5) Why is there still conflicting messages about hedging? On the CC, the CEO mishandled a discussion about a potential drawdown in equity markets. Prem's letter went to great lengths to communicate that there would be no more equity hedging because FFH learned its lesson. It also observes that US economic growth has been strong, rates have bumped up, inflation looks like it's bottomed out, there's a long runway, etc, but despite those clear and obvious conditions, FFH will continue to hold CPI derivatives worth a notional $114 billion. About this, I am perplexed. It's only a $25m market value, but if you are trying to communicate that you are moving on from hedging mistakes in the past, why not liquidate this position. That large notional value demonstrates that FFH was only speculating on inflation to begin with (ie, if you were hedging you would choose a hedge ratio and then buy your protection...the CPI derivatives exceed FFH's combined assets and gross revenue for a year). If Prem and Brian have changed their perspective about world markets (which is a legitimate thing to do, and there's no shame in changing your mind), just sell the damned things and recoup the $25m, which happens to be about $1/share of capital.
Haven't read the letter yet, but thanks for your summary - useful.
I'm not sure relating the notional to revenues or assets is useful. They'd only make the notional if absolute CPI went to zero, IIRC, and that seems unlikely! They could have made a couple of billion, maybe more in a depression, but nothing like the size of the notional. My major complaint is not that they hold this but that they should have structured their hedges this way: deep out of the money derivatives that offer outsized gains on low probability outcomes for (relatively) low absolute cost.
Okay, I guess the starting point of the conversation should be, "What is FFH trying to hedge against?" What would be the bad outcome of deflation that requires protection? I can offer a few possibilities: 1) FFH's fixed interest debt increases in real terms as a result of deflation, 2) FFH's equity portfolio might be adversely affected by deflation, 3) the collectability of amounts from reinsurers might become dubious, 4) corporate bonds could become shakey, 5) other?
On the liability side, deflation might actually result in reserve releases because presumably IBNR would decline? Deflation would be good for the real value of their sovereign bonds and possibly their munis. What else?
So net it out: what's their net exposure? What kind of hedge ratio should be selected for that notional exposure (somewhere between 0% and 100%)?
I thought I was being rather charitable when I compared the $100+ billion to their total assets. If you assume that the entire asset base would be adversely affected by inflation with no offsetting benefit on liabilities, and if you were so risk averse that you wanted a 100% hedge ratio, you need what, ~$64 billion notional? Being even more charitable, assume that a year of revenue would all be adversely affected with no offsetting benefit from expenses, that would be another $18-ish billion? So in my wildest dreams, that wold be ~$80 billion notional protection required?
Hedging is hedging. Speculation is speculation. So which is FFH currently doing, and does it mesh in any way with Prem's broader macro observations in the letter?
Re the other insurance operations, no, you're not alone, although several of these are in places where you can earn high real interest rates in fixed income with relatively little risk (e.g. Brazilian sovereign bonds). That transforms the economics of a 98% CR. Also, some of these businesses will probably benefit from operating leverage as they scale.
Sure, that's the theory, but what do you make of page 59 in the AR (or for that matter, the Asia breakdown on page 115)? Did we get a fair return on the capital that FFH has deployed? Adjusting for the risk of holding assets in shit-hole countries which do not always have a strong legal system, low levels of corruption, or stable central bank policy, are you happy with what you see on page 59? What kind of return would be fair for the risks involved with shit-hole assets?
SJ