Snarls in Insurance Investigation, Part 2

Investment Implications

I have made money on the long side through both Spitzer investigations (the investigation into insurance brokers Marsh & McLennan (MMC - commentary - Cramer's Take) and Aon (AOC - commentary - Cramer's Take), and the investigation into Universal Life Resources) so far on these positions:

Assurant (AIZ - commentary - Cramer's Take)
Allstate (ALL - commentary - Cramer's Take)
Endurance Specialty Holdings (ENH - commentary - Cramer's Take)
MetLife (MET - commentary - Cramer's Take)
Montpelier Re Holdings (MRH - commentary - Cramer's Take)
Old Republic International (ORI - commentary - Cramer's Take)
PartnerRe (PRE - commentary - Cramer's Take)
Prudential (PRU - commentary - Cramer's Take)
Reinsurance Group of America (RGA - commentary - Cramer's Take)
Safety Insurance (SAFT - commentary - Cramer's Take)
StanCorp Financial Group (SFG - commentary - Cramer's Take)

I don't think that the present investigations at their worst will have a material negative economic effect on any of these names.

The big brokers are another story. I would continue to avoid Marsh & McLennan and Aon. There are so many issues to be resolved there with so many parties that estimates of future earnings are problematic. Add to that a weak trend for casualty insurance premium rates, a possible willingness of large insureds to go without a broker in the future (though this is unlikely because risk managers need someone to blame) and brisk competition in the broker space, and the mix seems pretty toxic to me.

Possible Shorts: Debt-Rating Agencies

One area that might offer some interest for shorting is the debt-rating agencies. The main U.S. public players here are Moody's (MCO - commentary - Cramer's Take) and McGraw-Hill (MHP - commentary - Cramer's Take), which owns Standard & Poor's.

Spitzer has specialized in going after multiplayer relationships where there are overlapping economic payments and representations. In the debt-rating business, fees are paid by the issuer of debt, and the recipients of the research usually have to pay for the detailed analyses. Issuers often select the rating agencies that give them the most favorable ratings, subject to a limit on believability in the bond market (more ratings are better). Rejected agencies occasionally publish what are colloquially known as "retaliatory ratings." (The nice term is "unsolicited ratings"; the less tactful term is "hostile ratings.")

Usually there are few retaliatory ratings, and ratings are usually reasonable. But at its worst, the system resembles a protection racket. Ratings are so critical for a country, state, municipality, company or project to be able to access the debt markets that the loss of them can be devastating.

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At time of publication, Merkel and/or his fund was long Assurant, Allstate, Endurance Specialty Holdings, MetLife, Montpelier Re Holdings, Old Republic International, PartnerRe, Prudential, Reinsurance Group of America, Safety Insurance and StanCorp Financial Group, though positions may change at any time.

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.