Thinking About Insurance

particularly great toward the end of the year.  It is then that weather tends to kick up:  Of the ten largest insured losses in U.S. history, nine occurred in the last half of the year.  In addition, policies that are not triggered by a first event are unlikely, by their very terms, to cause us losses until late in the year.

Our worst case from a "once-in-a-century" super-cat is far less severe - relative to net worth - than that faced by many well-known primary companies writing great numbers of property policies.  These insurers don't issue single huge-limit policies as we do, but their small policies, in aggregate, can create a risk of staggering size.  The "big one" would blow right through the reinsurance covers of some of these insurers, exposing them to uncapped losses that could threaten their survival.  In our case, losses would be large, but capped at levels we could easily handle.

Berkshire is sought out for many kinds of insurance, both super-cat and large single-risk, because: (1) our financial strength is unmatched, and insureds know we can and will pay our losses under the most adverse of circumstances; (2) we can supply a quote faster than anyone in the business; and (3) we will issue policies with limits larger than anyone else is prepared to write. Most of our competitors have extensive reinsurance treaties and lay off much of their business. 

Suppose there is an event that occurs 25 times in every century.  If you annually give 5-for-1 odds against its occurrence that year, you will have many more winning years than losers. Indeed, you may go a straight six, seven or more years without loss.  You also will eventually go broke.  At Berkshire, we naturally believe we are obtaining adequate premiums and giving more like 3 1/2-for-1 odds.  But there is no way for us - or anyone else - to calculate the true odds on super-cat coverages.  In fact, it will take decades for us to find out whether our underwriting judgment has been sound.

What we do know is that when a loss comes, it's likely to be a lulu.  There may well be years when Berkshire will suffer losses from the super-cat business equal to three or four times what we earned from it.

Berkshire is ideally positioned to write super-cat policies. companies writing these policies need enormous capital, and our net worth is ten to twenty times larger than that of our main competitors.  In most lines of insurance, huge resources aren't that important:  An insurer can diversify the risks it writes and, if necessary, can lay off risks to reduce concentration in its portfolio.  That isn't possible in the super-cat business.  So these competitors are forced into offering far smaller limits than those we can provide.  Were they bolder, they would run the risk that a mega-catastrophe - or a confluence of smaller catastrophes - would wipe them out.

Ajit’s business is just the opposite of GEICO’s. At that company, we have millions of small policies that largely renew year after year. Ajit writes relatively few policies, and the mix changes significantly from year to year

From year to year, Ajit’s business is never the same. It features very large transactions, incredible speed of execution and a willingness to quote on policies that leave others scratching their heads. When there is a huge and unusual risk to be insured, Ajit is almost certain to be called.

I know of only eight P/C policies in history that had a single premium exceeding $1 billion. And, yes, all eight were written by Berkshire. Certain of these contracts will require us to make substantial payments 50 years or more from now. When major insurers have needed an unquestionable promise that payments of this type will be made, Berkshire has been the party – the only party – to call.

On Risks

We do know that it would be a huge mistake to bet that evolving atmospheric changes are benign in their implications for insurers. 

De-emphasizing Cats

We are for the first time including insurance underwriting income in business earnings. We did not do that when we initially introduced Berkshire’s two quantitative pillars of valuation because our insurance results were then heavily influenced by catastrophe coverages. If the wind didn’t blow and the earth didn’t shake, we made large profits. But a mega-catastrophe would produce red ink. In order to be conservative then in stating our business earnings, we consistently assumed that underwriting would break even over time and ignored any of its gains or losses in our annual calculation of the second factor of value.

Today, our insurance results are likely to be more stable than was the case a decade or two ago because we have deemphasized catastrophe coverages and greatly expanded our bread-and-butter lines of business. Last year, our underwriting income contributed $1,118 per share to the $12,304 per share of earnings referenced in the second paragraph of this section. Over the past decade, annual underwriting income has averaged $1,434 per share, and we anticipate being profitable in most years. You should recognize, however, that underwriting in any given year could well be unprofitable, perhaps substantially so. 2015 Letter

Berkshire's Willingness to Accept Volatility

[We] are quite willing to accept relatively volatile results in exchange for better long-term earnings than we would otherwise have had.  In other words, we prefer a lumpy 15% to a
smooth 12%.  Since most managers opt for smoothness, we are left with a competitive advantage that we try to maximize.  We do, though, monitor our aggregate exposure in order to keep our "worst case" at a level that leaves us comfortable.

Low Cost Operator

Our goal is to pass on most of the benefits of our low-cost operation to our customers, holding ourselves to about 4% in underwriting profit.

Another way to prosper in a commodity-type business is to be the low-cost operator. Among auto insurers operating on a broad scale, GEICO holds that cherished title. For NICO, as we have seen, an ebband-flow business model makes sense. But a company holding a low-cost advantage must pursue an unrelenting foot-to-the-floor strategy. And that’s just what we do at GEICO. 


The saying, "a fool and his money are soon invited everywhere," applies in spades in
reinsurance, and we actually reject more than 98% of the business we are offered. 

A bad reinsurance contract is like hell:  easy to enter and impossible to exit.

Most of the demand for reinsurance comes from primary insurers who want to escape the wide swings in earnings that result from large and unusual losses. In effect, a reinsurer gets paid for absorbing the volatility that the client insurer wants to shed.

 Choosing the wrong reinsurer, however – one that down the road proved to be financially strapped or a bad actor – would put the original insurer in danger of getting the liabilities right back in its lap.

"If a reinsurer fails to pay a loss, the original insurer is still on the hook for it. Choosing a reinsurer, therefore, that down the road proves to be financially strapped or a bad actor threatens the original insurer with getting huge liabilities right back in its lap."

A publicly-held reinsurer gets graded by both its owners and those who evaluate its credit on the smoothness of its own results. Wide swings in earnings hurt both credit ratings and p/e ratios, even when the business that produces such swings has an expectancy of satisfactory profits over time. This market reality sometimes causes a reinsurer to make costly moves, among them laying off a significant portion of the business it writes (in transactions that are called "retrocessions") or rejecting good business simply because it threatens to bring on too much volatility. Berkshire, in contrast, happily accepts volatility, just as long as it carries with it the expectation of increased profits over time. Furthermore, we are a Fort Knox of capital, and that means volatile earnings can't impair our premier credit ratings. Thus we have the perfect structure for writing -- and retaining -- reinsurance in virtually any amount.

Giants [who buy Berkshire re-insurance] understand that the test of a reinsurer is its ability and willingness to pay losses under trying circumstances, not its readiness to accept premiums when things look rosy.


[It is] vital it is that the interests of the people who write insurance business be aligned - on the downside as well as the upside - with those of the people putting up the capital.  When that kind of symmetry is missing, insurers almost invariably run into trouble, though its existence may remain hidden for some time.

"To combat employees’ natural tendency to save their own skins, we have always promised
NICO’s workforce that no one will be fired because of declining volume, however severe the contraction. "


In our insurance operations we have an advantage in attitude, we have an advantage in capital, and we are developing an advantage in personnel. Additionally, I like to think we have some long-term edge in investing the float developed from policyholder funds. The nature of the business suggests that we will need all of these advantages in order to prosper.

"What we’ve had going for us is a managerial mindset that most insurers find impossible to
replicate. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of
premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.

Most American businesses harbor an “institutional imperative” that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s). "

" It takes real fortitude – embedded deep within a company’s culture – to operate as NICO does. Anyone examining the table can scan the years from 1986 to 1999 quickly. But living day after day with dwindling volume – while competitors are boasting of growth and reaping Wall Street’s applause – is an experience few managers can tolerate. NICO, however, has had four CEOs since its formation in 1940 and none have bent. (It should be noted that only one of the four graduated from college. Our experience tells us that extraordinary business ability is largely innate.)"

It is commonplace, in corporate annual reports, to stress the difference that people make. Sometimes this is true and sometimes it isn’t.  But there is no question that the nature of
the insurance business magnifies the effect which individual managers have on company performance.  We are very fortunate to have the group of managers that are associated with us.


GEICO delivers all of its constituents major benefits: In 2004 its customers saved $1 billion or so compared to what they would otherwise have paid for coverage, its associates earned a $191 million profit-sharing bonus that averaged 24.3% of salary, and its owner – that’s us – enjoyed excellent financial returns. 

Insurance Cycle

Commentators frequently discuss the "underwriting cycle" and speculate about its next turn. If that term is used to connote rhythmic qualities, it is in our view a misnomer that leads to
faulty thinking about the industry's fundamental economics.

The term was appropriate some decades ago when the industry and regulators cooperated  to conduct the  business  in cartel fashion. At that  time, the combined ratio fluctuated
rhythmically for two reasons, both related to lags. First, data from the past were analyzed and then used to set new "corrected" rates, which were subsequently put into effect by virtually all
insurers. Second, the fact that almost all policies were then issued for a one-to three-year term - which meant that it took a considerable time for mispriced policies to expire - delayed the
impact of new rates on revenues. These two lagged responses made combined ratios behave much like alternating current. Meanwhile, the absence of significant price competition guaranteed that industry profits, averaged out over the cycle, would be satisfactory.

The cartel period is long gone. Now the industry has hundreds of participants selling a commodity-like product at independently-established prices. Such a configuration - whether
the product being sold is steel or insurance policies - is certain to cause subnormal profitability in all circumstances but one: a shortage of usable capacity. Just how often these periods
occur and how long they last determines the average profitability of the industry in question.

"It’s easy in insurance to goose earnings by either underpricing to drive short-term revenue or under-reserving for future losses." Peter Keefe

You can get a lot of surprises in insurance.    Nevertheless, we believe that insurance can be a very good business.  It tends to magnify, to an unusual degree, human managerial talent - or the lack of it. Berkshire 1979

“It’s easy in insurance to goose earnings by either underpricing to drive short-term revenue or under-reserving for future losses.” Peter Keefe

“There’s nothing inherently superior about the property/  casualty insurance model. But there is something inherently superior about a management team that over a very long

period of time has the discipline to walk away from underpriced business” Peter Keefe

“Ben Graham had blind spots. He had too low an appreciation of the fact that some businesses were worth paying big premiums for” Charlie Munger

“If I were ordaining rules for running boards of directors, I’d require that three hours be spent examining stupid blunders including quantification of effects considering opportunity costs” Charlie Munger

“I’m glad we have insurance, though it’s not a no-brainer, I’m warning you. We have to be smart to make this work.” Charlie Munger

“Reinsurance is not as much of a commodity business as it might appear. There’s such a huge time lag between when the policy is written and when it is paid that the customer has to evaluate the insurer’s future willingness and ability to pay. We have a reputational advantage, though it’s not as big as it should be.” Charlie Munger

“Our record in the past if you average it out has been quite respectable. Why shouldn¹t we use our capital strength?” “We’d be out of our minds if we wrote weather insurance on the opinion global warming would have no effect at all.” Charlie Munger

The tutorials and blogposts here draw on the lessons I've learnt from the Investment Masters, Business People, Psychology experts and other diverse fields of study. I hope most of what I put down in writing here is timeless. 

I spend my day studying and watching markets and advising institutions on investment opportunities, macro developments and the psychology of the markets. The blog posts and tutorials in the Investment Masters Class serve as a useful and easy reference point for me to come back to when I'm thinking about stocks.

Last year I re-read all of the annual Berkshire letters. ¥ou may have read the 'Buffett Series', ten short blogposts on interesting snippets I picked out of that reading. While I make a point of reading Buffett's letters every year and listening to Buffett's interviews I hadn't read the older letters cover to cover. I don't think there is much Warren and Charlie haven't worked out.

From time to time I'm looking at insurance stocks. Berkshire writes the world's largest insurance contracts.  This post draws on those quotes and others I've collected from some other investors I respect. 

"Berkshire’s marvellous outcome in insurance was not a natural result. Ordinarily, a casualty insurance business is a producer of mediocre results, even when very well managed. And such results are of little use. Berkshire’s better outcome was so astoundingly large that I believe that Buffett would now fail to recreate it if he returned to a small base while retaining his smarts and regaining his youth." Charlie Munger, 2014 Berkshire Letter