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Monday, February 8, 1999

An Investment Opinion
by Alex Schay

Know Business Risk Like an Insurer

As we noted at the top of the news, specialty insurance holding company Executive Risk (NYSE: ER) gained $21 1/8 to $65 1/8 today after Chubb Corp. (NYSE: CB) agreed to buy the firm for $71.71 per share in Chubb stock -- a hefty 63% premium to Friday's closing price. Through its various subsidiaries, Executive Risk develops, markets, and underwrites a number of liability insurance plans, including directors and officers liability insurance (D&O), which constitutes the largest class of business for the company (about 50%).

Executive Risk ranks among the top-five writers of D&O insurance in the U.S. -- with about 10% market share -- and one of the major factors motivating Chubb's move today has to be Executive Risk's underwriting performance. For most of the 1990s the firm's average statutory combined ratio has been about 13 percentage points lower than its "commercial lines" peer group, and about 11 percentage points better than the broader Property/Casualty industry (according to the firm, click on ITEM 1: Business section).

Don't all insurance firms have access to the same information with which to fill their databases and employ in their complex analytical applications, like Equal Employment Opportunity Commission (EEOC) reports on the number of discrimination complaints received by local agencies, or the number of sexual harassment charges filed with the EEOC? Don't all insurance firms that write policies in the D&O business know the permutations of the Americans With Disabilities Act and the Family Medical Leave Act? How can one company outperform? How does Executive Risk assess its own policy risk in such a consistently profitable way?

Without stretching the analogy too far, it's pretty clear that many of the same questions laid at the doorstep of outperforming insurance firms can also be re-packaged for delivery to investment "gooroos." The key question being, how do both groups "act" in a more profitable manner than the rest of the pack when presented with the same information? Insurance companies are really engaged in the "science" of risk on a daily basis, and therefore, are fascinating in my mind -- because risk is all about putting the future at the service of the present (to paraphrase Peter Bernstein). I used to think that analyzing insurance companies was about one step removed, on the boredom hierarchy, from watching paint dry. However, looked at the evolution of risk management, even the most jaded investors have to be amazed at the conceptual underpinnings of the modern insurance company.

Here's what Executive Risk would probably cite as some of the key factors in its success (taken from the 10K):

-- "The Company's general underwriting philosophy stresses two factors: expert consideration of complex insurance submissions, and profitability over premium growth."

-- "A large portion of the company's policies have a one-year term, though the number of multi-year policies has been growing in recent years. One-year terms offer the insurer the advantage of re-underwriting and repricing a risk, to take more frequent account of claims or other changes in the exposure."

-- "The Company emphasizes industry specialization within its underwriting staff, which includes a number of professionals with operational experience from the industries being underwritten."

Paying particular attention to the last item, Executive Risk has noted, "Within each of the principal D&O sectors, ERI has targeted subsectors and developed specialized expertise, a strategy that management believes has allowed ERMA and the Insurance Subsidiaries to develop and adapt their insurance products more knowledgeably and to underwrite submissions and process claims more professionally than competing companies."

While it borders on the absurd to state that success is dependent on really "knowing" a business and having an information advantage, think back to an investment you have made where you felt you were blindsided by a company -- only to conclude later that you really didn't know the business well enough to see the potential outcome. Most of us can probably say that has happened at least once in our investment careers.

A great story attributed to Wells Fargo/Nikko Investment Advisors, and related in the March 1995 edition of Global Currents, can serve to illuminate the problem area. A group of hikers come upon a high, narrow, and rickety bridge during the course of their travels and conclude that if they pass over it, the act will save them a number of hours of hiking time in their attempt to reach "home base." So they outfit themselves with the necessary ropes and harnesses in order to try and prevent any loss of life in the event of a bridge collapse. Finally, once they have all reached the other side successfully -- they encounter a hungry mountain lion that has been patiently awaiting their arrival.

Risk has many different dimensions, but even so-called "exogenous events" like the Asian financial crisis and hungry mountain lions should not come as a "surprise" to the investor who knows the investment "territory." Attempting to quantify these risks has been the province of Modern Portfolio Theory, which ironically has remained pretty much unchanged since Markowitz set the ball rolling in June 1952 with the publication of a fourteen page article entitled, "Portfolio Selection," in the Journal of Finance.

To a statistician, expected return is the probability weighted average of possible returns, and risk refers to the bunching of possible returns around the expected return. A method of measuring this tendency to cluster around an expected return is to come up with the probability weighted average of the deviations of possible returns from the expected return. A common average used in this endeavor is standard deviation. As Peter Bernstein notes in Against the Gods: The Remarkable Story of Risk, Markowitz makes no mention of the word "risk" in describing his investment strategy, but rather, the "objective in 'Portfolio Selection' was to use the notion of risk to construct portfolios for investors who 'consider expected return a desirable thing and variance of return an undesirable thing.'"

Variance, a concept mathematically linked to standard deviation, has since been enshrined by institutional investors as the "undesirable thing." For the last forty years, variance and risk have become synonymous. Perhaps, the best counter to this is offered by Warren Buffett (in both articulating the case, as well as Berkshire's performance returns):

"Finance departments teach that volatility equals risk. Now they want to measure risk. And they don't know any other way -- they don't know how to do it, basically. So they say that volatility measures risk. I've often used the example of the Washington Post stock when we first bought it: In 1973, it had gone down almost 50% -- from a valuation of the whole company of close to say $180 or $175 million down to maybe $80 million or $90 million. And because it happened very fast, the beta of the stock had actually increased. A professsor would have told you that the stock of the company was more risky if you bought it for $80 million than if you bought it for $170 million... we think first in terms of business risk. The key to Ben Graham's approach to investing is not thinking of stocks as pieces of paper or as part of of the stock market. Stocks are pieces of businesses."

If you want to be successful at focusing on business risk you have to be more like an insurance company. By knowing the business inside out and upside down, you also get the best handle on the risks involved.

Of course, an investor's time horizon has the effect of transforming the risk calculus, because as one risk commentator observed, "Volatility per se, be it related to weather, portfolio returns, or the timing of one's morning newspaper delivery, is simply a benign statistical probability factor that tells us nothing about risk until coupled with a consequence." A stock may get clobbered in the short term, but it only means something if you sell it during that same time period. What does volatility mean for the long-term investor?

Jeremy Siegel's book Stocks for the Long Run is not some fuzzy treatise about the "buy and hold" approach, but a relatively sophisticated discussion of managing risk. The thesis being that according to historical return data, risk is minimized over "sufficient" periods of time in such a way that stocks have never offered investors a negative real holding period return yield over blocks of time of 17 years or more (in contrast with bonds or T-bills). So, focus on the business, focus on the long run, and you won't have to focus as much on the returns.

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