Warren Buffett began his discussion on insurance operations in 1986 by giving out the table including yearly change in premium, combined ratio after policyholder dividends, yearly change in incurred losses and inflation rate measure by GNP Deflator. Combined ratio has been explained briefly in the previous post of PartnerRe’s analysis. It is actually the total insurance costs including expenses and losses incurred in comparison to revenue from premiums. A combined ratio over 100 means the insurance business is having an underwriting loss, and vice versa, if the combined ratio is well under 100, it represents the underwriting profit operation. When the investment income that the insurers earned from the policyholders’ funds is included in the calculation, a combined ratio in the 107-112 range typically produces an overall break-even result, exclusive of earnings on the funds provided by shareholders.
Buffett wrote that the math of the insurance business is not complicated. In years when the industry’s annual gain in revenue stayed around 4-5%, underwriting losses would be sure to mount. The reason was neither casualty events like auto accidents, fires, etc. occurring more frequently, or the general trend of rising inflation. It was because the “social and judicial inflation,” the cost of entering the courtroom, has simply ballooned. He believed that with the general inflation in the range of 2-4%, the industry’s revenues must grow around 10% annually for it to just hold its own in terms of profitability.
The insurance business was the commodity business, in which the market responded very strongly to the change in price. Buffett mentioned: “Only under shortage conditions are high profits achieved, and such conditions don’t last long. When the profit sun begins to shine, long-established insurers shower investors with new shares in order to build capital. In addition, newly-form insurers rush to sell shares at the advantageous prices available in the new-issue market (prices advantageous that is, to the insiders promoting the company but rarely to the new shareholders). These moves guarantee future trouble: capacity soars, competitive juices flow, and prices fade... Why can’t we learn from history, even out the peaks and valleys, and consistently price to make reasonable profits?”
At any time, insurers try to keep the underwriting volume growing, no matter what the price and sometimes no matter the quality of the underwriting. So they are competing with each other to gain volume, which further accelerates the declining trend of the underwriting price. But for Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), it was considered to be the slowest-growing large insurer. In fact, the business shrank when the price was inadequate. Buffett said: “Indeed, we are its most steadfast participant, always standing ready, at prices we believe adequate, to write a wide variety of high-limit coverage. The swings in our volume arise instead from the here-today, gone-tomorrow behavior of other insurers. When most insurers are 'gone,' because their capital is inadequate or they have been frightened by losses, insureds rush to us and find us ready to do business."
With the acceptance of having sometimes low volume in insurance business, the employees feel safe with Berkshire Hathaway. When the industry has a hard time of slow volume, normally there would be huge layoffs to reduce expenses in order to cover the low business underwritten. But that is not the case for Berkshire Hathaway. Warren Buffett said that he would not lay off people because they can’t generate business for insurance operations. If he just went for volume, the quality of the business written could be questionable, maybe even scary.
Because the insurance business is to sell promises, the real loss might not be recognized for several years — it might still out there in the future. The loss liabilities in a given year might be far from true — and that would make several years in the row of error. Insurance companies have to set up the loss reserve in order to put the estimated future loss into today’s income statement to somehow capture the future loss. Because the loss reserve is subject to management’s discretion, so it can be manipulated. There was the term that insurance executives often say is “reserve strengthening.” They made it sound like the executives were adding extra layers of strength to an already-strong balance sheet. But according to Warren Buffett, the term should be more properly called “correction of previous untruths.” In the insurance business, the investors should expect unpleasant surprises from time to time. As Woody Allen put it, “While the lamb may lie down with the lion, the lamb shouldn’t count on getting a whole lot of sleep.”
Last but not least, Buffett thought that Berkshire Hathaway’s insurance operation had an advantage in attitude, in capital, and in 1986, the firm was developing an advantage in personnel. In addition, the firm had a long-term edge in investing the float from policyholders’ funds. The nature of the business suggested that all these advantages were needed in order to prosper. Also check out:
Buffett wrote that the math of the insurance business is not complicated. In years when the industry’s annual gain in revenue stayed around 4-5%, underwriting losses would be sure to mount. The reason was neither casualty events like auto accidents, fires, etc. occurring more frequently, or the general trend of rising inflation. It was because the “social and judicial inflation,” the cost of entering the courtroom, has simply ballooned. He believed that with the general inflation in the range of 2-4%, the industry’s revenues must grow around 10% annually for it to just hold its own in terms of profitability.
The insurance business was the commodity business, in which the market responded very strongly to the change in price. Buffett mentioned: “Only under shortage conditions are high profits achieved, and such conditions don’t last long. When the profit sun begins to shine, long-established insurers shower investors with new shares in order to build capital. In addition, newly-form insurers rush to sell shares at the advantageous prices available in the new-issue market (prices advantageous that is, to the insiders promoting the company but rarely to the new shareholders). These moves guarantee future trouble: capacity soars, competitive juices flow, and prices fade... Why can’t we learn from history, even out the peaks and valleys, and consistently price to make reasonable profits?”
At any time, insurers try to keep the underwriting volume growing, no matter what the price and sometimes no matter the quality of the underwriting. So they are competing with each other to gain volume, which further accelerates the declining trend of the underwriting price. But for Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), it was considered to be the slowest-growing large insurer. In fact, the business shrank when the price was inadequate. Buffett said: “Indeed, we are its most steadfast participant, always standing ready, at prices we believe adequate, to write a wide variety of high-limit coverage. The swings in our volume arise instead from the here-today, gone-tomorrow behavior of other insurers. When most insurers are 'gone,' because their capital is inadequate or they have been frightened by losses, insureds rush to us and find us ready to do business."
With the acceptance of having sometimes low volume in insurance business, the employees feel safe with Berkshire Hathaway. When the industry has a hard time of slow volume, normally there would be huge layoffs to reduce expenses in order to cover the low business underwritten. But that is not the case for Berkshire Hathaway. Warren Buffett said that he would not lay off people because they can’t generate business for insurance operations. If he just went for volume, the quality of the business written could be questionable, maybe even scary.
Because the insurance business is to sell promises, the real loss might not be recognized for several years — it might still out there in the future. The loss liabilities in a given year might be far from true — and that would make several years in the row of error. Insurance companies have to set up the loss reserve in order to put the estimated future loss into today’s income statement to somehow capture the future loss. Because the loss reserve is subject to management’s discretion, so it can be manipulated. There was the term that insurance executives often say is “reserve strengthening.” They made it sound like the executives were adding extra layers of strength to an already-strong balance sheet. But according to Warren Buffett, the term should be more properly called “correction of previous untruths.” In the insurance business, the investors should expect unpleasant surprises from time to time. As Woody Allen put it, “While the lamb may lie down with the lion, the lamb shouldn’t count on getting a whole lot of sleep.”
Last but not least, Buffett thought that Berkshire Hathaway’s insurance operation had an advantage in attitude, in capital, and in 1986, the firm was developing an advantage in personnel. In addition, the firm had a long-term edge in investing the float from policyholders’ funds. The nature of the business suggested that all these advantages were needed in order to prosper. Also check out:
