The bulk of Warren Buffett (Trades, Portfolio)'s fortune has been made in the insurance business, and Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) is, at its core, an insurance conglomerate.
Insurance is an industry that is misunderstood by many people, which is why Buffett has been able to draw such enormous profits from the sector. It is all about risk, reward and balancing these two factors as well as the probability that a specific event will unfold.
Buffett on insurance
In his year-end 2017 letter to shareholders of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), Buffett discusses insurance and why last year's series of natural disasters is not, in the grand scheme of things, anything to be worried about.
Even though Berkshire Hathaway is one of the world's most substantial reinsurance and insurance companies, Buffett estimates total losses from the three major hurricanes last year will amount to no more than $3 billion for the group. That's compared to an estimated total of around $100 billion for the industry.
Berkshire is better prepared than any other company in the industry for such a loss due to its size. As Buffett describes in the letter:
"We believe that the annual probability of a U.S. mega-catastrophe causing $400 billion or more of insured losses is about 2%. No one, of course, knows the correct probability. We do know, however, that the risk increases over time because of growth in both the number and value of structures located in catastrophe-vulnerable areas.
No company comes close to Berkshire in being financially prepared for a $400 billion mega-cat. Our share of such a loss might be $12 billion or so, an amount far below the annual earnings we expect from our non-insurance activities. Concurrently, much β indeed, perhaps most β of the p/c world would be out of business. Our unparalleled financial strength explains why other p/c insurers come to Berkshire β and only Berkshire β when they, themselves, need to purchase huge reinsurance coverages for large payments they may have to make in the far future."
What separates the company from its peers is its strong balance sheet, which is a result of Buffett's dealmaking over the years and sensible investment decisions. Compared to other insurers, Berkshire's investment policy is relatively risky, but he understands the chances of these mega-catastrophes occurring are relatively small, and the chances of equities producing a positive return over the long term is high. Therefore, computing the probability, risk and reward lead to the conclusion it makes sense to invest the 'float' money in equities:
"Before 2017, Berkshire had recorded 14 consecutive years of underwriting profits, which totaled $28.3 billion pre-tax. I have regularly told you that I expect Berkshire to attain an underwriting profit in a majority of years, but also to experience losses from time to time. My warning became fact in 2017, as we lost $3.2 billion pre-tax from Underwriting."
Investors can benefit
There are two main takeaways I believe investors can learn from. First, the unique nature of the insurance business and how it can generate outsized returns for those investors who are prepared to take the risk. Second, there is a lesson in probability and the role it plays in investment management. Computing the risk of a mega-catastrophe at only 2%, Buffett is comfortable investing his funds in equities.
This is transferable to stocks. In particular situations, if the risk of permanent capital loss is only 5% or less, then the risk is low. If the chance of a favorable situation playing out is 95%, then it's a bet that should be taken. If your odds are 50-50 or even 60-40, however, then perhaps it's best to move on and find another opportunity.
Disclosure: The author owns no stocks mentioned.
