Scare up returns in emerging markets

Wed Aug 20, 2014

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A suggestion for making premium bets.

By Adam Bain

"The only thing you've got in this world is what you can sell."
--- Arthur Miller, Death of a Salesman

What did Willy Loman actually sell? Arthur Miller purposefully avoided telling the audience exactly what Willy peddled so they might identify with his plight more readily. He could have sold vacuum cleaners or toothpaste…I always thought Willy sold insurance. My dad and my grandfather sold insurance, and while they successfully provided for their families and were/are far more upbeat than Mr. Loman, insurance seemed to me, well, boring. In my mind, it was the quintessence of mundane. I wanted to be a doctor. Eventually, I became more interested in business than in biology. Now, I spend much of my time thinking about businesses and the more I learn, the more interesting I think the insurance business is. The insurance business is robust due to four key factors:

  1. Essential for Economic Expansion - Said simply, were it not for insurance, credit transactions would simply not exist, or at least be reduced to bare minimums. Insurance reduces risk, which creates a more effective platform for transactions and allows for increased investment. This also means there is inherent demand for the product.
  2. Scalability - Insurance depends on the law of large numbers. In fact the nature of actuarial math requires that insurance companies have a large and diversified client base, which can be done with a relatively small number of people and little CAPEX. Said differently, creating supply is inexpensive.
  3. Passive Income - though insurance contracts are time limited agreements which expire and must be continually renewed, the renewel is often more or less automatic and requires little "re-sell." Additionally, many forms of insurance require just the one point of sale, and effectively become annuity streams for the insurance company.
  4. Fear Sells Better Than Greed - this is a bonus to the demand side of the equation as humans tend to misprice tail events. They are therefore willing to pay a lot to avoid painful events, even if those events are statistically unlikely.

Selling Volatility

In macro hedge fund parlance, selling insurance is more or less synonymous with selling volatility, and therefore something to be avoided. Chris Cole at Artemis Capital, a volatility fund in Austin said recently, "There are really only two asset classes: long vol and short vol." While that is probably a very good way to look at the world if you're a hedge fund manager, I highlight the maxim in order to show two major differences between a hedge fund selling "insurance" and an insurance company.

The first of which is rooted in Gaussian distribution and actuarial math. In simple English, Gaussian functions are often used to describe a normal distribution, or a bell curve. This is a largely just a plot of outcomes, most of which fall in middle of the bell, while a smaller, and therefore much less likely, number fall into the tails (as in very positive or very negative). Actuarial math is regularly applied to these statistical standards to underwrite insurance policies. For example, such calculations might be used to determine how likely you are to be in an accident and subsequently make a claim on your car insurance, given some other variable inputs. As a data set increases, averages become "truer," making your losses more predictable and your business more stable. These same functions and standards are often used in markets as a quantitative basis for pricing "insurance" such as options or CDS. There is, however, an inherent flaw in the model which for some reason is frequently forgotten. Markets are a reflection of an outcome, not an outcome itself. More specifically, markets are reflexive and as such have a much greater convexity than events themselves. For example, a hurricane may create significant damage, but doesn't usually start a chain reaction of other hurricanes, where asset selling as a result of said hurricane may create much more reactionary selling and a much wider swing in market pricing than is merited by the fundamentals. It is for this reason that both market pricing in market "insurance" instruments and the predictability of outcomes within markets are subject to more "fat tails." Fortunately for insurance companies, the real world is, on average, more predictable.

The second major difference is structure. I noted briefly in my May writing that a hedge fund structure is usually not conducive to selling volatility. First, the capital base for a hedge fund and the liquidity terms are generally not appropriate for earning that type of risk premium. Maybe most importantly, the risk reward profile sought from a hedge fund investment is generally different from what is expected from a pure equity investment. An appropriately capitalized company with good access to financing and a consistent customer base is a far better structure for selling insurance because the volatility is but one factor in the quarterly report and because the stakeholders expect it.

Finding Prime Markets

Now that we've established the insurance business is a decent business, the question becomes, what is the right environment in which to operate? Think about who the market leaders were in the insurance business 30 years ago. Many of the same companies are still at the top of those league tables today. These companies have also been compounding machines, achieving exceptionally high returns for shareholders. Progressive, for example, has made 139x for an investor who invested in 1985, versus 18x for the same investment in the S&P. Similar results have been achieved in emerging markets. Standard Charter, one of Asia's largest insurers (based in Hong Kong) has done 115x since 2000. While those are probably still good businesses to invest in, they don't have quite the growth potential they once had given the maturity of the markets within which they operate. It seems the logical path is to find the next "emerging markets," places that have a good foundation for growth. More specifically, they have:

  1. Demographic Tailwinds
  2. Significant Increases in Per Capita Income
  3. Access to Technology (namely smartphones and internet)
Not surprisingly, there is a pretty clear correlation between GDP growth and insurance penetration. When people move from low income to middle income, the primary industry beneficiaries are financial services, consumer goods, and healthcare.

Clearly, there are other concerns as well; government stability, rule of law, etc. that may weed out some "frontier markets," there are a number of markets, that fit the above profile and are just now reaching the point in their evolutionary cycle where economies of scale become attractive and barriers to entry are significant enough to make starting from scratch difficult. Such places might include Ghana, Nigeria, Indonesia, Bangladesh and a few more. Insurance is a local game, where relationships, brand, and local management matter. As such, there are a number of insurers already at work in these countries. Most frontier markets have somewhere between 10 and 100 insurance companies already operating in the area. Therefore, there are already some established market leaders and brand names, but how does one invest there?

Based on all of the above, one might describe the ideal insurance investment as one in which a company (not a fund) buys controlling interests in market leading insurance companies, in markets that are primed for growth based on the above criteria. Moreover, one installs high level management and oversight (one might pull a team for a large and very reputable global management consulting firm for example) to operate those companies across a broad geographic spectrum, thus diversifying the risk. Fortunately, if all else fails, the principal investment can be insured!

Death of a Salesman Redux

As a resident of Los Angeles, I'm surrounded by people writing ridiculous plotlines for movies. Maybe I'll re-write Death of a Salesman, except this time Willy Loman will be an animal insurance titan and his biggest problem will be figuring out what to do with all his money.

As always, questions, comments, and/or constructive criticisms are encouraged.

Adam Bain is founder and managing partner of Stormont Capital Advisors, a business development consulting firm serving alternative asset managers. This column was adapted from a client communication.

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