Following on from my post on Level3 and prior to their quarterly results tom0rrow, I thought it was opportune to have a look at the current option pricing for Level3. With data sourced from Yahoo (which generally needs to be treated with caution), the contrast with the liquid Apple options outlined in another post could not be greater. Liquidity is a major issue to consider when looking at options for a firm like Level3. Like the stock itself, illiquid options on a historically volatile stock is not for the faint hearted. That said, the recent stability of the underlying stock over the past 18 months does potentially offer value by way of option pricing formula if Level3 is finally about to deliver on its potential.
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I don’t expect anything major from Level3 tomorrow and would take the selections of Robert Powell at Telecom Ramblings as a reasonable expectation. The long term key for Level3 is sustainable revenue growth but I would be happy with continued marginal movement on costs and EBITDA margin for now.
A confluence of events at my household has led us to finally enter the TV internet age. First, the kids use of the internet and fondness for youtube led to an increase in our broadband plan, then the closure of our local video store (the company went bankrupt, again!), and finally the burn out of our 12 year old television all converged in recent months resulting in us now enjoying the internet on our new TV.
Last night we watched a movie from Netflix (from a selection akin to a very average video store). As the movie downloaded in less a minute, it struck me that the long predicted revolution has indeed arrived (at our household at least). Almost to the day 20 years ago, in the cover story on BusinessWeek on the 12th of July 1993, the then Chairman of Time Warner Gerald Lavin is quoted as saying he envisaged a future where when “I turn on my television, I’ll be able to switch to anything, anywhere”. Of course the article was over optimistic on timing predicting that “interactive TV would get to 20% of US homes by the turn of the century”.
In investing terms over the intervening 20 years much has been lost on predicting the timing and quantum of the financial benefits of online TV and on betting on who the ultimate benefactors will be. Irrespective of the current entertainment benefits to my household, from a personal investing point of view the following quote from trader Yra Harris (see selected quotes gallery on right hand side of blog for more) sums up the lesson my experience brings to mind – “If you’re right at the wrong time, you’re wrong”.
Insurers and industry participants have reacted with the expected bemusement to the announcement on the 18th of July from the Financial Stability Board (FSB) on the list of “too big to fail” insurers, aka G-SIIs or Global Systemically Important Insurers. To be fair, the list of nine – three US, five European and one Chinese – does look inconsistent. No Japanese for example or the inclusion of Aviva but the exclusion of Zurich.
Industry groups such as the Geneva Association and Insurance Europe have asked for clarity on the criteria and more disclosure on the impact. The timetable released by the FSB includes announcing the reinsurers to be designated as G-SIIs by mid 2014 (now that will be interesting given the global focus of a reinsurer’s business model) and the finalization of the additional loss absorption measures for G-SIIs by the end of 2015 with an implementation date of the start of 2019.
The generous diversification credits that large insurers have calculated using economic capital models (likely to be used under Solvency II) can be seen in the graph below based upon data from a sample of published results from 2012 annual reports of a number of European insurance groups.
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The graph shows assumed diversification across risk modules of 30% to 40% but does not show the significant diversification assumed by insurers within risk modules, particularly for the larger firms with a wide spread of business classes. Munich Re, for example, highlights a further 30% and 50% discount in their non-life underwriting risk and market risk modules respectively. Aviva is perhaps startlingly open when it revealed, in its year end results presentation, a diversification discount within its business unit of 45% and a further diversification discount across business units and jurisdictions of 40%. Their gross undiversified capital of £31 billion reduced by 68% to £10 billion after been sprinkled with the diversification magic dust.
Given the competitive advantage that size and diversity brings under the risk based regulatory capital systems being introduced or planned for introduction across the globe, the large insurance groups just named as G-SIIs will likely step up their lobbying efforts to a new level in the next few years against any costly or detrimental measures by the FSB that could impact their hard won competitive advantage. Another avenue for the G-SII to negate any capital impact is to sharper their pencils further on the diversification effects calculated in their economic capital models!
Posted in Insurance Market, Insurance Models
Tagged additional loss absorption measures G-SII, AIG, Allianz, Aviva, AXA, diversification discount, diversification European insurance groups, economic capital models, Financial Stability Board, G-SII, G-SII competitive impact, G-SII timetable, Geneva Association, Global Systemically Important Insurers, Insurance Europe, Munich Re, Prudential, solvency ii, Solvency II competitive advantage, too big to fail insurers, Zurich
Hedge funds are becoming ever more active in the reinsurance space. Initially, the main draw was the ILS space as a source of high yields from an uncorrelated asset class. As the historical returns show (see previous post), this has been a successful strategy over the past 5 to 8 years.
However, as yield seeking investors, particularly from increased pension investment in specialist ILS funds, have flooded the market with supply over the past 12 months with the resulting downward pressure on rates (latest Willis Re report has some Florida rates down 25%), attention may switch towards strategies of getting directly involved in providing capital to the sector. Existing hedge fund backed reinsurers such as Greenlight Re, Third Point, SAC Re and PAC Re have attracted attention, most recently for their tax advantages as per this Bloomberg article in February.
Despite the obvious tax attraction of some hedge fund backed reinsurer strategies (particularly for those focussed on easy to enter commodity markets like property catastrophe), the more solid firms are driven by the leverage that medium to long term insurance float can bring to enhance their investment returns. The daddy of this strategy is of course Warren Buffet. A report entitled “Buffet’s Alpha” from 2012 co-authored by professionals in AQR Capital Management summarises the strategy. The report concludes that “the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails” and “that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance.”
With current accident year underwriting margins thin and reinsurance pricing increasingly driven by black box quant underwriting, it seems inevitable that naïve newcomers will try to repeat Buffet’s formula for success by aggressively chasing insurance float for leverage. Such new capacity, if substantial, will test the sector’s relatively newfound (and hard fought) reputation for underwriting discipline at a time of building headwinds for the sector.
Posted in Insurance Market
Tagged accident year underwriting, AQR Buffets Alpha, hedge funds reinsurance, insurance float leverage, PAC Re, property catastrophe pricing, reinsurance leverage, SAC Re, specialist ILS fund, Third Point Re, underwriting discipline, Warren Buffet float