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  • Chris Burand

Red Flags

I upset an insurance company executive some months ago by stating that insurance companies enjoy some luxuries in setting and releasing reserves both on a micro and a macro basis. He clearly believed, with all his heart, that carriers never transgressed the line of purposely manipulating reserves (the other option at least for some, is complete ineptness, making the choice between being inept or manipulative -- which is preferable?). He was obviously an honest and ethical person who had somehow, after thirty years' experience, not ever seen interesting odd reserving actions.

Most agency owners, or at least most of the ones I know, have probably suffered from interesting reserving actions by receiving lesser contingency bonuses. Case reserves or IBNRs magically increase at year-end and may be reversed quickly in January. An old wizened carrier VP remarked at one of my public presentations, "Well, you know, when leaves fall, reserves rise."


Someone explained these increases were a coincidence due to the timing of reserve reviews at year end. The reviews were not tied to contingency reviews and so forth, although contingencies were affected. That is a plausible explanation, but transparency is required to make it more believable to most agency veterans.


On a macro level, Warren Buffett called out carriers years ago for playing reserving games. There is nothing new in what I am describing. Owning one of the world's largest insurance companies lends credibility to his accusation that faulty reserving happens purposely. I believe some interesting reserving is just incompetence resulting from bad actuarial math to typographic errors. In reviewing open claims with clients, the obvious mistakes are incredibly common.


Hopefully this article has been interesting so far, but it is honestly a useless perspective. The value is in understanding the interesting reserve accounting happening today. Second quarter 2020 carrier results have arrived and I find it interesting that an industry that mostly denies BI COVID coverage is reserving so much, in some cases, for Pandemic BI losses. Perhaps these are ancillary line reserves and therefore not directly BI claims. Workers' compensation would be a good example. Maybe too, well capitalized carriers are taking the opportunity to reserve for past under reserving or diminish profits (some companies are reporting huge profits through the first half of 2020) related to the large decrease in claim frequency.


Carriers that are not so well capitalized and/or profitable may not be positioned to add reserves now even if they should. If that is the case, the hole they are in may be getting deeper, kind of like quicksand. It is hard to know where this might apply, so my thoughts are totally hypothetical.


Beyond reserve accounting (and mark-to-market transparency relative to investment portfolios), some serial acquirers might have some red flags. Chinese companies with poor accounting have been in the news lately. A firm specializing in identifying accounting issues is Muddy Waters. This firm may be controversial because they are also short sellers. The red flags they use are gaps in earning between GAAP and non-GAAP earnings. Some significant differences exist between GAAP net income and EBITDA for some of these serial acquirers. The SEC has advised against using EBITDA too, much less the exotic EBITDA derivatives like EBITDAC. Why then is EBITDA so popular when key authorities advise against it?


Another red flag Muddy Waters purports to use is serial acquisitions. Acquisitions give acquirers accounting flexibility, especially if acquisitions are happening due to the old adage, "When all else fails, what's the best strategy? Acquire!"


When the accounting amortization rules changed so that full amortization was not required (for regular agencies doing acquisitions, you are likely thinking that you amortize the full purchase over 15 years, but there is more to the rule than this straight line amortization). Instead, firms can consider asset impairment. This controversial rule is now being debated at the highest regulatory levels as to whether it should be reversed or modified. For now though, it enables an acquirer to buy a firm and not take a reduced charge against earnings. This inflates earnings versus organic growth because the cost of organic growth always goes against earnings. However, if one can buy a firm and not incur the full cost against earnings ever, it makes the growth look cheap.


The question that the regulators are hopefully considering in their discovery as to whether this rule makes sense is this (and the regulators are looking at the entire economy relative to the rule change -- not just in the insurance industry): If a broker buys a book of business for two times and the book generates $1 million in revenue, they pay $2 million. However, they only amortize maybe 50%, or $1 million. It makes it look like they only paid one time on their income statement. The other $1 million is reviewed for impairment annually. However, if the pandemic has shrunk revenues by 5% with 8% revenue increases, all else being equal, that book has lost 13% of its accounts. Is this an impairment?


Is a broker worth as much if it has lost 13% but made up some of that loss because of industry wide rate increases? Increased rates are a pretty easy way to inflate revenue today, but what happens when the market goes soft and the broker has many, many fewer clients? Is that when impairment is declared? As one executive of an acquirer stated publicly last year, to paraphrase, "We have to continue buying agencies to pay for our prior acquisitions."


A problem short sellers incur is that serial acquirers can obtain more and more capital, thus outlasting the short sellers' own capital and patience. Right does not always win.


Agents can use these indicators to their advantage without trading stock. Agencies can plant with the better carriers, i.e., more stability (from an agency perspective, not from a claims paying perspective, which is the purview of the rating companies), more competitive in the market. To me at least, it seems like life is easier with carriers that don’t have revolving marketing reps, constantly changing appetites, good claims paying behaviors, and also possess the capital to grow quickly versus those who seem to be nonrenewing even good accounts today.


For agencies that want to grow and need a lead list, they might consider the clients of serial acquirers. The bad part of the accounting rules affecting impairment is that capital for acquisitions is cheap, as cheap as I can ever remember, but capital for true organic growth is expensive. This disparity means the probability of the acquirers having disaffected clients is higher.


Perhaps the better investment then is that rather than combing through 10-K's and hiring smart investment firms and short selling or long selling, to simply execute better relative to the carriers you use and the quality of your customer experience being outstanding. Both are in your control and the amount of capital you have is an advantage, not a disadvantage relative to giant brokers. But always, always, watch your claims reserves!

NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.

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