Warren Buffett has discussed in-depth about loss reserving in the insurance industry in one of his shareholders’ letters.
Any knowledgeable shareholders which have significant interest in property/casualty insurance business should have the understanding of the weakness in earnings reporting in the industry. The financial statement of those insurers supplies only the first rough draft of earnings and insurers’ financial conditions.
Buffett said the determination of costs is the main problem. Most of insurers’ costs are from the losses on claims, and those losses that go through the income statement are exceptionally difficult to estimate. Some of the real expenses are not known for decades. He noted there are four kinds of losses that were charged in the income statement: “(1) losses occurred and were paid during the year, (2) estimates for losses that occurred and were reported to the insurer during the year, but which have yet to be settled; (3) estimates of ultimate dollar costs for losses that occurred during the year but of which the insurers were unaware (termed “IBNR”: incurred but not reported) and (4) the net effect of revisions this year of similar estimates for (2) and (3) made in past years.”
The revision of the estimates can be realized shortly or be long delayed. In any case, it means the real costs (leading to real earnings) of any single year which occurs corrected would be misstated. Buffett has given the example of a claimant been injured in 1979, and they thought the settlement might be $10,000. “That year we could have charged $10,000 to our earnings statement for the estimated cost of the loss and, correspondingly, set up a liability reserve on the balance sheet for that amount. If we settled the claim in 1984 for $100,000, we would charge earnings with a loss cost of $90,000 in 1984, although that cost was truly an expense of 1979. And if that piece of business was our only activity in 1979, we would have badly misled ourselves as to costs and you as to earnings.”
That leads to the conclusion of error in estimation that flows into the costs and earnings in the financial statement for that single year, no matter how good the management is. And in order to minimize those errors, most insurers use individual loss evaluations (case reserves) which involve raw data for estimation of aggregate liabilities, being called “bulk,” “development” or supplemental reserves.” In the common practice of Berkshire Hathaway (BRK.A)(BRK.B), Buffett discussed that he has added the appropriate supplemental reserves as he thought but they proved to be not adequate.
Buffett related a story which was applicable to insurance accounting problems: “A man was travelling abroad when he received a call from his sister informing him that their father had died unexpectedly. It was physically impossible for the brother to get back home for the funeral, but he told his sister to take care of the funeral arrangements and to send the bill to him. After returning home he received a bill for several thousand dollars, which he promptly paid. The following month another bill came along for $15, and he paid that too. Another month followed, with a similar bill. When, in the next moth, a third bill for $15 was presented, he called his sister to ask what was going on. “Oh” she said, “I forgot to tell you. We buried Dad in a rented suit.”
If insurers realistically appraised their loss costs, which would make liabilities of insurer are more than its asset, correctly presented, they would be out of the business. So in order to manipulate the financial statements, they simply take an extraordinarily optimistic view about yet-to-be-paid sums, while others have been involving in transactions to hide its true costs. And those can work well for considerable time.
“In most businesses, of course, insolvent companies run out of cash. Insurance is different: you can be broke but flush. Since cash comes in at the inception of an insurance policy and losses are paid much later, insolvent insurers don’t run out of cash until long after they have run out of net worth. In fact, these “walking death” often redouble their efforts to write business, accepting almost any price or risk, simply to keep the cash flowing in.” And during those times, the managers can still keep their jobs.
Because in the industry there are several players like that, it pushes up the competition between insurers. Those companies not only made others suffer from “sell-at-any-price” competition, but also suffer when their insolvency is financial acknowledged. “Through various state guarantee funds that levy assessments, Berkshire ends up paying a portion of the insolvent insurers’ asset deficiencies, swollen as they usually are by the delayed detection that results from wrong reporting.”
Other Warren Buffett discussions on insurance businesses can be found at the following links:
Valuing Insurance Companies
Warren Buffett: Accounting And Bond Investment Of InsurersAlso check out:
Any knowledgeable shareholders which have significant interest in property/casualty insurance business should have the understanding of the weakness in earnings reporting in the industry. The financial statement of those insurers supplies only the first rough draft of earnings and insurers’ financial conditions.
Buffett said the determination of costs is the main problem. Most of insurers’ costs are from the losses on claims, and those losses that go through the income statement are exceptionally difficult to estimate. Some of the real expenses are not known for decades. He noted there are four kinds of losses that were charged in the income statement: “(1) losses occurred and were paid during the year, (2) estimates for losses that occurred and were reported to the insurer during the year, but which have yet to be settled; (3) estimates of ultimate dollar costs for losses that occurred during the year but of which the insurers were unaware (termed “IBNR”: incurred but not reported) and (4) the net effect of revisions this year of similar estimates for (2) and (3) made in past years.”
The revision of the estimates can be realized shortly or be long delayed. In any case, it means the real costs (leading to real earnings) of any single year which occurs corrected would be misstated. Buffett has given the example of a claimant been injured in 1979, and they thought the settlement might be $10,000. “That year we could have charged $10,000 to our earnings statement for the estimated cost of the loss and, correspondingly, set up a liability reserve on the balance sheet for that amount. If we settled the claim in 1984 for $100,000, we would charge earnings with a loss cost of $90,000 in 1984, although that cost was truly an expense of 1979. And if that piece of business was our only activity in 1979, we would have badly misled ourselves as to costs and you as to earnings.”
That leads to the conclusion of error in estimation that flows into the costs and earnings in the financial statement for that single year, no matter how good the management is. And in order to minimize those errors, most insurers use individual loss evaluations (case reserves) which involve raw data for estimation of aggregate liabilities, being called “bulk,” “development” or supplemental reserves.” In the common practice of Berkshire Hathaway (BRK.A)(BRK.B), Buffett discussed that he has added the appropriate supplemental reserves as he thought but they proved to be not adequate.
Buffett related a story which was applicable to insurance accounting problems: “A man was travelling abroad when he received a call from his sister informing him that their father had died unexpectedly. It was physically impossible for the brother to get back home for the funeral, but he told his sister to take care of the funeral arrangements and to send the bill to him. After returning home he received a bill for several thousand dollars, which he promptly paid. The following month another bill came along for $15, and he paid that too. Another month followed, with a similar bill. When, in the next moth, a third bill for $15 was presented, he called his sister to ask what was going on. “Oh” she said, “I forgot to tell you. We buried Dad in a rented suit.”
If insurers realistically appraised their loss costs, which would make liabilities of insurer are more than its asset, correctly presented, they would be out of the business. So in order to manipulate the financial statements, they simply take an extraordinarily optimistic view about yet-to-be-paid sums, while others have been involving in transactions to hide its true costs. And those can work well for considerable time.
“In most businesses, of course, insolvent companies run out of cash. Insurance is different: you can be broke but flush. Since cash comes in at the inception of an insurance policy and losses are paid much later, insolvent insurers don’t run out of cash until long after they have run out of net worth. In fact, these “walking death” often redouble their efforts to write business, accepting almost any price or risk, simply to keep the cash flowing in.” And during those times, the managers can still keep their jobs.
Because in the industry there are several players like that, it pushes up the competition between insurers. Those companies not only made others suffer from “sell-at-any-price” competition, but also suffer when their insolvency is financial acknowledged. “Through various state guarantee funds that levy assessments, Berkshire ends up paying a portion of the insolvent insurers’ asset deficiencies, swollen as they usually are by the delayed detection that results from wrong reporting.”
Other Warren Buffett discussions on insurance businesses can be found at the following links:
Valuing Insurance Companies
Warren Buffett: Accounting And Bond Investment Of InsurersAlso check out:
