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We can look at two extreme ways of operating a property and casualty insurance
company to make this case. When a prospective customer decides to buy
insurance, he tends to focus on two basic features: dependability, and cost. There
can be other factors that come into play, but ultimately, people want to feel safe that
their claims will be met, and they want this protection at a reasonable price.
Therefore, if any two insurers are of similar credit quality or financial strength, often
they must compete with each other on price in order to win business. And here we
begin to see the extremes.
On one hand, there are insurers that want to add new account business
immediately, and they want revenues today. That is because they want to show
those revenues to Wall Street and their shareholders. They are eager to sell
insurance, and they are willing to discount the price to do so.
Why would they do such a thing? Am I suggesting these insurers would actually
sacrifice the long-term profitability of the company in order to add customers today?
Indeed I am.
That is precisely what occurs among a large portion of the property-casualty
insurance industry. It keeps the premium revenue coming in at a steady pace, but
this insurance approach has major downstream implications.
The most obvious is that in subsequent years, on average, they will face higher
claims per premium dollar received. Quite simply, this approach is just less profitable
over time.
There are also secondary implications that are even more profound. When
insurance companies receive customer premiums, they invest them. They invest in
all sorts of things ranging from government bonds to stocks, to loans, to real estate,
and other investments. The result of a less profitable company is that they must be
more conservative with their investment dollars over time. They are forced to. They
cannot withstand the volatility inherent is riskier assets because they know they will
need substantial liquid assets to meet claims. Therefore, this approach ultimately
leads to lower investment returns over time.
Why on earth would any firm do this? There are many specific reasons, but
ultimately they are all a result of poorly structured incentive schemes for
management and the very professionals that sell the insurance. It is not easy to tell
an insurance agent “sorry, we’re pricing you out of the market for awhile, you won’t
be selling much insurance this year.”
There is yet another derivative effect from this business approach. The hyper-
conservative investment approach inhibits the ability for the insurer to build
“reserves”, i.e. build wealth that just makes the company stronger, financially
speaking. Furthermore, after any period in which claims are unexpectedly high, they
are actually forced to stop writing insurance. The recent disaster in New Orleans
and the Southern US was precisely this kind of event. Many property and casualty
insurers that were hit with unexpectedly high claims were unable to further
jeopardize their financial strength. They were forced to stop writing new policies until
the storm clouds disappeared.
That environment presents substantial opportunities for an insurer which uses an
entirely different strategy. Historically, this “different kind” of insurer only sells
insurance policies when it is confident it will be well compensated for the risk it is
assuming. Although very difficult to do, if the compensation for the risk did not seem
adequate, this insurer walked away, allowing another insurer to accept the business.
Subsequently, when other insurers have been forced to stop writing new policies,
this insurer steps in and sells large amounts of insurance at significant premiums. At
times, this insurer has a near monopolistic market environment as others literally
withdraw from the market.
This is the Berkshire Hathaway story in 2007. As virtually every insurer stopped
writing policies due to the massive claims they withstood in 2005-2007, Berkshire
stepped in and wrote insurance and named their price. In 2008 the storm clouds
have dissipated, and most insurers have returned to the market. Prices have
therefore come down again, and not surprisingly, Berkshire has quietly moved
toward the sidelines, accepting only those policies that sustain their strategy. The
long-term effect of this opposite approach is equally profound. Berkshire has built a
massive reserve: its assets compared to its liabilities are considerably stronger than
any other insurance company in the world. As such, over time Berkshire is able to
withstand volatility in its investment portfolio. It is not forced to invest exclusively in
bonds. It has been able to invest in stocks and entire businesses, permanently
increasing its return on its investment portfolio.
The successful years such as 2007 more than offset the softer years. In the mean
time, Berkshire continues to put its massive cash position to work, steadily acquiring
more equity positions in both common stocks and entire businesses. When I see
Berkshire’s operating profit down because insurance earnings are down 43%, I know
and understand it is because they are simply building this competitive advantage,
waiting for the right time to sell insurance. And now you know too.
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