The revenge of the balance sheet

I’ve been building up to this piece for a while now. It’s a little bit like the end of the season episode where you get the payoff for the various plotlines.

Today I’m going to tie together all my scepticism of MGAs, my views on overvalued brokers, the importance of the reinsurance market turn, and the impact of higher interest rates and inflation to make the Big Argument:

You want to be a balance sheet going forward. The days of asset-light are in the past. It is still the better model over the long term, but not during an inflationary era.

Don’t live in the past

One of the most important skills to have as a strategist or analyst is being able to recognise paradigm shifts. For example, cat models were a paradigm shift. Insurance-linked securities were a paradigm shift. Credit scoring and now UBI in auto were a paradigm shift.

From a macro standpoint, the low interest rate era after the financial crisis was a paradigm shift. The lower return on capital disadvantaged balance sheets (not enough reward for the risk) and the easy money built excess capacity which led to more competition.

This rewarded asset-light strategies such as brokers and MGAs that could easily find balance sheet capacity for mediocre business, demand higher commissions and use cheap funding to accelerate M&A.

There was no reason to have a balance sheet in insurance unless you were a legacy player stuck with one.

However, many asset-light players misjudged the permanence of this state of affairs. In other words, they thought it was the forever state, not just an extended cycle.

With the return of inflation and the likelihood that we have entered a new paradigm, strategies need to adapt. I call this new era the revenge of the balance sheet.

Why do you want to be a balance sheet in an inflationary world?

You can think of these as float, moat and boat. (You likely know the first two from Warren Buffett. Think of the third as when you have the only boat at the river crossing. That’s pricing power!)

Before I expand on these, you might object that didn’t Buffett buy asset-light businesses in the 1970s and 1980s to beat inflation? He did, but that’s also when he bought his big insurance balance sheets.

There are also important differences between brokers and Coke that I’ll explain later, but let’s get to the main points first.

Float (cheap funding)

Buffett bought those insurers for the cheap float, as we all know. While float has been cheap in recent years, it wasn’t all that exciting when you could otherwise borrow for free.

But if traditional debt is going to cost 5-10 percent, then float at negative 5-10 percent is now the best thing since sliced peanut brittle.

Not to mention, you get to leverage that negative cost float at 2-3x (or 10x on a life insurer). The ROE on investing will overwhelm the ROE from underwriting.

Investors are going to very much want to own balance sheets. An insurance licence will become a valued asset.

I could make an argument that someone should have bought Argo for the opportunity to reposition it as a total return play (drastically overhaul the underwriting and write “boring” business with mid-long duration).

Moat (barrier to entry)

It’s really hard to build a traditional underwriter. It takes a lot of capital, lots of people, licences, claims organisations, big investment departments, a distribution platform, a recognised brand, a strong rating. I could go on.

These things don’t happen overnight. That’s why even crappy ones will get acquired at premium valuations. The cost to buy can be far less than the cost to build.

If someone wants to start a new MGA, they can be in business relatively quickly. To create a new US-based insurer is a heavy lift. Even if you get the licences, it will be decades before you are able to grow reliably and simultaneously underwrite profitably.

Even during the easy money era, new entrants learned how hard it was to build a profitable insurer. Imagine how much harder it gets going forward when capital isn’t free.

Once markets realise that balance sheets are good again and that there aren’t that many of consequence left, valuations will rise to reflect the scarcity value.

Boat (pricing power)

While most commodity industries with high capital intensity have low returns over time, there are exceptions. These exceptions usually occur when there is some constriction on capacity that is hard to resolve.

I already wrote about how insurance may well be going through a moment of prolonged capacity shortage given the lack of interest from pension and private equity investors, the flop of insurtech underwriters, the low valuations of public companies (especially smaller ones), etc., combined with the realisation among management that certainty over the future is clouded (by climate, cats, etc.).

If this thesis plays out and capacity is slow to return, prices will remain higher than normal and the cost of float will be even cheaper.

Asset-light but people-heavy

Let me return to the “doesn’t asset-light win during inflation” argument? Asset-light doesn’t buffer you from inflation if you can’t raise prices as fast as wages.

Financial repression keeps wages down while inflation moves them up. It’s great to be a broker when fees are rising and wages are barely moving. It kind of sucks when fees are being pressured at the same time your people need 5 percent raises.

Brokers spent the last 15 years pitting carriers with too much capital against each other to drive commissions up, charge for ancillary services, etc. while keeping wages down. That’s how margins kept going up each and every year!

Those days are now over. This is why I am negative on margins going forward.

Worse, the leverage inherent in the private brokers means a decline in margins could be catastrophic. Wait until underwriters figure out that brokers can’t afford to push back on rate increases for clients because they need to keep commissions up!

As for the Buffett and Coke argument, the reason Buffett bought Coke was because it made an important change where it sold off its bottlers to become asset-light. It knew it had market power over the bottlers and could drive better terms.

In other words, it shifted costs in the system from distribution to manufacturing. Brokers and MGAs can’t do that anymore because they have already played the Coke card. There is no room left to squeeze carriers further.

Eventually, the bottlers got pushed too far and Coke had to buy them back (and has since spun them off again). The brokers are about to find out what happens when the balance sheets push back.

New strategies

So how should one react to this changing environment? I mean there is the obvious piece which is sell your brokers at 15+x Ebitda while you still can and look for some underwriters in the turnaround pile that may be fixable.

I suspect we’ll see the private equity types look for cheap balance sheets they can try to transform. They have experience in this though it often hasn’t worked out well over the last cycle.

But with the ability to now use the asset side of the balance sheet as a partial funding source, I bet we will see creative private equity deals going forward.

Like I said, Argo was a viable test strategy for this approach and I suspect some other private equity-held insurers will head down this path soon.

Bermuda may become more viable again if more of the ROE is coming from NII going forward since the excise tax only applies on the underwriting side. Tax-free investment income is very attractive. Max Re 2?

I also suspect investment firms will find new ways to partner with insurers to promise higher returns on float in return for part of the upside. Again, Max Re 2?

This would also be a decent time to try a modified version of a Markel or Cincinnati asset strategy though perhaps with a credit bent rather than primarily equities.

I’m sure creative types will explore options I haven’t considered as well.

What can go wrong?

Plenty. I didn’t say underwriters were going to suddenly be smarter. Tailwinds don’t guarantee success.

There will still be bad underwriting. There will still be reckless pursuit of growth. There will be cats. There will be excess investment risk taken.

I am not declaring insurance balance sheets are suddenly wonderful businesses. But they are going to have tailwinds which will make them the most attractive they’ve been in a long time.

If you stubbornly dismiss them because of the last 15 years, you will likely look foolish.

There is an old saying at the racetrack: there are horses for courses. You bet differently on a muddy track than a fast surface.

The financial world is now on a muddy track. Place your bets accordingly.

Ian Gutterman is an insurance industry investor and the founder of Informed Group, a start-up homeowners insurer seeking to change the way people buy home insurance. His regular Nominal Returns blog can be found here.