Warren Buffett (Trades, Portfolio) likes to buy companies for his portfolio that have a competitive advantage. More often than not, this competitive advantage is a strong brand and relationships with consumers.
These qualities are likely to ensure that the companies always have a market. The Oracle of Omaha has said that the only way to value a business is to calculate the stream of cash flows generated by the enterprise from now until “judgment day.”
Unless a company has a durable competitive advantage, such as a one-of-a-kind product or strong brand, it is unlikely the business will be able to generate the sort of sustainable cash flows that allow for this valuation.
This is one of the main reasons why the billionaire has built Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) around the insurance industry. Insurance is one of those markets that is quite difficult to succeed in, but it can be very lucrative if you have the right ingredients.
Most insurance companies struggle to make money consistently because of the nature of the market. However, there will always be a need for insurance. Customers will always want to buy insurance policies because they need to protect against exceptional disasters, even in uncertain times.
The need for insurance
Buffett explained this idea at the 1994 Berkshire annual meeting of investors. He noted that there are two reasons why people would buy insurance. The first was the most important:
“One is to protect yourself against a loss that you are unable or unwilling to bear yourself. And that is partly a — an objective decision. It’s partly subjective. For example, a manager that’s terribly worried that his board of directors may second-guess him if he has an uninsured loss, is going to buy a lot more protection, probably, than the company really needs. But he knows he’s never going to have to go in front of his board of directors and say, “We just had a million-dollar fire loss.” And then the next question the director asks is, “Was it insured?” And then he doesn’t want to answer no.”
To put it another way, many individuals will buy insurance purely because they don’t want to have to tell someone else that they didn’t buy insurance.
This works both in the business world and at home. A manager might be worried about what their superiors might say if they have not bought the cover. At the same time, a married couple is unlikely to want to reveal to each other that they’re going to have to clear out their savings to replace a ring they lost because one of them didn’t buy insurance.
Therefore, the demand for insurance is driven by both financial and psychological factors. Ultimately, the primary goal is to protect against a loss “you’re unwilling or unable to bear yourself.”
The other reason why some might buy an insurance policy, as Buffett went on to add, is where one has a “mathematical advantage.” In this situation, a company might be selling a policy that is too cheap compared to the risks it is taking on:
“And a typical case, you know, might be a company that had a lot of homeowners policies in California. And if those include earthquake coverage, they may not be able to sustain the kind of loss that is possible, even though they want to keep a distribution system in place that merchandises en masse to homeowners in California.”
These are the reasons why Buffett has built Berkshire around the insurance business. There will always be a demand for insurance policies, and both psychological and business factors will drive this demand.
For a company like Berkshire, which has the financial firepower and distribution network to capitalize on these opportunities and make the most of the profits it generates by investing earnings back into the market, the insurance business is a long-term profit center that will never disappoint.
