John Amos, Founder of AFLAC

AFLAC is an amazing company. When I first studied the company over ten years ago, I was certain that the information was wrong. It was inconceivable that a company from south Georgia dominated the insurance market in Japan. But I learned it was true. So much for the fabled inability of U.S. companies to do well in the Japanese market.

I searched for the story and found it in a book titled "The Man From Enterprise: The Story of John Amos, Founder Of AFLAC." After reading about his entrepreneurial childhood, wonderful marriage, early law career, I found what I wanted. In Chapter 16, the author describes that John was on a round-the-world trip with an eighty-one year old friend of his.

On a cold, rainy April day in 1970, John saw something. "Many of the Japanese wore surgical masks to prevent other people from catching their colds. Most people would think...how quaint. John...thought of something else..these were a health conscious people, people who might buy cancer insurance if it could be made available."

Over the next four years, AFLAC worked to get approved. They were not only approved, but granted a monopoly on the writing of supplemental cancer insurance for a period of three years that was extended for eight. The first year was portentous. They expected to write about $3.5 million of premium and ended up writing $25 million. The rest, as they say, is history.

Most Fun Annual Report of 2006.

I have always said that Berkshire Hathaway's (BRK) annual report was the most fun read, but I may have found a contender - the 2006 Annual Report of Mercury General (MCY).

George Joseph and his excellent team at MCY have created a report under "flash movie" that summarizes the developments at MCY since 1962 decade by decade while highlighting some of the cultural changes in the U.S.

To view this, it requires a computer with certain software. It worked great on my computer. Make sure to run your cursor over the little images. Some of the sound effects are wonderful.

What Is Appropriate Exposure?

The financial guarantors, such as MBI, receive a premium from borrowers in order to lower their borrowing costs. For an example, consider a company which wants to borrow $10 million. Also, in this example, let's assume the company is considered investment grade. Such a company may find that by "wrapping" its bond with a financial guarantee provided by a guarantor, the interest rate may be reduced by more than than cost of the guarantee.

This "free lunch" is a result of asymmetry of information, that is, the financial guarantor may have a greater understanding of the risk than the investor. The principle here is similar to the father who cosigns an auto loan for a child. Not only does the lender receive the additional comfort of the father's financial statement, but the father also, ("theoretically" as my partner Joel says), knows better the likelihood of the child's repayment.

By providing a guarantee, the financial guarantor exposes a portion of its portfolio to risk. For example, the financial guarantor may have a multi-billion dollar capital base. By guaranteeing the bond of the company above, how much of the capital base of the guarantor should be "set aside" to fund the risk that the company may have a problem?

The first answer is $10 million. Intuitively, this simple answer seems too conservative. If the company is investment grade, then some rating agency discovered enough ability to repay its IOU so that a complete loss, while possible, would be highly unlikely.

The second answer would be to simply fund a "gap" number by understanding the difference between the current investment grade rating and a AAA rating. A AAA rating is a result of what's backing up the IOU. If Company XYZ has $10 million in cash backing up a $10 million IOU, then it wouldn't need the guarantor. But the company may have some real estate assets or receivables which could be used as collateral. The more collateral, the higher the rating.

If a company needs, for example, 12% overcollateralization to achieve AAA rating, then a $10 million loan would need $11.2 million in collateral. If the company has only put up a 5% overcollateralization to achieve the investment grade rating, then the "gap" number would be $700,000.

The third answer is a statistical modeling approach. This approach takes historical default rates of investment grade bonds and simply applies the loss rate as an average. So, for example, if investment grade bonds have failed 1% of the time, then $100,000 would be set aside as the appropriate exposure.

You can see a wide variety of choices. These model in a real way the challenges faced by the current situation for financial guarantors.