Overview
The startup insurer, reinsurer, or bank must provide significantly higher returns than the HF or FoHF, without a proportionate increase in risk, or the HF or FoHF manager’s clients, Strategic Investors, and the public are not likely to provide permanent capital.
When any investor makes an investment, he or she surveys the landscape and commits to the one investment whose prospective returns exceed all others of a similar degree of perceived risk and/or legal and regulatory constraints at that moment in time. As such, it is assumed that each investor in a given HF or FoHF has already come to this conclusion about that fund when he or she initially invests and then continues to hold the fund only if there is nothing better to invest the after-tax proceeds of the fund investment into something more promising.
For purposes of this section, we will assume that the prospective investor has narrowed his or her choice to either investing in (or holding, if already an investor) a given hedge fund (alternatively a fund of hedge funds) or investing in an insurer, reinsurer, or bank that allocates all of its investable assets to that same HF or FoHF strategy managed in the same fashion by the same HF or FoHF manager.
To make this choice, the investor needs to examine the sources of return, terms and conditions for the investment, and the risks of a hedge fund or fund of hedge funds relative to those for an insurer, reinsurer, or bank that allocates its investable assets to that given HF or FoHF strategy.
Hedge Fund and Fund of Hedge Funds Investing
When an investor buys into a HF or FoHF at NAV and he or she may be subject to a combination of lock ups, longer than one month redemption periods, lengthy notification periods, and gating limits. When he or she exits, it is also at NAV.
In addition, U.S. taxable investors are taxed each year on any dividend or interest income and any realized gains in the portfolio (if the fund actively trades, these gains are usually subject to ordinary income rates). In the UK and many other jurisdictions, taxable investors are only taxed on their gains when they exit the investment, but at far higher rates than their capital gains rates.
In other words, a $1 million investment in a HF or FoHF comes in at NAV, has limits on its liquidity, compounds at whatever rate of performance, exits at NAV, and may be subject to taxation on annual gains or taxation on exit at very high rates.
For example, assume that $1 million is invested in a HF or FoHF yielding 12% per annum, net of all fees and expenses. Aside from liquidity constraints and taxation issues, the $1 million would grow to $3.11 million in 10 years, for a gross return (net to an offshore or tax-exempt investor) of $2.11 million.
However, if the investor is taxable in the UK, he is subject to a 40% tax on his returns leaving a 10 year net gain of $1.28 million. If he or she were based in Florida (whose 35% rate is 5% lower than the UK rate), he would have only $1.00 in 10 year net gain (the lower return despite a lower tax rate illustrates the power of tax deferral for the UK investor). If he or she were a New Yorker, the 10 year net gain would only be $690 thousand (hardly seems worth the effort relative to New York Municipal bonds).
Investing in Insurers, Reinsurers, and Banks
When that same $1 million is invested in a startup insurer, reinsurer, or bank, the capital works twice. First of all, the equity capital is invested in the HF or FoHF strategy and should earn the same return as the fund (since it can take advantage of less liquid opportunities, it is arguable that it should outperform the fund).
However, the equity capital not only yields the same (or greater) returns as the HF or FoHF strategy, it also provides the statutory capital to support the insurance, reinsurance, or banking businesses (and their attendant profits).
If the insurance, reinsurance, or banking business breaks even, then the insurer, reinsurer, or bank would earn the same (or greater) return that the fund does. If the insurer, reinsurer, or bank loses on its operational activities, then its ROEs would be less than the returns on the identical HF or FoHF strategy. To the extent that the insurer, reinsurer, or bank profits from its operational activities, then the ROEs should exceed those of the HF or FoHF strategy.
As it will be shown, it is relatively easy to make a profit from insurance, reinsurance, or banking operations and very difficult to either consistently lose money in them or lose money over multiple time periods. Assuming that this is true, then each startup insurer, reinsurer, and bank should reasonably be expected to have higher ROEs than a HF or FoHF with an identical investment strategy.
These ROE enhancements can be significant. An insurer or reinsurer with a core investment strategy yielding 12% could readily have ROEs in excess of 30% and a bank with a core strategy yielding 12% could readily have ROEs in excess of 36%.
While these may seem out of line with reality, it must be remembered that a conventional insurer, reinsurer, or bank generally uses long only fixed income instruments in its core investment strategy. When the 12% is reduced to the long-only, fixed income standard of 6%, balance sheet leverage of 2 to 1 means that the higher ROEs we expect would reduce by 18% for a conventional insurer, reinsurer, or a bank (which is about how they actually perform).
Higher ROEs mean that the book value of an insurer, reinsurer or bank will be far higher (proportionately) in the future (when compared to the NAV of the fund or fund of hedge funds with an identical strategy) than the relative proportion of ROE differential, due to Einstein’s eight wonder of the world (compounding). In other words, twice the rate of return means far more than twice the returns over long periods of time.
However, higher ROEs are only part of the story. Insurers and reinsurers tend to trade at 1.25 to 2.5 times book value. Banks tend to trade at 1.5 to 3 times book value (Swiss banks trade from 2.5 x to 4 x of book value). Hedge funds and funds of hedge funds redeem at NAV.
Using a figure closer to the lower of the multiple of book value range (1.5 x for insurers or reinsurers and 2x for banks), the gross value of the investment in an insurer or reinsurer increases by another 50% and doubles for a bank, setting even a greater multiple of distance relative to a like investment in the hedge fund.
Combining the higher ROEs with market multiples, a $1 million investment in an insurer or reinsurer with a core investment strategy yielding 12% should be up $20.7 million in 10 years versus only $2.11 million in a fund with an identical strategy, which is nearly a ten-fold improvement.
A $1 million investment in a bank should be up more than $43.7 million or more than 20 times the return of the fund in 10 years. This gross difference would be the benefit for an offshore investor or a tax-exempt investor and should be more than enough to attract offshore and tax-exempt investors.
If this were not enough, there are additional benefits beyond significantly better returns relative to directly investing in the HF or FoHF for some or all of the investors. Assuming the insurers, reinsurers, and banks are publicly traded, the investor also has daily liquidity (instead of lock ups, periodic liquidity, notice periods, and gaiting that most hedge funds and funds of hedge funds impose).
In addition, there are no annual taxes on earnings at the corporate level nor are there annual taxes on the investor’s share of the earnings for U.S. taxable investors. When U.S. and UK taxable investors (who have held their shares for a proscribed period of time) sell their shares, their gains will be taxed at far lower rates than they would have been if the same amount had been invested in the HF or FoHF with an identical investment strategy. Thus, taxable investors will see a far greater percentage of the gross return after taxes than they would in the fund, so the difference between the insurer, reinsurer, or bank is even greater when compared to after-tax returns of the HF or FoHF.
Tax-exempt investors in the U.S. usually avoid investing in onshore HF and FoHF funds, because they often use leverage, take short positions, and use derivatives, each of which can cause the tax-exempt to generate Unrelated Business Taxable Income (“UBTI”). Consequently, they invest in offshore funds, if at all, and even then, those tax-exempts that are covered by ERISA can cause anguish for offshore funds in terms of making the offshore fund subject to ERISA.
Tax-exempt investors in offshore insurers, reinsurers, and banks are also exempt from these taxation issues and the ERISA issues go away, regardless of the size of the investment relative to the total capital of the company.
While no one should ever invest in a company solely for tax reasons, tax benefits can be a competitive advantage (as the Bermuda insurance industry repeatedly demonstrates) and tax efficiency can also turn average returns for the fundamentals of a business into great returns and great returns for the fundamentals of a business into spectacular returns.
In order of importance, higher ROEs are the primary driver of these superior returns for insurers, reinsurers, and banks that allocate their investable assets in HF or FoHF strategies, followed by market multiples, and tax benefits (only when applicable) as a distant (but not unimportant) third.
Operational Profits without a Proportionate Increase in Risk
All of this sounds good provided that profits occur in the insurance, reinsurance, and banking businesses. While there can be no guarantees, they can generally be operated to virtually assure a profit.
Anecdotally, insurers, reinsurers, and banks have to compete with the rest of the world for equity capital, so they must post earnings comparable to other companies to do so. They can usually do this in one of three ways - invest their assets to achieve equity like returns, be more operationally efficient than the competition (thus increasing operating margins), or price their products higher (without chasing business away).
Since they generally invest their assets in long only fixed income securities, they start in the hole with respect to equity like returns and they must rely on a combination of operating efficiencies or pricing superiority (underwriting in the case of insurers or reinsurers) to make up the difference.
Regulatory regimes often restrict operational efficiencies and pricing opportunities. Because there are few operating efficiencies to be had unless total change is made to the fundamental business (think Berkshire’s GEICO), because regulations and the commoditization of the products tend to harmonize pricing, and because most insurance is high frequency, low severity in nature and all actuaries have identical data, there are very few edges to be had. (In the high severity, low frequency arena, it is arguable that luck plays a huge factor in the results).
Thus, the conclusion is that the industry’s operational efficiency and pricing as a whole is enough to overcome the investment deficiency that takes place due to long-only fixed income investing and if one can simply match the operational efficiencies and pricing of the insurance, reinsurance, or banking industries as a whole, it should make fairly substantial operating profits (after all, the competition must do so to remain competitive for equity capital, given the lag in investment returns).
One of the keys to profitability in insurance, reinsurance, or banking is avoiding one of Taleb’s Black Swans. In insurance or reinsurance this means contractually limiting tail risk or laying it off on a secured basis (converting reinsurance risk to credit risk is not enough). In banking, the key is to avoid significant loan losses.
This is the defensive viewpoint. Let’s examine a more optimistic outlook. There are significant opportunities in insurance, reinsurance, and banking (without proportionate increases in risk) waiting to be grabbed by those with vision.
Most hedge fund strategies depend on finding and exploiting inefficiencies in the capital markets, whereby the pricing tradeoff between risk and return is out of kilter with the natural laws of supply and demand. Systemic inefficiencies are far broader versions of the same idea. They may occur due to regulatory, accounting, taxation, ratings or mass purchasing behaviors that are so out of kilter with the natural laws of supply and demand that they beg to be exploited.
Opportunities in Insurance and Reinsurance
The insurance and reinsurance industries offer a treasure trove of these systemic inefficiencies, beginning with the granddaddy of them all – an investment strategy that is predominant in the portfolios of most of the insurers and reinsurers in the world: Buy and hold, long-only, high-grade, fixed income securities. In the U.S. and in many other jurisdictions, this investment practice is the vestige of a balkanized regulatory environment that has existed for more than 100 years when fixed income investing meant hold to maturity rather than its evolutionary changes over the last 35 years.
In many cases, this cultural DNA has been passed on to successive regulatory offspring who are the result of a Darwinian selection process: those who would be inclined to think differently would never become insurance regulators (or join the insurance or reinsurance industries) and are better suited to the more interesting and higher paying world of investment banking, commercial banking, asset management, and (shudder) hedge funds.
Those who are inclined to accept this old way of thinking are not competitive enough for the more lucrative world (including entry into the higher paying insurance and reinsurance industries) and become insurance regulators by default. This situation is further abetted by the lack of talent in the insurance, reinsurance, and ratings industries, ratings agency practices (just look at the MBIA situation), accounting treatments, and tax regimes.
While financial services are higher up the economic food chain than working as a regulator, employment in the insurance or reinsurance industries or with ratings agencies is still a far cry from the rest of the financial services industry in terms of an interesting environment and compensation, so there are far fewer of the best and brightest in their midst.
By way of anecdotal illustration, a former professor at a top tier business school, who had also served as high level federal regulator and later in a very senior position with a major Wall Street firm, was asked how many of his former students worked for investment banks, large consultancies, commercial banks, asset managers, and hedge funds. In each of those categories, he could think of many. When asked if any of his former students had joined the insurance or reinsurance industries, he could not think of one.
To the extent that the Lehman Bond Index is a proxy for a high grade, long-only fixed income strategy, there are numerous studies that show that a diversified portfolio of hedge funds consistently yields better returns with less volatility than the Lehman Bond Index. The same could be said for many single manager strategies.
Thus, a truly conservative regulator or ratings agency should applaud any insurer that turned its back on long-only fixed income investing for better risk adjusted returns in a diversified portfolio of hedge funds. Ain’t gonna happen. The regulators confuse risk of default with investment risk and regard more volatile assets (that are not likely to default) as less risky than “risky” hedge funds (which also tend not to default).
Anecdotally, if a long-only, buy and hold, fixed income strategy consistently offered higher risk adjusted returns, every Wall Street firm and commercial bank would have nuked their trading floors and gotten rid of those disruptive prima donnas in a New York nanosecond (the interval of time from when a stoplight turns green to the moment a New York taxi driver behind you honks his horn). Hundreds of thousands of man-years of executive bonuses on Wall Street and in commercial banks say otherwise.
It is no mere coincidence that two of the greatest companies in the history of the insurance business, Berkshire Hathaway and AIG, have never followed the conventional wisdom when it came to investment strategy. Buffett is known as the “world’s greatest investor”, not the “world’s greatest insurance guy”, but the results of his insurance and reinsurance businesses have been spectacular. No one else in the insurance or reinsurance industries fills any of the next places on any one’s list of great investors. In the land of the blind, the one-eyed man is king.
Accounting and tax treatments also perpetuate systemic inefficiencies in the insurance and reinsurance industries. Insurers and reinsurers in the U.S. can avoid any mark to market impact on their balance sheet or income statement, when they designate fixed income securities as “held to maturity”.
If they sell any undefaulted securities so designated, they must mark to market the whole “held to maturity” portfolio on the balance sheet that is so designated. If they designate securities “available for sale” in order to take advantage of interest rate changes, they must mark them to market for balance sheet purposes, but not for income statement purposes.
Any fixed income securities available for trading and all other securities (such as equities) must be marked to market for both balance sheet and income statement purposes and any fixed income securities designated as “held to maturity” or “available for sale” that are found to be subject to trading run the result through both the income statement and balance sheet.
For the insurer or reinsurer who worries about smooth earnings growth, trading fixed income securities or holding equities, hedge funds, or funds of hedge funds make the task nearly impossible. Powerful incentive to buy and hold fixed income securities. On the other hand, if one is more focused on compounding since inception (as is Buffett and most hedge fund investors), equities (whether traded or held for the long term), trading fixed income securities, and hedge funds or funds of hedge funds should win out in the end.
Another accounting treatment that alters the natural laws of supply and demand in the insurance and reinsurance industries is that U.S. GAAP does not permit property and casualty insurers or reinsurers to discount their reserves for reporting purposes (but the IRS requires them to do so for tax purposes).
When interest rates are very low, as they have been until recently, there is very little impact on behavior. However, at current levels, many insurers and reinsurers will take a pass on certain liability business because they will have to take an earnings hit and will have to pay taxes on the underwriting “profits” that they can not report at the same time.
Under IFRS, all investments are marked to market for income statement and balance sheet purposes and reserves are discounted for reporting purposes, bringing cash flows and earnings into line with each other (as each year passes, the company earns income on its portfolio to offset the reserve creep that occurs as the discount applies to one year less).
The combination of the investment, regulatory, and tax systems also encourages a significant number of insurers and reinsurers to invest in municipal bonds. In addition, avoiding U.S. taxes has been a major driver in attracting more capital to Bermuda than exists in insurance or reinsurance industries of any other country other than the U.S.
The insurance industry also offers systemic inefficiencies in terms of policyholder behavior. For example, in many forms of insurance, the actuarially fair price for the risk assumed is conveyed to the buyer (usually via an agent) by means of comparison between competing vendors or dictated by regulators. In many others, insurance is ancillary to another transaction (often dictated by a third party), the cost of insurance is small compared to the cost of the transaction, and the buyer is unable to easily compare prices.
Examples of this might include being required to buy title insurance when buying a home or credit life or disability insurance when financing any large purchase. Other examples entail point of sale insurance sales such as warranties, rental car insurance, and extra insurance for shipping packages (UPS built a $2.5 billion business in Bermuda, tax-free, off of this). While insurers compete heavily for this business, the key to success is in sharing the profits with the point of sale or transaction providers.
Given all of these systemic inefficiencies, how does one exploit them? Set up an offshore reinsurance company.
We favor reinsurance over insurance by a wide margin. Insurers tend to be very transaction and operationally intensive. Lots of salesmen, lots of monthly premiums, lots of administration, lots of claims. Reinsurers do not need a lot of people, but they do need persons who are a cross between actuaries and investment bankers to structure contracts.
Thus, our reinsurers tend to take one of several forms, each of which is designed to take advantage of the fact that competitors structure products using buy and hold fixed income returns in their pricing, while our reinsurers assume that the assets will earn superior risk adjusted returns, especially if the assets can be held for more than five years on average, and they can structure the contract and price competitively to get the business.
Recurring themes include:
(1) general reinsurers who provide capital capacity to 4,000 captives and 4,000 small and
medium sized insurers in the U.S. almost all of which are profitable.
(2) specialty (re)insurers that can hedge their risks in the reinsurance or capital markets;
(3) insurers and reinsurers whereby there is an underwriting and/or investment profit
participation with the producers of the business or point of sale gatekeepers
In each case, the objective is to gain long-term assets that earn higher risk adjusted returns for the benefit of both the hedge fund manager (who does not have to make any sales calls) and the shareholders.
When an insurer goes offshore for its reinsurance, the assets become less regulated (investable in hedge funds or funds of hedge funds) and because they now belong to the reinsurer, their returns are untaxed (the onshore insurer’s investment returns would be taxed). Furthermore, if the reinsurer mirrors the onshore insurer’s investment strategy the reinsurer gains no investment edge in assuming risks and needs to have a likelihood of losing less and/or making more on an underwriting risks than the insurer would.
However, when the reinsurer is confident that he will realize superior risk adjusted returns in his investment portfolio relative to the Lehman bond Index or the 10 year Treasury (particularly over longer periods of time), he can leave some of the expected underwriting profit to the insurer in order to attract the business, so he can invest the assets and more than offset the reduced profitability from underwriting (provided that tail risk is capped).
The profitable insurer often reinsures to create capacity to write even more business (earning additional profits) without having to increase its capital (and investing the proceeds the old fashioned way, which hurts future ROEs) or to reduce the capital tied up in the business (most captives). For the profitable insurer, most reinsurance is analogous to a bank securitizing a loan portfolio and collecting fees for servicing it.
Opportunities in Banking
Banking also offers significant systemic inefficiencies. These also include regulatory, accounting, taxation, ratings, supplier, or mass purchasing behaviors that are out of kilter with the natural laws of supply and demand.
Think of how inefficient the processes of gathering deposits and making loans are. Ordinarily, they are people intensive and expensive. Depositors are either too small or have liquidity needs that prevent them from being paid a fair rate for the weighted average duration for their collective deposits. Lenders need to balance spread opportunities against liquidity requirements.
Thus, a bank that can lower the cost of, but pay more, to attract deposits (think ING Direct or the inter-bank wholesale markets) or can pay less (think Swiss private banking) and still attract deposits would have a significant advantage as would a lender that can lower the costs of lending without a proportionate decrease in interest income or increased liquidity issues (think margin lending at Merrill Lynch, prime brokerage to hedge funds, and the inter-bank wholesale markets). Invest the bank’s assets in a better risk adjusted portfolio and/or outsource its proprietary trading activity to the hedge fund industry and move it offshore so that it is barely taxable and the expected returns become very, very attractive.
It is estimated that more than $2 trillion is invested in hedge funds. It is also estimated that 40% to 50% comes from FoHFs and its share of market is growing. Lastly, it is estimated that 25% to 30% of the FoHF business comes from structured products (and margin lending to fund of hedge funds investors) and its share of market is growing. Combining these numbers, structured products account for $200 to $300 billion, which is growing faster than the rest of the hedge fund industry (whose growth is pretty spectacular in and of itself).
Aside from the size and growth of the current market, there are some opportunities that an innovative bank can exploit. First of all, the current business is dominated by a handful of banks and is part of their capital markets operations, rather than the credit operations. Capital markets people are highly paid (compared to credit people) for providing complex, one-off solutions. One fund of hedge funds linked structured product in which we were involved, had 19 separate agreements, totaling more than 500 pages with so many cross references between the documents that our eyes have yet to uncross. Furthermore, we had to pick up the financial products provider’s legal bills of $357,000.
The current nature of the hedge fund linked margin lending and structured products business has two unintended consequences. Because the total number of people with competence in this area is relatively limited, the size of each deal must be rather large (which plays to the compensation aspirations of the capital markets personnel – the more zeros and commas, the better) and each of the incumbent financial products providers places a large minimum for each deal or relationship.
As such, each structure becomes a mini-IPO and the fund manager must have the capability of selling a one off deal (Man Group plc and some of the Swiss banks are extraordinarily good at this) or he must hire an investment bank (to include the financial products providers) to distribute the structure for a fee.
The benefits of standardizing documentation can be seen in the margin lending line item in historic profit and loss statements of Merrill Lynch, Bear Stearns, and Pershing. In each of these cases, tens of thousands of stockbrokers can each lend millions of dollars on a non-recourse basis without going to a credit committee.
Aside from the far lower loan development and operational costs, document standardization would permit the delivery to be in much smaller increments (say $1 million) and be offered on a continuous basis (instead of a mini IPO) by the FoHF manager or sales agents (who would be adding a full portfolio of new products for very little extra effort in managing the assets or cost of launching).
The second unintended consequence of the nature of the hedge fund and funds of hedge funds linked structured product business, is that they are rarely linked to single manager products (as opposed to funds of hedge funds). Part of this is attributable to the minimum size requirements, but part of it is also a perception that single manager strategies entail more risk than funds of hedge funds.
We would argue that a managed account for many single manager strategies would be far less risky than a normal fund of hedge funds. We would also argue that with full transparency and monthly liquidity, a narrower number of hedge funds would also be less risky than a normal fund of hedge funds. A such, the combination of far smaller increments so that a continuous offering might ensue, and linking them to single manager strategies with the proper transparency, liquidity, and volatility profiles could open up a market that could grow as large as today’s market on its own.
Another market inefficiency that can be exploited by banks is the raison d’être for most credit funds. However, if the skills of a credit fund manager could be directed to the loan portfolio of a bank that he or she controlled, then it is arguable that his or her investors would be better off as shareholders in the bank than as investors in a credit fund run by the same lending guru.
Anecdotally, we know of a credit fund whose loan participations were 100% performing. Unfortunately, the fund was levered six to one and when the subprime crisis hit, they suffered redemptions. The prime broker was nowhere to be found to bridge the need, so each $1 of redemptions required $6 of loans to be sold. There were no buyers. As loans were sold at steep discounts, losses were reported and more redemptions occurred. The spiral was on.
Had those same loan participations been on the books of a bank and if they were still performing, there would have been no redemptions or write downs. There is no reason that we can see for a credit fund manager to operate through a fund, instead of his or her own bank.
What’s it all about, Alfie?
Just prior to going public, Goldman Sachs had something on the order of $210 billion of assets, $203 billion of liabilities, only $7 billion of equity, and an off balance sheet swap and derivatives book with a notional value of roughly $3 trillion. Some might argue that the notional value should have been added to both sides of the balance sheet.
Regardless, the assets are the assets are the assets. It is brain power that makes those assets perform. What is amazing about Goldman Sachs is that the duration of its liabilities can be measured in nanoseconds. The duration of liabilities in the life insurance industry is often 30-50 years, so it is arguable that a life insurer that had the brain power to run the assets like Goldman Sachs would be far better suited to handle Goldman Sachs balance sheet (and even more profitable). The same could be said for a property and casualty insurer, a reinsurer or a commercial or private bank.
While a life insurer (or reinsurer) is unlikely to attract that brain power, it can rent it from the hedge fund industry. For all of the structural reasons previously outlined, that is very unlikely to happen. What is more likely to happen is that hedge fund and fund of hedge funds managers will most likely start (or take over – but legacy liabilities and the premium to book value entry fee makes this less likely) insurers, reinsurers, or banks and impose those risk adjusted economics from without.
The total equity capital of the North American life insurance, property and casualty insurance, and reinsurance industries is on the order of $500 billion. The total equity capital of the U.S. banking system is less than $1 trillion. The total equity capital in hedge funds and funds of hedge funds is approximately $2 trillion. Not so far-fetched an idea.
On June 5th, 2007, James Altucher wrote in the Financial Times, “My prediction is that the next big investment move we see will come from Mr. Lampert (Edward Lampert of ESL, which controls both Sears and K-Mart). He will end up doing what Mr Buffett did: getting into insurance. I would not be surprised to see him start his own insurance company or buy one of the more interesting players out there such as Endurance Specialty Insurance or Markel”. http://www.ft.com/cms/s/d98445a0-1302-11dc-a475-000b5df10621.html.
Going into the insurance or reinsurance business is a great idea for Mr. Lampert. Buying either Markel or Endurance is a terrible idea, because Mr. Lampert would be ill-served in trying to acquire either of these companies. To be sure, Markel is a fine company, one of the best in the industry. However, acquiring Markel or Endurance risks taking on unforeseen legacy liabilities (asbestos, pollution, tobacco, Subprime etc.) that rarely turn out to be pleasant surprises later on and can result in frightening financial restatements with alarming frequency.
Assuming that legacy liabilities were not a factor, Markel trades at 1.8 x of book value, so if Mr. Lampert acquired Markel, his capital would only work half as hard as it would if he started a new insurer or reinsurer offshore. A lot less than the nearly $2 billion premium to book value of Markel could buy all of the talent that Markel has and have a lot left over for investment in Lampert’s strategy. Furthermore, his capital would be trapped in the inefficiencies of the U.S. regulatory, ratings agency, accounting, and tax regimes. Lastly, Markel’s earnings are taxed, whereas an offshore startup that replicated the best parts of Markel’s business would not be taxed.
In the case of Endurance, Lampert could avoid the premium to book value (since Endurance trades at 1x of book value) and avoid having his capital trapped in the inefficiencies of the U.S. system, since Endurance is in Bermuda. However, there is a reason that Endurance trades well below the market multiples accorded the industry (such multiples generally apply when the market suspects that liabilities are under-reserved), and complex U.S. tax laws makes it very difficult for a U.S. person or U.S. based business to take over an offshore reinsurer.
As such, we feel Mr. Lampert would be far better off starting his own insurer or reinsurer offshore, so that he can avoid the legacy liabilities, use a small portion of the premium to book value that he would dodge to lure the best talent, and avoid the regulatory, ratings agency, accounting, and tax traps of the U.S. system. It would also allow him to structure the mix of shareholders and voting rights from the outset to avoid unnecessary taxation.