Anyone who has read about the insurance business would know about the combined ratio. A combined ratio represents total insurance costs (losses incurred plus expenses), in comparison with revenue from premiums. A ratio of 100 would indicate break-even, below 100 would yield underwriting profits and above 100 is a loss. It only reflects the underwriting performance, more specifically, the cost of getting premiums. In addition, insurers will get another income source — the investment income. Buffett stated that in 1987, when the investment income earnings from holding on to policyholders’ funds (the float) is taken into account, a combined ratio in the 107 to 111 range typically produces overall breakeven results, exclusive of earnings on the funds supplied by shareholders.
He mentioned further: “The math of the insurance business, encapsulated by the table, is not very complicated. In years when the industry’s annual gain in revenues (premiums) pokes along at 4% or 5%, underwriting losses are sure to mount. That is not because of auto accidents, fires, windstorms, and the like are occurring more frequently, nor has it lately been the fault of general inflation. Today, social and judicial inflation are the major culprits; the cost of entering a courtroom has simply ballooned… we continue to believe that the industry’s revenue must grow at about 10% annually for it to just hold its own in terms of profitability, even though general inflation may be running at a considerably lower rate.”
In the insurance industry, there is a lag factor. Even when the revenue gain decreases, earnings will not sink right away. “Because most policies are written for a one-year term, higher or lower insurance prices will not have their full impact on earnings until many months after they go into effect,” he added.
The insurance industry was claimed to be a commodity business by Buffett. It has hundreds of competitors, ease of entry, and a product which can not be differentiated in any meaningful way. In order to sustain high profitability, a commodity-like business needs to be a very low-cost operator or operate in a protected and small niche. And of course, when a shortage exists, even the commodity businesses would flourish. However, most managers in the commodity businesses don't like shortage situations, although it is the only time to provide good returns.
Buffett went further explaining two ways that Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) tried to escape from commodity economics. First was the financial strength. “When a buyer really focuses on whether a $10 million claim can be easily paid by his insurer five or ten years down the road, and when he takes into account the possibility that poor underwriting conditions may then coincide with depressed financial markets and defaults by insurers, he will find only a few companies he can trust. Among those, Berkshire will lead the pack.”
Second was the total indifference to volume that Berkshire made. Berkshire followed a price-based-o exposure, not on competition policy because it made sense for its shareholders. Many other players followed an “in-and-out” approach. When they were “out” because of losses or lack of capital, Berkshire would be available.
Last but not least, he challenged the figures reported by insurers: “You should be very suspicious of any earnings figures reported by insurers (including our own, as we have unfortunately proved to you in the past). The record of the last decade shows that a great many of our best-known insurers have reported earnings to shareholders that later proved to be wildly erroneous. In most cases, these errors were totally innocent: The unpredictability of our legal system makes it impossible for even the most conscientious insurer to come close to judging the eventual cost of long-term claims.”