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In an insurance business operation, in years when the industry’s annual gain in revenues were along 4%-5%, the underwriting losses were sure to mount. The cause was not that accidents, fires, etc., occurred more frequently, or general inflation, but social and judicial inflation, or as he called it, “the cost of entering a courtroom has simply ballooned.”
For Buffett in 1987, the industry’s revenue must grow at around 10% annually for it to just hold its profitability, even when the general inflation happened at a much lower rate. In this industry, even when the revenue experienced a decreasing rate, the earnings would not immediately sink with it right away, and the effect is gradual. Warren Buffett mentioned the lag factor in the industry: “Because most policies are written for a one-year term, higher or lower insurance prices do not have their full impact on earnings until many months after they go into effect. Thus, to resume our metaphor, when the party ends and the bar is closed, you are allowed to finish your drink. If results are not hurt by a major natural catastrophe, we predict a small climb for the industry’s combined ratio in 1988, followed by several years of larger increases.”
When looking at the industry from the Porter Five Forces, we can see clearly its weaknesses, as frequently discussed by Buffett. The industry has low barriers to entry, hundreds of competitors with tough competition, huge customers bargaining power, and the product cannot be differentiated in any meaningful way. It is like the commodity business. And as common sense, only very low-cost players and/or any players in a protected, and usually small, niche can get a high profitability level.
In the commodity business, when shortages occur, as the rule of supply and demand, even the commodity business flourishes. Buffett explained: “One of the ironies of capitalism is that most managers in the commodity industries abhor shortage conditions – even though those are the only circumstances permitting them good returns. Whenever shortages appear, the typical manager simply can’t wait to expand capacity and thereby plug the hole through which money is showering upon him. This is precisely what insurance managers did in 1985-87, confirming again Disraeli’s observation: “What we learn from history is that we do not learn from history.”
In Berkshire Hathaway (BRK.A)(BRK.B), Buffett leads the company to work to escape the industry’s commodity economics in two ways. First is to differentiate the product by the company’s financial strength, to be the top notch of the insurance industry. Nevertheless, this kind of strength means nothing in the personal insurance field as the buyer of an auto or homeowners is going to get his claim paid even if his insurer fails. And it means nothing in commercial insurance field as well. Buffett commented: “When times are good, many major corporate purchasers of insurance and their brokers pay scant attention to the insurer’s ability to perform under the more adverse conditions that may exist, say, five years later when a complicated claim is finally resolved (Out of sight, out of mind, and, later on, maybe out-of-pocket).”
And of course, sometimes, the buyers experienced the old sentence of Benjamin Franklin that it is hard for an empty sack to stand upright, and to recognize the importance of insurers with enduring financial strength. It is then Buffett thinks that Berkshire Hathaway has the major competitive advantage.
The second differentiating method that Buffett uses for Berkshire Hathaway is the total volume which the firm maintains. Back in 1989, Berkshire would be willing to write five times as much business as the previous year. Because of its financial strength, it can sustain that kind of large volume. But nobody can control the market prices. So if the price is unsatisfactory, it would do little business.
In the insurance industry, there are three conditions which allow for flexibility of Berkshire Hathaway. First, the market share does not determine the firm’s profitability. Second, distribution channels are not proprietary and can be entered easily. And third, idle people, does not result in intolerable costs. Buffett compared:”In a way that in industries such as printing or steel cannot, we can operate at quarter-speed much of the time and still enjoy long-term prosperity.”
Berkshire Hathaway followed the price-based-on-exposure, not on competition policy because it does make sense for its shareholders. Many other insurers follow what he called the “in-and-out approach.” When they are “out” — because of large losses, lack of capital, etc. — Berkshire Hathaway would be available.
About the author:
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam Visit Anh Hoang's Website
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