How CBL went bust in a month
The sudden demise of this former high-flyer is a stark reminder of the importance of understanding and managing risk.
Insurance is a unique business. Premiums are priced upfront for risks (claims) that are made (or not) at some stage down the track, for uncertain amounts. There is no business where understanding and managing risk is more critical. In fact, it is the business.
The failure of New Zealand-based insurer CBL Corporation (ASX:CBL), a true riches-to-rags story, illustrates this point.
It all began well. CBL listed in October 2015 with an attractive story. The New Zealand-based and ASX-listed company was achieving strong revenue and earnings growth (largely overseas) in challenging insurance conditions.
Management and the board had industry experience and skin in the game, owning more than 50% of the company. Upon listing at $1.62 a share on 13 October 2015, the share price rose to a high of $3.76 around a year later – representing a market value of about $890m. This was one kiwi that could fly.
Cracks emerged in August 2017, but investors kept the faith. Unbeknownst to the market, though, regulators were concerned.
An extraordinary series of announcements ensued last month, revealing that the company had drastically underestimated expected claims and culminating in it being placed into voluntary administration on 26 February.
This regulator's report provides some juicy details but the key mistakes were in misunderstanding and mismanaging risks.
Questionable business model
Well-run insurers typically have significant resources and capabilities to assess and manage risks, especially in the areas of underwriting, pricing and claims assessments, which can be a source of competitive advantage.
CBL didn't operate in this manner – it outsourced key insurance functions.
Such a model isn't unheard of in the insurance industry, but the arrangement can mean that management is less informed of risks. Beyond its reliance on outsourcing, CBL acted as a reinsurer, taking a proportional share of the premiums and risks of other insurers (known as 'cedants'). Hence, the value added by CBL seems to have been limited.
CBL's demise was down to its concentration on the French construction market, selling compulsory insurance products that protect builders from claims against shoddy work. This accounted for about 54% of premiums during 2016.
Claims for these products can take more than a decade to be settled and long periods of low claims can quickly be followed by spells of heavy losses. In essence, CBL was taking a big bet on a tricky risk.
Whilst market premiums were stagnant for years, CBL was building market share. In 2006, CBL generated NZ$1m in premiums from the French construction market. A decade later that figure had risen to NZ$130m, accounting for 3–5% of that market.
The proportion of those risks it passed on to other reinsurers also waned in recent years, meaning it wore more of the risks.
CBL's business model and market position raise the question: how is a small insurer reliant on third parties able to grow so quickly in a mature and competitive market?
Growth hides flaws
CBL's small size and volatile credit rating mean it was limited to attracting smaller clients. It grew via two avenues: A small (and seemingly unsophisticated) Danish insurer and a broker (eventually replaced by a CBL subsidiary). The underlying insured clients were small French building contractors.
The company was, however, still competing against large well-resourced insurers. Along with its cedants and third-parties, CBL woefully underestimated the cost of future claims and underpriced its policies. This meant that, in effect, prior recorded profits were overstated.
Management admitted as much when it announced an exit of the French construction business in February, although the regulator probably gave them little choice.
Eventually, the risks became apparent as the claims came in. The years of low apparent losses and rapid growth offered management and investors a false sense of confidence when, below the surface, large liabilities were accumulating.
Leveraged balance sheet
Misjudging claims is not infrequent in the insurance industry and can be managed with a robust balance sheet. Shareholder capital can absorb unexpected claims – but for an insurer such as CBL, underwriting concentrated and complex risks, a large buffer is warranted.
By 30 June 2017, CBL's balance sheet was starting to look stretched. Its regulatory solvency ratio looked sound but debt had risen sharply after several acquisitions. High growth compounded the situation, making the company vulnerable to a deterioration in French construction insurance.
Despite increasing reserves in August 2017, last month CBL revealed it needed to strengthen its French construction reserves by NZ$100m. On top of that, there was a writedown of NZ$44m of overdue premium receivables.
That pushed the company into insolvency. Plans to raise capital didn't eventuate, and CBL was placed into administration. Shareholders are unlikely to receive much after creditors get their dues.
Lessons from the fall
The nature of insurance makes it a difficult area for investors. It's hard to assess management on its appreciation and management of risk. A track record of managing through insurance cycles, supported by the appropriate business capabilities and a robust balance sheet, certainly helps.
As for management's skin in the game, well, that only helps if it understands the game. In CBL's case, it clearly didn't.
In an amusing side-note, CBL's managing director was even crowned New Zealand's entrepreneur of the year by EY last year. It all goes to show that there's no substitute for independent research.
The fallout from CBL's failure is still to be fully realised. But the lessons for investors are much clearer.
Join the Conversation...
There are comments posted so far.