government might not allow the rational pricing of risk. I said that the political environment was “brutal”. He said it was “hard”. After some back and forth, he eventually admitted it was “brutal”, but to me, it seemed like it was very emotionally difficult for him to even say the word.

    VI. A few times in the conversation, Dick referred to Fremont as an “agent company”. I corrected him, saying that it was a “shareholder company” and that he had to do what was best for shareholders, not agents, despite the fact that he had three agents on his board.

    VII. Dick seemed to express that even if he wanted to contract premiums (which he didn’t seem to want to do at all), that it might upset agents. I pointed out that many of his competitors had zero growth or contraction, and that his agents would not find this unusual. In addition, I said that at double digit growth rates in personal lines, that he was nowhere near contraction, and that regardless, of course agents like growth--they get more commissions. I said, furthermore, your fiduciary responsibility is to shareholders to protect the capital they have entrusted you with. It shouldn’t even be a question in management’s mind--shareholders have to come first. If it is a question between upsetting agents and losing shareholder capital, you have to protect shareholder capital.

    VIII. I told Dick that, in my view, it was awful for employee morale that I was getting out in front of problems with strong solutions, while he wasn’t. I told him that he needed to show leadership as a CEO and confront problems in personal lines head on. I told him that, furthermore, he needed to clearly communicate with shareholders in a transparent way. He needed to formulate a plan and put out a press release. He said he couldn’t do this, since then competitors would be tipped off to company strategy. I said that was ridiculous. Would reducing premiums in a line with losses really be so revolutionary that competitors would have never heard of such a thing? Warren Buffett discusses it all the time. Few companies regularly follow his example (but the ones that do prosper immensely).

    IX. Dick at one point asked how I would propose to reduce premiums, since it took time. I told him that I would do it exactly as I had advocated publicly:
    1. Send executives to under performing agencies, asking them to cancel their contracts. Dunning admitted that the vast majority of agents, when asked to cancel their contracts, do. The under performing agencies are gone, while the agents with good loss ratios are kept, bringing down the average loss ratio and not upsetting good agents.
    2. Do a sale and leaseback of the headquarters, thereby freeing up capital that can be used to expand to Indiana, where personal lines could be rationally priced.

    X. I expressed to Dick that while Warren Buffett himself might not be able to get a better combined ratio in personal lines in Michigan, that he would recognize reality for what it was and not stick his head in the sand like an ostrich. I said that Buffett would beat a hasty retreat in Michigan personal lines, and expand in a place like Indiana far sooner. I told Dick that he was not paid to be perfect, but rather to recognize and correct mistakes quickly. I told Dick that if he really wanted to grow over the long term, that he needed to protect shareholder capital. I told him that if he impaired the company’s capital base, that he would never be able to grow, even if premium pricing was great. I told him to put his foot on the brakes and regroup. He could always grow again. Dick expressed that expanding to other states is hard. I said, that’s why you’re paid almost a quarter million dollars a year--to do the things which are hard.

    The meeting ended on a funny note. I felt that we were going in circles. Dick had heard my concerns, but I am not sure that he listened in the sense of actually considering there was a probability, however small, that I might be right on a lot of the issues. I have never met someone in the business world in all my years who didn’t reflect on the correctness of strategies which lead to loss in a business line. It was very odd. Either risk control, conservatism, humility, and good sense are in someone’s psyche and DNA, or they aren’t. After that meeting, I do not believe that Dick Dunning is the right person to run Fremont. I find many of his notions about insurance terrifyingly wrong. And evidently, I can’t even expect him to do simple things that he commits to, like bringing Skip and Shantz to the meeting.

    --------------------------------
    Disclosure: Harry Long owns FMMH shares directly, through partnerships, and through trusts. To the best of his knowledge, certain of his family members own FMMH shares through partnerships and trusts. Such ownership may change at any time.
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