After 35 years of stockbroking for some of the biggest houses and investors in Australia and the UK, the Secret Broker is regaling Stockhead readers with his colourful war stories — from the trading floor to the dealer’s desk.

Sometimes, allowing people to go too far their own way can lead them straight into jail, when they choose not to follow a few simple rules and bite off more than they can chew.

If you look at one of the richest men in the world and follow his simple rules on investing, then you shouldn’t go too far wrong.

I love studying and reading about how Warren Buffet uses his disciplined approach to build wealth and how running an insurance company helps build wealth for his shareholders.

Then, over here in Australia, a couple of ego driven chaps who both started out in the same industry became undisciplined and came out with their shareholders facing the final curtain with absolutely nothing.

Our two chaps, Rodney Adler and Ray Williams, both ran insurance companies, just like Warren still does, yet both of them ended up in jail.

Same industry. Bipolar result.

Warren loves the fact that when you own an insurance company, you get free cash flow from all those premiums coming in. Then if you invest this free cash flow into other investments that create even more free cash flow, you are multiplying your returns all round.

Our two jail birds could have done the same, but unfortunately for them and their shareholders there were more than a few regrets when they went off and did it their way.

 

How insurance is like the bookies

Insurance is one of the most profitable industries on the planet. Companies use statistics every second of the day to calculate what monthly premiums to charge their customers, in the same way as a bookmaker calculates what odds to offer.

Where it gets tricky for insurance companies is allocating what future liabilities they are up for when underwriting other people’s risks. That is why they ask so many questions before giving you a quote.

Even the colour of your car can effect what premiums they will charge you.

They use the same terminology in the insurance industry as in the stock market, with the terms a ‘short’ tail and a ‘long’ tail.

A short tail is used to describe their liabilities when underwriting car insurance or anything that is settled quickly. Crash the car, get it repaired, all paid and settled within a month or two and incoming premiums can cover most of this off.

Long tail is used to describe their long-term liabilities, which are unknown but statistically calculated with a little sprinkle of guesswork. Death, disability and income protection are all examples of an anticipated liability, which may occur and have to be cared for, at a future but yet unknown date.

I use the term anticipated, as even on an insured payout upon death, an average of 14 out of every 100,000 claims are disputed and I presume they deem those 14 people as being immortal.

(Now here’s a tip for you: If your strict Catholic Filipino parents insisted on naming you Jesus, then we would suggest using your middle name when filling in your life insurance application).

Another interesting fact I discovered is if you go through a broker, instead of going direct to an insurance company, then the disputed payout ratio falls to six out of every 100,000 claims. This is because they fight harder for you or they know the old first name trick.

 

Where it all went wrong

So, how is it that one person can get it spectacularly right and others fail so miserably?

Well, a lot of it is to do with how they manage their long tail liabilities and how they handle their PCA coverage ratio. PCA stands for Prescribed Capital Amount and if your insurance company has a PCA coverage ratio of two, then it has enough liquid assets to cover off on any future liabilities two times over.

In Australia, the coverage average ratio is around 1.68 times but (and this is where the trouble begins) this ratio does not discriminate on the size of the insurance company.

Even if they are valued at $50bn or at $50m and this ratio deteriorates because of bad investment decisions and it falls below say one, then they cannot cover off their future liabilities and will collapse.

In the case of Rodney Adler and Ray Williams, they could see that both of the insurance companies they headed up were experiencing a deteriorating ratio cover and they thought that by merging their two companies together, they could improve it.

This tactic in fact had the opposite effect, as Rodney’s insurance company contained too many dog investments and, like trying to save a drowning man, Ray got pulled under with him.

 

A win-win but not really

The merger of their two listed companies, FAI Insurance and HIH Insurance, was promoted by both of them as a win-win situation for everyone involved, whereas in reality the writing for both of them was on the wall and before FAI got eaten up, Ray should have spat it out.

In 1998, HIH purchased FAI for $300m dollars and this purchase, which I don’t say in a shy way, led to the biggest insurance company collapse in Australian history.

The combined group when it collapsed on the 15th of March (beware of the Ides of March!) 2001, was valued at $5.3bn and came 32 years after HIH was founded by Ray.

In 2005, both men got sentenced to four-and-a-half years in jail and were stripped of their Orders of Australia medals. In 2005, Warren was worth $40bn, and today is worth $US83bn and his insurance investments generate $US100m of free cash flow every day.

If the other two had just followed the simple philosophy of looking for cash generating investments, instead of chasing assets which produced the opposite, then they would both be billionaires today and their shareholders would be like Warren’s, laughing all the way to the AGM.

Now, watch this:

And then join in with me and follow the words to the Frank Sinatra song.

If you imagine Rodney and Ray, arm in arm, singing this song together in the prison Christmas panto and then you imagine Warren singing this at one of his AGM’s, then you will see how the words work for both winners and losers.

Same song. Bipolar effect!

So now, after three, sing with me:

And now, the end is near

And so I face the final curtain

My friends, I’ll say it clear

I’ll state my case of which I’m certain

I’ve lived a life that’s full

I travelled each and every highway

But more, much more than this

I did it my way

Regrets, I’ve had a few

But then again, too few to mention

I did what I had to do

And saw it through without exemption

I planned each chartered course

Each careful step along the byway

But more, much more than this

I did it my way

Yes, there were times, I’m sure you knew

When I bit off more than I could chew

But through it all, when there was doubt

I ate it up and spit it out

I faced it all and I stood tall

And did it my way

I’ve loved, I’ve laughed and cried

I’ve had my fill, my share of losing

And now, as tears subside

I find it all so amusing

To think I did all that

And may I say, not in a shy way

Oh no, no, no, not me

I did it my way

For what is a man, what has he got

If not himself then he has not

To say all the things he truly feels

And not the words of one who kneels

The record shows, I took the blows

But I did it my way.

The Secret Broker can be found on Twitter here @SecretBrokerAU or on email at thesecretbroker@stockhead.com.au.

Feel free to contact him with your best stock tips and ideas.