The Value of Catastrophe

How to make easy money in a "hard" market – an ideal post-9/11 investment strategy.

"August 31 – I paid over $200,000 today in just one day. I found myself very emotionally upset at the severe destruction… Everywhere that I stopped the people would rush around my car, which had the signs of my insurance company on it, asking for help. People were sitting outside of what was left of their homes, with their insurance company’s names and their policy numbers written on whatever part of their home was left standing.

"September 20 – Many adjusters have left- unable to take the strain. Some did not last for more than a few days. It’s like being in a ‘war zone.’ I must try and take a day off to relieve my stress.

"September 28 – I called my wife tonight…While I am talking to her, there is gunfire in the background. I hope she doesn’t hear it. Yesterday, when I was doing a claim, 3 young men came up to the house with guns. The owner and I stood outside while they took away what was left in the house."

Reinsurance: Every Penny for 22 Years

These words are from an insurance adjuster’s personal journal of the devastation caused by Hurricane Andrew on August 24, 1992. At the end of his journal, he says that when he gets home, he’ll tell his wife everything he couldn’t tell her while he was on the ground in Florida. Then she’ll understand why he’s going to buy a gun.

To this day, Hurricane Andrew is still the worst U.S. hurricane on record. Twenty-three people were killed. More than 135,000 homes were destroyed or damaged, 160,000 people were left homeless and 86,000 lost their jobs.

In just a few hours, the insurance industry lost every penny of premiums it collected in Florida during the previous 22 years, plus another $6 billion. Between 1970 and 1992, the insurance industry had taken in about $10.8 billion in insurance premiums in Florida. Andrew caused an estimated total of $26.5 billion in damages. Just over $16 billion of that was insured.

Hurricane Andrew is still fresh in the insurance industry’s mind, too. To this day, State Farm won’t insure many coastal Florida homes. The state insurance commission won’t approve the 22% premium increase it needs to make it worth the risk. State Farm’s biggest competitor, Allstate, did the same math. It also asked for a 22% hike in premiums but only got 15.7%. Allstate won’t insure homes on the coast, and won’t renew some policies.

Andrew was the largest insured loss in history until September 11, 2001. Losses from 9/11 are now estimated in the range of $40 billion – $50 billion. That’s as much as 16% of a whole year’s worth of insurance premiums for the entire United States insurance market ($300 billion), wiped out in a few hours.

Twelve insurance companies went out of business after Hurricane Andrew. I asked James Peavey at A.M. Best, the global insurance ratings firm, if his company kept a list of which insurance companies went out of business each year. They don’t. But he did send me a report on the property/casualty insurers covering the years 1993 through 2002. Sure enough, 1993 was the second worst year on record for insurance insolvencies, with 1.2% of the industry going bust. The worst year on record was 2002, when 1.33% of the property/casualty insurers went bust.

Losses from 9/11 removed 38 companies from the market in 2002. We’re not talking about a bunch of featherweights, either. Kemper Insurance Company was the seventh largest insurer in the United States; it closed and went out of business. Gerling Reinsurance was the seventh largest reinsurer in the world. Its property/casualty reinsurance business is in run-off. That means it’s not taking on any new business. It’s simply allowing its existing policies to expire. SCOR Reinsurance, the French company, was the 10th largest reinsurance company in the world, and was named Reinsurance Company of the year in 2000 by The Review – Worldwide Reinsurance magazine. Today, it’s struggling to stay alive.

Reinsurance: The Combined Ratio

As if the lingering malaise of 9/11 weren’t enough, there are more reasons to be repelled by the thought of investing in the reinsurance business. My favorite is that it’s an awful business, measured by the industry’s own favorite benchmark. The benchmark I’m talking about is a number called the combined ratio.

Insurance companies bring in money in two ways, insurance underwriting and investment income. The combined ratio gauges the profitability of insurance underwriting only. If you take in $1 of premium and pay out 90 cents of expenses and losses, your combined ratio is 90%. Obviously, anytime your combined ratio is below 100%, you are making money on your premiums. Historically, anything under 90% is superb – and exceedingly rare. Since 1975, the combined ratio for the entire property/casualty industry has been below 100% in only two years. The property/casualty companies are the ones who buy catastrophe reinsurance. If they have a hard time making money, you better believe the reinsurers do, too…

The Reinsurance Association of America tracks the combined ratio for the entire reinsurance industry. Its latest report covers the 22-year period from 1981 through 2002. The combined ratio for the reinsurance industry never got below 101.5%. The average was 111.60%. In 1981, there were 120 reinsurance companies reporting to the RAA. It’s no wonder that number has fallen steadily for 22 years, with about 40 companies reporting to the RAA in 2002. For a long time, the only way most insurance companies stayed in business was by investing in stocks and bonds. Now that risk-free interest rates are 4% and Aaa corporate yields are 5.5%, that’s not going to be possible anymore. The bursting of the biggest stock market bubble in history in early 2000 didn’t help.

Now you know exactly why, by any reasonable yardstick, reinsurance stocks are still cheap. The 9/11 catastrophe wrecked a bunch of companies. And insurance and reinsurance are just crappy, unprofitable businesses fraught with peril.

Who’d want to put their money into such a business? I would. Let me explain why you should, too.

Reinsurance: Profits from Disasters

Forgive me if this sounds crass. But it’s true. Disasters like Hurricane Andrew and 9/11 are exactly the type of big, ugly misfortune that creates excellent investment opportunities. And industries that appear to be universally reviled are often where the biggest profits lie.

Even before 9/11, property catastrophe insurance premiums were beginning to rise, after falling for 6 years in a row. When 9/11 hit, reinsurance premiums shot up 20% to 100% in the property catastrophe, marine and aerospace lines of business. Terrorism insurance today is like homeowners insurance for residents of coastal Florida – often impossible to get. With so many insurance companies either gone from the market or in trouble, the market is likely to remain hard, as they say in the insurance business, for at least a few years. A "hard" market is one where prices are rising, and underwriting capacity is inadequate to meet demand.

What’s more, the current hard insurance market will probably be even longer than the 5-year post-Andrew cycle. Michael Paisan, insurance analyst for Williams Capital Group, explains why: "Despite the sideline capital that has entered in this market in the aftermath of 9/11, it is not nearly enough to supplant the lost capital. Moreover, the capital that is entering the market now has to be disciplined capital (unlike that in 1992) because the low interest rate environment is not as conducive to cash flow underwriting as it was back then. Hence, the capital inflow should not curtail the hardening pricing cycle as it has done in the past."

After Andrew, about $4 billion of new capital was raised in about 12 months. About $20 billion of new capital entered the reinsurance industry within four months following 9/11. It sounds like a lot, but the supply of reinsurance underwriting capacity is still lagging demand.

These market conditions create exactly the sort of opportunity a successful company can profit enormously from.

One reinsurance company in particular has proven its ability to take a big hit to the balance sheet, and yet take full advantage of hard market conditions. Out of respect for my paying subscribers to Extreme Value, I won’t mention the name here. But I will say the firm specializes in property catastrophe reinsurance, which covers claims arising from hurricanes, windstorms, hailstorms, earthquakes, volcanic eruptions, freezes, fires, floods, industrial explosions, riots and other man-made or natural disasters.

Hurricane Andrew provides a perfect case study of how this company survived – and prospered – in a "hard" market. In 1992, it took Andrew’s punch on the chin, like every other company. When Andrew had got done with its balance sheet, book value had dropped 16%. But in the next year, the company managed to raise $95 million of new capital by selling millions of shares of common stock and bonds. The strategy paid off. For the next five years, from 1993 to 1997, the firm reported nearly double that amount in profits…and outperformed the S&P every one of those years.

Rest assured, the 9/11 "hard" market cycle started on an equally difficult note for reinsurers. But just as Hurricane Andrew signaled a 5-year hard market boom in the industry – despite the pain of a big hit to every reinsurer’s earnings and balance sheets – those companies with proven track records and solid management strategies will have an opportunity to flourish in coming years. No matter how despised the industry may seem right now, hard market conditions will allow which well-managed companies to prosper – which makes them an ideal contrarian investment.


Dan Ferris
for The Daily Reckoning
January 20, 2004

P.S. One reason the company I mentioned can take full advantage of a hard market is that it can do something the industry as a whole has trouble with – it can actually make money by selling insurance. The combined ratio we looked at above indicated that, in the aggregate, the property/casualty and reinsurance industries do not generally make money by selling insurance. But compared to the rest of the reinsurance industry, this company is a paragon of efficiency. And as hard markets begin, nothing counts more than solid, efficient management.

Editor’s Note: Dan Ferris is the Editor of Extreme Value, an investment advisory service that uncovers the safest, cheapest shares in the market. Following the wisdom of original value investors Benjamin Graham and Warren Buffett, Ferris takes investors behind the numbers to learn the true value of a business – and to point out from a ‘bottom-up’ perspective which individual companies are trading at prices simply too cheap and safe to pass up.

"We have a friend who had a stroke. When he recovered, his personality had changed. He had been a very pessimistic investor. But the stroke, he said, damaged the part of his brain that encouraged negativity. So, he became an optimist…and has now made a lot of money in biotech stocks."

We were talking to a group of investment pros – Money Week magazine’s monthly "Roundtable" group. The table was not round at all; it was square. But the group had already been drinking long enough so that even though the discussion had few right angles, there were still some dangerous corners.

"Ha…I knew it…" exclaimed The Daily Reckoning’s London correspondent, Sean Corrigan. "You have to be brain damaged to believe in tech stocks at these prices."

Of course, tech stocks have been the best performers for the last 12 months. And when it came time for last night’s participants to give us their number-one investment recommendation, Tom Bulford, editor of a UK small-cap investment service called Red Hot Penny Shares, came up a company that at least sounded like a tech. "Invox," he suggested. "I don’t know what they do…but the numbers are fantastic."

Everybody has an opinion, of course. Where they come from – from ourselves or our stars – we do not know.

"I just can’t get it out of my head," said hedge fund manager, Hugh Hendry. "From November 1929 until June 1939, stocks in America rose 50%. People like Jesse Livermore, one of the greatest investors who ever lived…he got out in time to avoid the Oct. ’29 collapse. But he was destroyed by the rally, lost all his money and blew his brains out. And then the bear market resumed and stocks went down 80%. Anything that goes down that much is bound to go back up by 50% to 100%…but there’s no information content in it…I don’t know what to make of it, but I’m Scottish…so I’ve got to be depressed."

"America is running a huge con game," opined Sean Corrigan. "They’ve loaded the entire country down with debt. And the only way they can get out is by inflating their way out. The Fed has no moral courage…Bernanke has promised to inflate. They’ll do it…

"Everyone wants to keep this global ponzi scheme going. You know, there are about $23,000 worth of derivatives for every man, woman and child on the planet. I don’t know what is going to go wrong – China, oil, derivatives – but something is going to go wrong."

"Yes," added Brian Durrant, editor of the Fleet Street Letter, UK, "inflation is coming. And long-dated U.S. bonds must be the biggest sell around."

"But I don’t think anything very serious is going to happen until after the election," replied Dan Denning. "In fact, we could even see a decline in long rates…down to 3%… What would this mean? Another round of refinancing…another debt-led, consumer-led boom…Look, despite the fall in the dollar, the cost of living in America is not going up. There is still room to cut rates. The Fed is definitely not going to raise rates before the election. The only thing that could force up rates would be the price of oil going up suddenly. Did you see in yesterday’s paper? Dr. Mahathir Mohamad, the former Prime Minister of Malaysia, gave a speech in Saudi Arabia in which he urged the Arabs to price oil in gold! He’s a provocateur…and maybe a bit of a nut…but it’s an idea that is bound to attract attention."

"But wait a minute," cautioned Hugh. "You’re in big danger of letting yourselves get carried along by your emotions and prejudices. Everybody thinks things are fine until after the election…and that’s the crowded trade. Somehow, the market has to find a way to shake people out. That’s what we’re going to see. If people think something is going to happen after the elections, it will happen before…"

We weren’t sure whether Hugh meant that the market would shake people out of their dollar positions…or their anti- dollar positions. Was it the people who were long bonds who would lose their grip…or those who were short? Lately, the dollar has been rising…and bonds have been doing just fine, thank you. We have a feeling that what we’ve seen so far has only been the first stage of a great bear market in the dollar…which must end in the collapse of U.S. bonds.

A little more from the Money Week Roundtable below…but first…news from our man on Wall Street:


Eric Fry from the concrete jungle, better known as Lower Manhattan…

– With the U.S. financial markets closed in observance of Martin Luther King Day, the foreign stock markets – like latchkey children – were left to fend for themselves. The foreign markets managed to make it through the day unharmed…even without Wall Street’s help. Japan’s Nikkei index jumped 179 points to 11,036, while most European bourses gained half a percent each. South of the border, the Mexican bolsa also gained about half a percent, while the Brazilian Bovespa rallied 1% – close to the 6-year high it reached two weeks ago.

– In the currency markets, the U.S. dollar firmed 0.3% to $1.236 per euro. Despite last week’s dollar rally, few investors are prepared to sound the all-clear for the beleaguered buck. Curiously, even amidst the dollar’s very recent "strength," we find the central bank of Japan continuing to buy dollars to prop up its value against the yen.

– Of course, the Japanese central bank’s dollar purchases are not so surprising. It buys dollars as habitually as a Congressman buys votes. What is somewhat more surprising is the fact that Brazil’s central bank is also trying to prop up the dollar…Yes, it’s true; about two weeks ago the Brazilian central bank began buying dollars for the first time in five years, trying to stem a rally in the Brazilian real that threatens the large South American economy’s export-led recovery.

– Many readers will recall that in 1994 Brazil fixed the dollar/real exchange rate to one-for-one, and managed to maintain that rate for nearly five years. But the real "broke the peg" in early 1999, losing half its value immediately, on its way to losing 75% of its value against the dollar by late 2002. Throughout those years, the Brazilian central bank would periodically intervene to support the real. The idea of SELLING reals to make it even weaker would have been unthinkable.

– Since then, however, the formerly forlorn Brazilian currency has been performing heroically. Over the last year and a half, the real has jumped 40% against the dollar and 14% against the euro. We doubt the real is on its way to becoming the world’s next reserve currency. Still, we wonder how soon the dollar might become the next real…

– But the dollar’s long-term fate will have no impact on today’s stock market action. To the contrary, when America’s professional traders and investors return to their Bloomberg terminals this morning, they will find the global financial marketplace even slightly more agreeable than when they left it last Friday…The dollar is a little stronger, global stock markets are a little higher and U.S. stocks are poised to continue rallying…What’s to worry about?

– The economy is showing unmistakable signs of strength and technology companies are reporting earnings surprises once again. For good measure, interest rates are still hovering at generational lows. Now that the 10-year Treasury bond’s yield has fallen back down to 4%, the mortgage market is showing signs of life.

– Demand for new mortgages jumped 17% for the week ending Jan. 9, according to the Mortgage Bankers Association. The trade group’s mortgage refinance index soared 25%. That’s the good news…But before investors rush out to buy the shares of their favorite mortgage lender, they should know that the latest refinance reading is nearly 80% below the record high set last May.

– A graph of the refinance index trend over the last 8 months looks remarkably similar to the Nasdaq’s price graph after its peak in March, 2000…Is there any fundamental similarity between the refi index and the Nasdaq, or merely a coincidental resemblance? Was the refi boom a Nasdaq- style bubble, or just a stroke of good luck…like winning the lottery?

– And if the refi boom was a bubble, could it reflate, just like the Nasdaq bubble is attempting to do? We are skeptical. On the other hand, financial bubbles and "echo bubbles" are as prevalent in the Greenspan Economy as corrupt mutual fund managers. Indeed, the economy itself – or at least the financial part of it – seems lighter than air.

– May the bubbles never burst.


Bill Bonner, back in London:

*** "That’s the big question," Brian Durrant tried to summarize. "Is the bull market in bonds over or not?"

We did not say so – we didn’t want to interrupt the conversation – but our guess is that it is not. Which is not to say that we would counsel anyone to buy them.

"I can’t recommend bonds to investors," said Andrew Vaughn, investment advisor to the Zürich Club. "They are just too risky. You just can’t make any good case for holding them."

"I don’t see what the problem is," countered Tom Bulford. "I’d be surprised if the dollar fell more this year. People don’t worry about these macro issues. They just want to know if they’ve got the money to make the payments. That’s why British property will go up again this year. As long as there is money available, there will be no problem."

Bulford’s own portfolio of UK small caps rose "more than 50%" last year, he told us. But Hendry’s portfolio of longs and shorts rose more than 100%. Neither claimed bragging rights; it would invite the wrath of the gods.

"There are TV shows of people who gave up their jobs to invest in property," Hendry warned again. "This has got to be a bubble…

"And in the U.S. debt is now 350% of the economy…and the financial economy is more than 4 times as large as the real economy. This is the real bubble…and Bernanke is trying to keep it inflated.

"But Bernanke’s paradox is this: if he gets the inflation he wants, he also gets interest rates up…say to 7% or 7.5%. But the real economy can’t stand interest rates that high."

"That’s right," agreed Denning. "Greenspan gave a speech recently praising the financial economy. All those derivatives make it possible for the U.S. to run even larger deficits, he said, because the markets could sell the debt onward. But to whom? And at what price? Homeowners in America are already having trouble keeping up with mortgage payments – with the lowest rates in half a century. All it would take would be for these markets that Greenspan loves so much to discount American debt just a little bit – driving up interest rates and mortgage payments in the U.S. – and the real economy will be destroyed."

*** Asked to give his one favorite investment recommendation, Hugh Hendry came up with this:

"Coffee. Long coffee. It’s been in a bear market for 20 years. They don’t even bother to pick the coffee beans in some places. Buy coffee."

"Instant or decaf?" we wondered.

*** It is a wicked, inconstant world. We say that in commiseration with our friend Conrad Black. We say ‘friend’ loosely; we only luncheoned with him once, a couple of years ago. Still, we liked his wit and erudition. Conrad likes history, as we do. In fact, he had recently written a history of his hero, Franklin Roosevelt. But we liked him anyway.

But poor Conrad. The papers are all against him. Among many news sources, Conrad owned the Chicago Sun-Times. But his "media empire [is] in tatters," says the New York Times. ABC News reports he was "sacked" by the same. Apparently his money was not up to his ambitions. There never were many people on the planet who could afford to live in the style to which Lord and Lady Black were accustomed, the press tells us. Too bad Conrad and his wife weren’t, either.

Conrad is a big man and a smart one. In his Palm Beach house, he installed a $2.5 million fountain. In Toronto, he built a model of the copper cupola of the dome of St. Peter’s. That he seems to have lived beyond his means distinguishes him from few North Americans. He merely out- did nearly all of them in extravagance.