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.

Cost of "Free" Choice

This Goldman Sachs graph illustrates the explosive growth of movement from Defined Benefit plans to Defined Contribution plans.

In my first post (IBM Freezes Pension Plan), I commented that employees have never understood the tremendous benefits that Defined Benefit plans provide. Just as a teenager underestimates the benefits of living at home, so too do employees underestimate their Defined Benefit plan. I would guess it to be a factor of three.

And just as parents are financially relieved to see these freedom-seeking teenagers go off on their own, so too are companies financially relieved to see employees get control of their money by moving from Defined Benefit plans to 401(k) Defined Contribution plans.

This movement illustrates a powerful force not accounted for in economic theories describing "rational" participants. "Freedom" is a powerful elixir. Individuals would rather control their own outcome to suit their own desires than take a prescribed outcome with generally higher benefits. Recently, Alan Greenspan himself had to intercede as Americans were clamoring to use their own retirement plans rather than the benefits of the Social Security system.

Another fascinating chapter in the story of this principle is about to shape the healthcare world as participants move towards the Consumer-Directed Health Plan approach.

Glenn Greenberg

Near the top of my list of cochamim is investor Glenn Greenberg who is a partner at Chieftain Capital. In reviewing their latest 13F filing (which for the uninitiated is an SEC filing that lists the investment holdings), I sat in amazement at their willingness to put nearly 40% of client funds in one stock - Comcast (CMCSK). I created this graphic analysis of their accumulation of CMCSK.

Studying their decisions reveals a few important truths. First, Chieftain invests heavily in what they understand and can value. Starting in the second quarter of 2002, Chieftain invested about 15% of their funds in CMCSK (after a significant decline). Investment managers typically consider 2% a significant commitment.

Second, Chieftain invests and reinvests for the long term. Chieftain moved this concentration consistently over the next five years from 15% to nearly 40% as the stock price rose. Most investment managers are reducing their positions as the stock price rises and do so over much shorter time horizons.

Third, Chieftain is willing to abandon a position because of management direction. The first time Chieftain reduced their CMCSK was in response to CMCSK's attempt to purchase Disney. Despite a dropping stock price, Chieftain was willing to sell in order to express its disagreement.

Fourth, Chieftain is willing to engage in short term buying and selling. In response to a rapid rise in price, CMCSK took some gains only to return quickly and repurchase those shares. An advantage of such sizeable positions seems to be that short term buying and selling can enhance returns without forcing abdication of the stock.

Aflac: Something to Quack About

Aflac (AFL) is based in Columbus, Georgia and has a wonderful story, for its investors especially. Kenneth Janke, head of investor relations for AFL, reports "Investors who purchased 100 shares in 1955 when Aflac was founded paid $1,110. As a result of 28 stock dividends or splits, those 100 shares had grown to 187,980 shares valued at $9.6 million at the end of April 2007. In addition, those early investors would receive approximately $150,300 in cash dividends in 2007."

FinanceSpeak

So many terms in finance are deceptive that I am not surprised to hear general distrust of the industry. Sometimes I have to reread a paragraph several times to understand the negatives I am actually being presented. I wanted to establish a post to with examples.

The first and most deceptive one is "strengthening reserves." When one reads this phrase in an annual report, it sounds like something good is happening, while it should read "poorly estimated losses and now taking a bath in them." In reading for the reverse, the reports never state "weakening reserves," rather they say "releasing reserves." The proper way, then, to be truthful and clear might be to say "taking reserves," rather than "strengthening reserves."