MBIA s Business Model
MBIA 's business model is to collect a small amount of money up front (insurance premiums) in exchange for a promise to pay potentially large but unlikely-to-occur losses in the future—in most cases, decades into the future. The best analogy for this business model is picking up pennies in front of a steamroller—it's nicely profitable until something goes wrong, and then . . . splat!
This is a very different type of business model from, for instance, an auto insurer like GEICO, which collects premiums up front to insure a car for a certain period (generally six to twelve months), so it knows almost exactly what its losses will be within a short period of time. In contrast, nobody—not MBIA, its investors, its regulators, or anyone else—can estimate with any degree of precision whatsoever what its losses might be decades from now on an insurance policy sold today. Given that losses (claims) are an insurance company's primary expense (this is especially true at MBIA, which, at its peak, had only about 500 employees), this presents an accounting conundrum: What does an insurance company report for earnings when it doesn't know what its costs will be?
The answer for all companies, not just insurers, is that they must estimate what their losses will be and recognize them at the same time they recognize the associated premium revenue. But for a handful of companies like MBIA, where there is a very long time between collecting the money and paying out claims, and where the amount of the ultimate claims is so uncertain, management has enormous leeway to estimate losses. The enormity of this leeway is matched only by the incentives to estimate minimal losses, thereby inflating profits, capital levels, and, of course, the share price. Imagine the incentives for a CEO to write risky new lines of business and set aside inadequate reserves; in the short run, profits would soar and it's very likely that long before anyone realized the onerous consequences of these reckless and irresponsible actions, the CEO would have long since cashed in his stock options and retired.
This is pretty much what happened to MBIA. It turns out that the company was massively underreserved, and the combination of actual payouts and credit impairments against expected future payouts has crushed book value by more than 90 percent. In an ironic twist, the longtime CEO, who had indeed earned a bundle and retired before the stock collapsed from losses on business written under his watch, is now back as CEO, trying to save the company (and his reputation).
We highlight these risk factors because we think they apply not only to MBIA, but also to many other companies, so investors need to be very cautious when investing in companies with business models like MBIA 's.
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