הערה מקדימה: בדף זה תמצאו הסבר על חברות ביטוח. מהי מהותה
הכלכלית של חברת ביטוח, כיצד היא מרוויחה כסף ומאילו מקורות, כיצד
יש לנתח חברות ביטוח, מהם היחסים הפיננסיים החשובים, מהן הבעיות
האינהרנטיות ועוד. כל ההסברים המופיעים כאן נלקחו ממכתביו
השנתיים של וורן באפט לבעלי המניות של חברת ההשקעות שלו
- ברקשייר האת'ווי. במכתבים אלו, פורס באפט את משנתו ומסביר, מדי
שנה לאורך כ-40 השנים האחרונות, אספקט מסויים על חברות ביטוח. מה
שניסיתי לעשות בדף זה הוא לאגד הסברים אלו, שנפרסים כאמור על-פני
עשרות מכתבים שנתיים, לדף אחד. ניסיתי לארגן את הדברים בסדר הגיוני
מסויים שיוביל את הקורא להבנת הנושא. גם אם משפט מסויים או מושג
מסויים לא יובנו בתחילה, סביר להניח שניתן יהיה להבינם לאחר קריאה
מלאה של דף זה. הערות והארות בנוגע לאגד זה, יתקבלו בברכה.
הבהרה: ברקשייר האת'ווי, זרוע האחזקות של וורן באפט שהחלה את
דרכה כחברת טקסטיל, מחזיקה בשלוש חברות ביטוח מרכזיות: (1) חברת
National Indemnity שנרכשה בשנת 1967, מנוהלת כיום בידי Ajit Jain
ומתמחה בפוליסות ביטוח חריגות, (2) חברת GEICO שאת מניותיה רכש באפט
1951 (ובשנת 1995 הצליח להשיג שליטה מלאה בחברה), מנוהלת
כיום בידי Tony Nicely ומתמחה בפוליסות ביטוח רכב, (3) חברת ביטוח
המשנה General Re שנרכשה בשנת 1998, מנוהלת כיום בידי Joe Brandon
ו-Tad Montross והיוותה בתחילת דרכה אחזקה בעייתית במקצת.
Float and Cost
What counts in insurance,
our core business, is the amount of "Float" and its
cost over time.
Float is the total
of loss reserves, loss adjustment expense reserves and unearned
premium reserves minus agents balances, prepaid acquisition costs
and deferred charges applicable to assumed reinsurance. And the
cost of float is measured by our underwriting loss.
money that doesn't belong to us but that we temporarily hold.
Float arises because premiums are received before losses are paid,
an interval that sometimes extends over many years. loss events
that occur today do not always result in our immediately paying
claims, because it sometimes takes many years for losses to be
reported (asbestos liability losses would be an example - the
problems they signify lie dormant for decades, before virulently
manifesting themselves.), negotiated and settled. During that
time, the insurer invests the money. Insurance has provided a
fountain of funds with which we've acquired the securities and
businesses that now give us an ever-widening variety of earnings
streams. This pleasant activity typically carries with it a downside:
The premiums that an insurer takes in usually do not cover the
losses and expenses it eventually must pay. That leaves it running
an "underwriting loss", which is the cost of float.
An insurance business
has value if its cost of float over time is less than the cost
the company would otherwise incur to obtain funds. But the business
is a lemon if its cost of float is higher than market rates for
money. If this cost (including the tax penalty) is higher than
that applying to alternative sources of funds, the value is negative.
If the cost is lower, the value is positive - and if the cost
is significantly lower, the insurance business qualifies as a
very valuable asset.
We hold an exceptional
amount of float compared to premium volume. Float is wonderful
- if it doesn't come at a high price. Its cost is determined by
underwriting results, meaning how the expenses and losses we will
ultimately pay compare with the premiums we have received. When
an insurer earns an underwriting profit, float is better than
free. In such years, we are actually paid for holding other people's
money. For most insurers, however, life has been far more difficult:
In aggregate, the property-casualty industry almost invariably
operates at an underwriting loss. When that loss is large, float
becomes expensive, sometimes devastatingly so.
Overall, our results
have been good. True, we've had five terrible years in which float
cost us more than 10%. But in 18 of the 37 years Berkshire has
been in the insurance business, we have operated at an underwriting
profit, meaning we were actually paid for holding money. And the
quantity of this cheap money has grown far beyond what I dreamed
it could when we entered the business in 1967 (Berkshire purchased
National Indemnity ("NICO") in 1967).
e.g. During 1990 we
held about $1.6 billion of float slated eventually to find its
way into the hands of others. The underwriting loss we sustained
during the year was $27 million and thus our insurance operation
produced funds for us at a cost of about 1.6%. There are important
qualifications to this calculation - the fat lady has yet to gargle,
let alone sing, and we won't know our true 1967 - 1990 cost of
funds until all losses from this period have been settled many
decades from now.
Since our float has
cost us virtually nothing over the years, it has in effect served
as equity. Of course, it differs from true equity in that it doesn't
belong to us. Nevertheless, let's assume that instead of our having
$3.4 billion of float at the end of 1994, we had replaced it with
$3.4 billion of equity. Under this scenario, we would have owned
no more assets than we did during 1995. We would, however, have
had somewhat lower earnings because the cost of float was negative
last year. That is, our float threw off profits. And, of course,
to obtain the replacement equity, we would have needed to sell
many new shares of Berkshire. The net result - more shares, equal
assets and lower earnings - would have materially reduced the
value of our stock. So you can understand why float wonderfully
benefits a business - if it is obtained at a low cost.
Accounting irony: Though
our float is shown on our balance sheet as a liability, it has
had a value to Berkshire greater than an equal amount of net worth
would have had.
The downward trend
of interest rates in recent years has transformed underwriting
losses that formerly were tolerable into burdens that move insurance
businesses deeply into the lemon category. Some years back, float
costing, say, 4% was tolerable because government bonds yielded
twice as much, and stocks prospectively offered still loftier
returns. Today, fat returns are nowhere to be found (at least
we can't find them) and short-term funds earn less than 2%. Under
these conditions, each of our insurance operations, save one,
must deliver an underwriting profit if it is to be judged a good
and Long Tails
The combined ratio
represents total insurance costs (losses incurred plus expenses)
compared to revenue from premiums.
הבהרה: היחס המשולב הוא מדד רווחיות מקובל במגזר הביטוח. היחס
מייצג את האחוז מכל דולר של פרמייה שמוצא על תביעות והוצאות. היחס
המשולב מהווה סיכום של יחס ההפסדים ויחס ההוצאות. יחס ההפסדים משקף
באחוזים את היחס בין ההפסדים לבין הפרמיות. יחס ההוצאות משקף באחוזים
את היחס בין ההוצאות לבין הפרמיות. למעשה, היחס המשולב משקף את היחס
בין ההפסדים וההוצאות לבין הפרמיות שנגבו. כאשר היחס המשולב הוא
מעל 100, העסק הביטוחי נמצא בהפסד חיתומי, הווי אומר שתשלומי התגמולים
וההוצאות שהוצאו לצורך יישוב התביעות (לדוגמא, הוצאות בית-משפט),
היו גבוהים מהפרמיות שנגבו. במרבית השנים, הכנסות מהשקעות על ה-float
מקזזות את ההפסדים החיתומיים ובלבד שהללו בגדר הסביר (לא חורגים
הרבה מעל 100).
Because the funds
are available to be invested, the typical property-casualty insurer
can absorb losses and expenses that exceed premiums by 7% to 11%
and still be able to break even on its business. Again, this calculation
excludes the earnings the insurer realizes on net worth - that
is, on the funds provided by shareholders. i.e. when the investment
income that an insurer earns from holding on to policyholders'
funds ("the float") is taken into account, a combined
ratio in the 107-111 range typically produces an overall break-even
result, exclusive of earnings on the funds provided by shareholders.
However, many exceptions
to this 7% to 11% range exist. For example, insurance covering
losses to crops from hail damage produces virtually no float at
all. Premiums on this kind of business are paid to the insurer
just prior to the time hailstorms are a threat, and if a farmer
sustains a loss he will be paid almost immediately. Thus, a combined
ratio of 100 for crop hail insurance produces no profit for the
At the other extreme,
malpractice insurance covering the potential liabilities of doctors,
lawyers and accountants produces a very high amount of float compared
to annual premium volume. The float materializes because claims
are often brought long after the alleged wrongdoing takes place
and because their payment may be still further delayed by lengthy
litigation. The industry calls malpractice and certain other kinds
of liability insurance "long-tail" business, in recognition
of the extended period during which insurers get to hold large
sums that in the end will go to claimants and their lawyers (and
to the insurer's lawyers as well).
In long-tail situations
a combined ratio of 115 (or even more) can prove profitable, since
earnings produced by the float will exceed the 15% by which claims
and expenses overrun premiums. The catch, though, is that "long-tail"
means exactly that: Liability business written in a given year
and presumed at first to have produced a combined ratio of 115
may eventually smack the insurer with 200, 300 or worse when the
years have rolled by and all claims have finally been settled.
The pitfalls of this
business mandate an operating principle that too often is ignored:
Though certain long-tail lines may prove profitable at combined
ratios of 110 or 115, insurers will invariably find it unprofitable
to price using those ratios as targets. Instead, prices must provide
a healthy margin of safety against the societal trends that are
forever springing expensive surprises on the insurance industry.
Setting a target of 100 can itself result in heavy losses; aiming
for 110 - 115 is business suicide.
preferable measure? Combined Ratio or Cost of Float?
What should the measure
of an insurer's profitability be? Analysts and managers customarily
look to the combined ratio - and it's true that this yardstick
usually is a good indicator of where a company ranks in profitability.
We believe a better measure, however, to be a comparison of underwriting
loss to float developed.
This loss/float ratio,
like any statistic used in evaluating insurance results, is meaningless
over short time periods: Quarterly underwriting figures and even
annual ones are too heavily based on estimates to be much good.
But when the ratio takes in a period of years, it gives a rough
indication of the cost of funds generated by insurance operations.
A low cost of funds signifies a good business; a high cost translates
into a poor business.
is a Commodity-like product
Insurers have generally
earned poor returns for a simple reason: they sell a commodity-like
product - a non-proprietary piece of paper containing a non-proprietary
promise. Anyone can copy anyone else's product. No installed base,
key patents, critical real estate or natural resource position
protects an insurer's competitive position. Unlike the situation
prevailing in many other industries, neither size nor brand name
determines an insurer's profitability.
The insurance industry
is cursed with a set of dismal economic characteristics that make
for a poor long-term outlook: hundreds of competitors, ease of
entry, and a product that cannot be differentiated in any meaningful
What finally determines
levels of long-term profitability in such industries is the ratio
of supply-tight to supply-ample years. When shortages exist (when
capacity is short), even commodity businesses flourish. In some
industries, capacity-tight conditions can last a long time. Sometimes
actual growth in demand will outrun forecasted growth for an extended
period. In other cases, adding capacity requires very long lead
times because complicated manufacturing facilities must be planned
and built. But in the insurance business, capacity can be instantly
created by capital plus an underwriter's willingness to sign his
name. In this industry, unlike most, capacity is an attitudinal
concept, not a physical fact. Insurance managers can write whatever
amount of business they feel comfortable writing. That's exactly
what was going on in 1985. About 15 insurers raised well over
$3 billion, piling up capital so that they could write all the
business possible at the better prices then available. The capital-raising
trend had accelerated dramatically in 1986. (Even capital is less
important in a world in which state-sponsored guaranty funds protect
many policyholders against insurer insolvency). Insurance, therefore,
would seem to be a textbook case of an industry usually faced
with the deadly combination of excess capacity and a "commodity"
How do Berkshire's
insurance operations overcome the dismal economics of the industry
and achieve some measure of enduring competitive advantage? We've
attacked that problem in several ways. In such a commodity-like
business, only a very low-cost operator or someone operating in
a protected, and usually small, niche can sustain high profitability
levels. The critical variables, therefore, are managerial brains,
discipline and integrity.
and Low Cost is all that counts (rather than underwriting volume
are judged by their cost of float. If our insurance operations
are to generate low-cost float over time, they must:
(a) underwrite with
unwavering discipline (accept only those risks that you are able
to properly evaluate (staying within your circle of competence)
and that, after you have evaluated all relevant factors including
remote loss scenarios, carry the expectancy of profit. Ignore
market-share considerations and be sanguine about losing business
to competitors that are offering foolish prices or policy conditions);
(b) reserve conservatively; and
(c) avoid an aggregation of exposures that would allow a supposedly
"impossible" incident to threaten their solvency.
No matter what others
may do, we will not knowingly write business at inadequate rates.
We unwittingly did this in the early 1970's and, after more than
20 years, regularly receive significant bills stemming from the
mistakes of that era. My guess is that we will still be getting
surprises from that business 20 years from now. A bad reinsurance
contract is like hell: easy to enter and impossible to exit. I
actively participated in those early reinsurance decisions, and
Berkshire paid a heavy tuition for my education in the business.
We wish to write only
properly-priced business, whatever the effect on volume. Size
simply doesn't count.
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?
What CEO wants to report to his shareholders that not only did
business contract last year but that it will continue to drop?
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. 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.
Another way to prosper
in a commodity-type business is to be the low-cost operator. A
man named Leo Goodwin had an idea for an efficient auto insurer
and, with a skimpy $200,000, started GEICO in 1936. Goodwin's
plan was to eliminate the agent entirely and to deal instead directly
with the auto owner.
State Farm is one of
America's greatest business stories. Studying counter-evidence
is a highly useful activity, though not one always greeted with
enthusiasm at citadels of learning. State Farm was launched in
1922, by a 45-year-old, semi-retired Illinois farmer, to compete
with long-established insurers - haughty institutions in New York,
Philadelphia and Hartford - that possessed overwhelming advantages
in capital, reputation, and distribution. Because State Farm is
a mutual company, its board members and managers could not be
owners, and it had no access to capital markets during its years
of fast growth. Similarly, the business never had the stock options
or lavish salaries that many people think vital if an American
enterprise is to attract able managers and thrive.
In the end, however,
State Farm eclipsed all its competitors. In fact, by 1999 the
company had amassed a tangible net worth exceeding that of all
but four American businesses. If you want to read how this happened,
get a copy of The Farmer from Merna.
Despite State Farm's
strengths, however, GEICO has much the better business model,
one that embodies significantly lower operating costs. And, when
a company is selling a product with commodity-like economic characteristics,
being the low-cost producer is all-important. This enduring competitive
advantage of GEICO - one it possessed in 1951 when, as a 20-year-old
student, I first became enamored with its stock - is the reason
that over time it will inevitably increase its market share significantly
while simultaneously achieving excellent profits. Our growth will
be slow, however, if State Farm elects to continue bearing the
underwriting losses that it is now suffering.
in Long Tailed Business
We should point out
again that in any given year a company writing long-tail insurance
(coverages giving rise to claims that are often settled many years
after the loss-causing event takes place) can report almost any
earnings that the CEO desires. Too often the industry has reported
wildly inaccurate figures by misstating liabilities. Most of the
mistakes have been innocent. Sometimes, however, they have been
intentional, their object being to fool investors and regulators.
For these reasons,
the results in this column simply represent our best estimate
at the end of 2004 as to how we have done in prior years. Profit
margins for the years through 1999 are probably close to correct
because these years are "mature", in the sense that
they have few claims still outstanding. The more recent the year,
the more guesswork is involved. In particular, the results shown
for 2003 and 2004 are apt to change significantly.
In most businesses,
insolvent companies run out of cash. Insurance is different: you
can be broke but flush. Since cash comes in at the inception of
an insurance policy and losses are paid much later, insolvent
insurers don't run out of cash until long after they have run
out of net worth. In fact, these "walking dead" often
redouble their efforts to write business, accepting almost any
price or risk, simply to keep the cash flowing in.
In insurance, the urge
to keep writing business is intensified because the consequences
of foolishly-priced policies may not become apparent for some
time. It takes a long time to learn the true profitability of
any given year. First, many claims are received after the end
of the year, and we must estimate how many of these there will
be and what they will cost. (In insurance jargon, these claims
are termed IBNR - incurred but not reported). Second, claims often
take years, or even decades, to settle, which means there can
be many surprises along the way. 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 1970).
failure and Nicely in 1993
Between 1936 and 1975,
GEICO grew from a standing start to a 4% market share, becoming
the country's fourth largest auto insurer. But after my friend
and hero Lorimer Davidson retired as CEO in 1970, his successors
soon made a huge mistake by under-reserving for losses. This produced
faulty cost information, which in turn produced inadequate pricing.
By 1976, GEICO was on the brink of failure. Jack Byrne then joined
GEICO as CEO and, almost single-handedly, saved the company by
heroic efforts that included major price increases. Though GEICO's
survival required these, policyholders fled the company, and by
1980 its market share had fallen to 1.8%. By 1993 its market share
had grown only fractionally, to 1.9%. Then Tony Nicely took charge.
And what a difference that's made: In 2005 GEICO will probably
secure a 6% market share. Better yet, Tony has matched growth
Catastrophes were not
the culprit in this explosion of loss cost. A partial explanation
for the surge in the loss figures is all the additions to reserves
that the industry made in 1985. As results for the year were reported,
the scene resembled a revival meeting: shouting "I've sinned,
I've sinned", insurance managers rushed forward to confess
they had under reserved in earlier years. Their corrections significantly
affected 1985 loss numbers.
The only bright spot
in this picture is that virtually all of the underreserving revealed
in 1984 occurred in the reinsurance area - and there, in very
large part, in a few contracts that were discontinued several
years ago. This explanation, however, recalls all too well a story
told me many years ago by the then Chairman of General Reinsurance
Company. He said that every year his managers told him that "except
for the Florida hurricane" or "except for Midwestern
tornadoes", they would have had a terrific year. Finally
he called the group together and suggested that they form a new
operation - the Except-For Insurance Company - in which they would
henceforth place all of the business that they later wouldn't
want to count.
A more disturbing ingredient
in the loss surge is the acceleration in "social" or
"judicial" inflation. The insurer's ability to pay has
assumed overwhelming importance with juries and judges in the
assessment of both liability and damages. More and more, "the
deep pocket" is being sought and found, no matter what the
policy wording, the facts, or the precedents.
Loss reserves at an
insurer are not funds tucked away for a rainy day, but rather
a liability account. If properly calculated, the liability states
the amount that an insurer will have to pay for all losses (including
associated costs) that have occurred prior to the reporting date
but have not yet been paid. When calculating the reserve, the
insurer will have been notified of many of the losses it is destined
to pay, but others will not yet have been reported to it. These
losses are called IBNR, for incurred but not reported. Indeed,
in some cases (involving, say, product liability or embezzlement)
the insured itself will not yet be aware that a loss has occurred.
Sometimes the problems they signify lie dormant for decades, as
was the case with asbestos liability, before virulently manifesting
The loss expense charged
in a property/casualty company's current income statement represents:
(1) losses that occurred and were paid during the year;
(2) estimates for losses that occurred and were reported to the
insurer during the year, but which have yet to be settled;
(3) estimates of ultimate dollar costs for losses that occurred
during the year but of which the insurer is unaware (termed "IBNR":
incurred but not reported); and
(4) the net effect of revisions this year of similar estimates
for (2) and (3) made in past years.
Such revisions may
be long delayed, but eventually any estimate of losses that causes
the income for year X to be misstated must be corrected, whether
it is in year X + 1, or X + 10.
In effect, insurance
accounting is a self-graded exam, in that the insurer gives some
figures to its auditing firm and generally doesn't get an argument.
use of estimates in assembling the figures that appear in such
deceptively precise form in the income statement of property/casualty
companies means that some error must seep in, no matter how proper
the intentions of management. In an attempt to minimize error,
most insurers use various statistical techniques to adjust the
thousands of individual loss evaluations (called case reserves)
that comprise the raw data for estimation of aggregate liabilities.
The extra reserves created by these adjustments are variously
labeled "bulk", "development", or "supplemental"
reserves. The goal of the adjustments should be a loss-reserve
total that has a 50-50 chance of being proved either slightly
too high or slightly too low when all losses that occurred prior
to the date of the financial statement are ultimately paid.
The following table
shows the results from insurance underwriting as we have reported
them to you, and also gives you calculations a year later on an
"if-we-knew-then-what-we think-we-know-now" basis. I
say "what we think we know now" because the adjusted
figures still include a great many estimates for losses that occurred
in the earlier years. However, many claims from the earlier years
have been settled so that our one-year-later estimate contains
less guess work than our earlier estimate:
Results as Reported to You
Figures as Reported After One Year's Experience
It is important that
you understand the magnitude of the errors that have been involved
in our reserving. You can thus see for yourselves just how imprecise
the process is, and also judge whether we may have some systemic
bias that should make you wary of our current and future figures.
As you can see from reviewing the table, my errors in reporting
to you have been substantial and recently have always presented
a better underwriting picture than was truly the case.
You should be very
suspicious of any earnings figures reported by insurers (including
our own, as we have unfortunately proved to you in the past).
The record of the last decade shows that a great many of our best-known
insurers have reported earnings to shareholders that later proved
to be wildly erroneous. In most cases, these errors were totally
innocent: The unpredictability of our legal system makes it impossible
for even the most conscientious insurer to come close to judging
the eventual cost of long-tail claims. We want to emphasize that
we are not faulting auditors for their inability to accurately
assess loss reserves (and therefore earnings). We fault them only
for failing to publicly acknowledge that they can't do this job.
Because our business
is weighted toward casualty and reinsurance lines, we have more
problems in estimating loss costs than companies that specialize
in property insurance. (When a building that you have insured
burns down, you get a much faster fix on your costs than you do
when an employer you have insured finds out that one of his retirees
has contracted a disease attributable to work he did decades earlier).
errors of other property/casualty companies are of more than academic
interest to Berkshire. Not only does Berkshire suffer from sell-at-any-price
competition by the "walking dead", but we also suffer
when their insolvency is finally acknowledged. Through various
state guarantee funds that levy assessments, Berkshire ends up
paying a portion of the insolvent insurers' asset deficiencies,
swollen as they usually are by the delayed detection that results
from wrong reporting. There is even some potential for cascading
trouble. The insolvency of a few large insurers and the assessments
by state guarantee funds that would follow could imperil weak-but-previously-solvent
insurers. Such dangers can be mitigated if state regulators become
better at prompt identification and termination of insolvent insurers,
but progress on that front has been slow.
Because of this one-sided
experience, it is folly to suggest, as some are doing, that all
property/casualty insurance reserves be discounted, an approach
reflecting the fact that they will be paid in the future and that
therefore their present value is less than the stated liability
for them. Discounting might be acceptable if reserves could be
precisely established. They can't, however, because a myriad of
forces - judicial broadening of policy language and medical inflation,
to name just two chronic problems - are constantly working to
make reserves inadequate.
Knowing Insurance Costs is Vital (Under-Reserving)
("Loss Development") ("Reserve Strengthening")
It's clearly difficult
for an insurer to put a figure on the ultimate cost of all such
reported and unreported events. But the ability to do so with
reasonable accuracy is vital. Otherwise the insurer's managers
won't know what its actual loss costs are and how these compare
to the premiums being charged. GEICO got into huge trouble in
the early 1970s because for several years it severely underreserved,
and therefore believed its product (insurance protection) was
costing considerably less than was truly the case. Consequently,
the company sailed blissfully along, underpricing its product
and selling more and more policies at ever-larger losses.
I can promise you that
our top priority going forward is to avoid inadequate reserving.
We are making every effort to get our reserving right. But I can't
guarantee success. The natural tendency of most casualty-insurance
managers is to underreserve, and they must have a particular mindset
- which, it may surprise you, has nothing to do with actuarial
expertise - if they are to overcome this devastating bias. Additionally,
a reinsurer faces far more difficulties in reserving properly
than does a primary insurer. Nevertheless, at Berkshire, we have
generally been successful in our reserving, and we are determined
to be at General Re as well.
Any insurer that has
no idea what its costs are is heading for big trouble. Not knowing
your costs will cause problems in any business. In long-tail reinsurance,
where years of unawareness will promote and prolong severe underpricing,
ignorance of true costs is dynamite.
When it becomes evident
that reserves at past reporting dates understated the liability
that truly existed at the time, companies speak of "loss
development." In the year discovered, these shortfalls penalize
reported earnings because the "catch-up" costs from
prior years must be added to current-year costs when results are
This is what happened
at General Re in 2001: a staggering $800 million of loss costs
that actually occurred in earlier years, but that were not then
recorded, were belatedly recognized last year and charged against
current earnings. At yearend 2001, General Re attempted to reserve
adequately for all losses that had occurred prior to that date
and were not yet paid - but we failed badly. Therefore the company's
2002 underwriting results were penalized by an additional $1.31
billion that we recorded to correct the estimation mistakes of
earlier years. The mistake was an honest one, I can assure you
of that. Nevertheless, for several years, this underreserving
caused us to believe that our costs were much lower than they
truly were, an error that contributed to woefully inadequate pricing.
Additionally, the overstated profit figures led us to pay substantial
incentive compensation that we should not have and to incur income
taxes far earlier than was necessary.
suggests to investors that some natural, uncontrollable event
has occurred in the current year, and "reserve strengthening"
implies that adequate amounts have been further buttressed. The
truth, however, is that management made an error in estimation
that in turn produced an error in the earnings previously reported.
The losses didn't "develop" - they were there all along.
What developed was management's understanding of the losses (or,
in the instances of chicanery, management's willingness to finally
fess up). A more forthright label for the phenomenon at issue
would be "loss costs we failed to recognize when they occurred"
(or maybe just "oops"). Underreserving, it should be
noted, is a common - and serious - problem throughout the property/casualty
in Mergers and Restructuring
In the acquisition
arena, restructuring has been raised to an art form: Managements
now frequently use mergers to dishonestly rearrange the value
of assets and liabilities in ways that will allow them to both
smooth and swell future earnings. Indeed, at deal time, major
auditing firms sometimes point out the possibilities for a little
accounting magic (or for a lot). Getting this push from the pulpit,
first-class people will frequently stoop to third-class tactics.
CEOs understandably do not find it easy to reject auditor-blessed
strategies that lead to increased future "earnings".
An example from the
property-casualty insurance industry will illuminate the possibilities.
When a p-c company is acquired, the buyer sometimes simultaneously
increases its loss reserves, often substantially. This boost may
merely reflect the previous inadequacy of reserves - though it
is uncanny how often an actuarial "revelation" of this
kind coincides with the inking of a deal. In any case, the move
sets up the possibility of "earnings" flowing into income
at some later date, as reserves are released.
A preliminary tally
by R. G. Associates, of Baltimore, of special charges taken or
announced during 1998 - that is, charges for restructuring, in-process
R&D, merger-related items, and write-downs - identified no
less than 1,369 of these, totaling $72.1 billion. That is a staggering
amount as evidenced by this bit of perspective: The 1997 earnings
of the 500 companies in Fortune's famous list totaled $324 billion.
Berkshire has kept
entirely clear of these practices: If we are to disappoint you,
we would rather it be with our earnings than with our accounting.
In all of our acquisitions, we have left the loss reserve figures
exactly as we found them. After all, we have consistently joined
with insurance managers knowledgeable about their business and
honest in their financial reporting. When deals occur in which
liabilities are increased immediately and substantially, simple
logic says that at least one of those virtues must have been lacking
- or, alternatively, that the acquirer is laying the groundwork
for future infusions of "earnings".
Vs. Premium growth
We expect the industry's
incurred losses to grow by about 10% annually, even in years when
general inflation runs considerably lower. If premium growth meanwhile
materially lags that 10% rate, underwriting losses will mount,
though the industry's tendency to underreserve when business turns
bad may obscure their size for a time.
Strength of Promise to Pay Means a Lot
Insurance sold to other
insurers who wish to lay off part of the risks they have assumed
- should not be a commodity product. At bottom, any insurance
policy is simply a promise, and as everyone knows, promises vary
enormously in their quality. When insurers purchase reinsurance,
they buy only a promise - one whose validity may not be tested
for decades - and there are no promises in the reinsurance world
equaling those offered by Gen Re and National Indemnity.
Reinsurance is characterized
by extreme ease of entry, large premium payments in advance, and
much-delayed loss reports and loss payments. Initially, the morning
mail brings lots of cash and few claims. This state of affairs
can produce a blissful, almost euphoric, feeling akin to that
experienced by an innocent upon receipt of his first credit card.
The solvency risk in
primary policies, pales in comparison to that lurking in reinsurance
policies. When a reinsurer goes broke, staggering losses almost
always strike the primary companies it has dealt with. This risk
is far from minor: GEICO has suffered tens of millions in losses
from its careless selection of reinsurers in the early 1980s.
Here's one footnote to GEICO's 2002 earnings that underscores
the need for insurers to do business with only the strongest of
reinsurers. In 1981-1983, the managers then running GEICO decided
to try their hand at writing commercial umbrella and product liability
insurance. The risks seemed modest: the company took in only $3,051,000
from this line and used almost all of it - $2,979,000 - to buy
reinsurance in order to limit its losses. GEICO was left with
a paltry $72,000 as compensation for the minor portion of the
risk that it retained. But this small bite of the apple was more
than enough to make the experience memorable. GEICO's losses from
this venture now total a breathtaking $94.1 million or about 130,000%
of the net premium it received. Of the total loss, uncollectable
receivables from deadbeat reinsurers account for no less than
$90.3 million (including $19 million charged in 2002). So much
for "cheap" reinsurance. "Cheap" reinsurance
is thus a fool's bargain: When an insurer lays out money today
in exchange for a reinsurer's promise to pay a decade or two later,
it's dangerous - and possibly life-threatening - for the insurer
to deal with any but the strongest reinsurer around.
Some reinsurers, particularly
those who, in turn, are accustomed to laying off much of their
business on a second layer of reinsurers known as retrocessionaires
- are in a weakened condition and would have difficulty surviving
a second mega-cat. When a daisy chain of retrocessionaires exists,
a single weak link can pose trouble for all. In assessing the
soundness of their reinsurance protection, insurers must therefore
apply a stress test to all participants in the chain, and must
contemplate a catastrophe loss occurring during a very unfavorable
economic environment. After all, you only find out who is swimming
naked when the tide goes out. At Berkshire, we retain our risks
and depend on no one. And whatever the world's problems, our checks
Unlike most reinsurers,
we retain virtually all of the risks we assume. Therefore, our
ability to pay is not dependent on the ability or willingness
of others to reimburse us. This independent financial strength
could be enormously important when the industry experiences the
mega-catastrophe it surely will.
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.
Our willingness to
put such a huge sum on the line for a loss that could occur tomorrow
sets us apart from any reinsurer in the world. There are, of course,
companies that sometimes write $250 million or even far more of
catastrophe coverage. But they do so only when they can, in turn,
reinsure a large percentage of the business with other companies.
When they can't "lay off" in size, they disappear from
the market. Berkshire's policy, conversely, is to retain the business
we write rather than lay it off. When rates carry an expectation
of profit, we want to assume as much risk as is prudent. And in
our case, that's a lot.
We will accept more
reinsurance risk for our own account than any other company because
of two factors: (1) by the standards of regulatory accounting,
we have a net worth in our insurance companies of about $6 billion
- the second highest amount in the United States; and (2) we simply
don't care what earnings we report quarterly, or even annually,
just as long as the decisions leading to those earnings (or losses)
were reached intelligently.
and Mega-Cats (Super-Cats)
are reinsurance contracts that primary insurance companies (and
also reinsurers themselves) buy to protect themselves against
a single catastrophe, such as a tornado or hurricane, that produces
losses from a large number of policies. Say, terrorists detonated
several large scale nuclear bombs in an attack on the U.S. A disaster
of that scope was highly improbable, of course, but it is up to
insurers to limit their risks in a manner that leaves their finances
rock-solid if the "impossible" happens. In these contracts,
the primary insurer might retain the loss from a single event
up to a maximum of, say, $10 million, buying various layers of
reinsurance above that level. When losses exceed the retained
amount, the reinsurer typically pays 95% of the excess up to its
contractual limit, with the primary insurer paying the remainder.
(By requiring the primary insurer to keep 5% of each layer, the
reinsurer leaves him with a financial stake in each loss settlement
and guards against his throwing away the reinsurer's money.)
CAT covers are usually
one-year policies that also provide for one automatic reinstatement,
which requires a primary insurer whose coverage has been exhausted
by a catastrophe to buy a second cover for the balance of the
year in question by paying another premium. This provision protects
the primary company from being "bare" for even a brief
period after a first catastrophic event. The duration of "an
event" is usually limited by contract to any span of 72 hours
designated by the primary company. Under this definition, a wide-spread
storm, causing damage for three days, will be classified as a
single event if it arises from a single climatic cause. If the
storm lasts four days, however, the primary company will file
a claim carving out the 72 consecutive hours during which it suffered
the greatest damage. Losses that occurred outside that period
will be treated as arising from a separate event.
Depending upon many
variables, a CAT premium might generally have run 3% to 15% of
the amount of protection purchased. For some years, we've thought
premiums of that kind inadequate and have stayed away from the
But because the 1989
disasters left many insurers either actually or possibly bare,
and also left most CAT writers licking their wounds, there was
an immediate shortage after the earthquake of much-needed catastrophe
coverage. Prices instantly became attractive, particularly for
the reinsurance that CAT writers themselves buy. Just as instantly,
Berkshire Hathaway offered to write up to $250 million of catastrophe
coverage, advertising that proposition in trade publications.
Though we did not write all the business we sought, we did in
a busy ten days book a substantial amount.
Reinsurance is a business
that is certain to deliver blows from time to time. Were a true
mega-catastrophe to occur in the next decade or two - and that's
a real possibility - some reinsurers would not survive. The largest
insured loss to date is the World Trade Center disaster, which
cost the insurance industry an estimated $35 billion. Hurricane
Andrew cost insurers about $15.5 billion in 1992 (though that
loss would be far higher in today's dollars). Both events rocked
the insurance and reinsurance world. But a $100 billion event,
or even a larger catastrophe, remains a possibility if either
a particularly severe earthquake or hurricane hits just the wrong
place. Four significant hurricanes struck Florida during 2004,
causing an aggregate of $25 billion or so in insured losses. Two
of these - Charley and Ivan - could have done at least three times
the damage they did had they entered the U.S. not far from their
actual landing points. Many insurers regard a $100 billion industry
loss as "unthinkable" and won't even plan for it. But
at Berkshire, we are fully prepared. Our share of the loss would
probably be 3% to 5%, and earnings from our investments and other
businesses would comfortably exceed that cost. When "the
day after" arrives, Berkshire's checks will clear.
When viewing our quarterly
figures, you should understand that our accounting for super-cat
premiums differs from our accounting for other insurance premiums.
Rather than recording our super-cat premiums on a pro-rata basis
over the life of a given policy, we defer recognition of revenue
until a loss occurs or until the policy expires. We take this
conservative approach because the likelihood of super-cats causing
us losses is particularly great toward the end of the year. The
bottom-line effect of our accounting procedure for super-cats
is this: Large losses may be reported in any quarter of the year,
but significant profits will only be reported in the fourth quarter.
how to price Super-Cats (Experience And Exposure)
Experience, of course,
is a highly useful starting point in underwriting most coverages.
At certain times, however, using experience as a guide to pricing
is not only useless, but actually dangerous. Late in a bull market,
for example, large losses from directors and officers liability
insurance ("D&O") are likely to be relatively rare.
When stocks are rising, there are a scarcity of targets to sue,
and both questionable accounting and management chicanery often
go undetected. At that juncture, experience on high-limit D&O
may look great. But that's just when exposure is likely to be
exploding, by way of ridiculous public offerings, earnings manipulation,
chain-letter-like stock promotions and a potpourri of other unsavory
activities. When stocks fall, these sins surface. Consequently,
the correct rate for D&O "excess" (meaning the insurer
or reinsurer will pay losses above a high threshold) might well,
if based on exposure, be five or more times the premium dictated
Since September 11th,
Ajit has been particularly busy. Among the policies we have written
and retained entirely for our own account are (1) $578 million
of property coverage for a South American refinery once a loss
there exceeds $1 billion; (2) $1 billion of non-cancelable third-party
liability coverage for losses arising from acts of terrorism at
several large international airlines; (3) £500 million of property
coverage on a large North Sea oil platform, covering losses from
terrorism and sabotage, above £600 million that the insured retained
or reinsured elsewhere; and (4) significant coverage on the Sears
Tower, including losses caused by terrorism, above a $500 million
threshold. We have written many other jumbo risks as well, such
as protection for the World Cup Soccer Tournament and the 2002
Winter Olympics. In all cases, however, we have attempted to avoid
writing groups of policies from which losses might seriously aggregate.
We will not, for example, write coverages on a large number of
office and apartment towers in a single metropolis without excluding
losses from both a nuclear explosion and the fires that would
in profits is welcomed (compared with 'smooth' annual profits)
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.
I have known the details
of almost every policy that Ajit has written since he came with
us in 1986, and never on even a single occasion have I seen him
break any of our three underwriting rules. His extraordinary discipline,
of course, does not eliminate losses; it does, however, prevent
foolish losses. And that's the key: Just as is the case in investing,
insurers produce outstanding long-term results primarily by avoiding
dumb decisions, rather than by making brilliant ones. We want
to emphasize, however, that we assume risks in Ajit's operation
that are huge - far larger than those retained by any other insurer
in the world. Therefore, a single event could cause a major swing
in Ajit's results in any given quarter or year. Reinsurance is
a highly volatile business.
That bothers us not
at all: As long as we are paid appropriately, we love taking on
short-term volatility that others wish to shed. At Berkshire,
we would rather earn a lumpy 15% over time than a smooth 12%.
We are perfectly willing to lose $2 billion to $2½ billion in
a single event (as we did on September 11th) if we have been paid
properly for assuming the risk that caused the loss.
When a claims manager
walks into the CEO's office and says "Guess what just happened,"
his boss, if a veteran, does not expect to hear it's good news.
Surprises in the insurance world have been far from symmetrical
in their effect on earnings.
Insurance - Accountancy
In this line of business,
we assume from another insurer the obligation to pay up to a specified
amount for losses they have already incurred - often for events
that took place decades earlier - but that are yet to be paid
- (for example, because a worker hurt in 1980 will receive monthly
payments for life). In these arrangements, an insurer pays us
a large upfront premium, but one that is less than the losses
we expect to pay. We willingly accept this differential because
a) our payments are capped, and b) we get to use the money until
loss payments are actually made, with these often stretching out
over a decade or more. About 80% of the $6.6 billion in asbestos
and environmental loss reserves that we carry arises from capped
contracts, whose costs consequently can't skyrocket.
When we write a retroactive
policy, we immediately record both the premium and a reserve for
the expected losses. The difference between the two is entered
as an asset entitled "deferred charges - reinsurance assumed".
This is no small item: at yearend, for all retroactive policies,
it was $3.4 billion. We then amortize this asset downward by charges
to income over the expected life of each policy. These charges
- $440 million in 2002, including charges at Gen Re - create an
underwriting loss, but one that is intentional and desirable.
By their nature, these losses will continue for many years, often
stretching into decades. As an offset, though, we have the use
of float - lots of it.
Clearly, float carrying
an annual cost of this kind is not as desirable as float we generate
from policies that are expected to produce an underwriting profit
(of which we have plenty). Nevertheless, this retroactive insurance
should be decent business for us.
Finally, the competitive
picture changed in at least one important respect: State Farm
- by far the largest personal auto insurer, with about 19% of
the market - has been very slow to raise prices. Its costs, however,
are clearly increasing right along with those of the rest of the
industry. Consequently, State Farm had an underwriting loss last
year from auto insurance (including rebates to policyholders)
of 18% of premiums, compared to 4% at GEICO. Our loss produced
a float cost for us of 6.1%, an unsatisfactory result. (Indeed,
at GEICO we expect float, over time, to be free.) But we estimate
that State Farm's float cost in 2000 was about 23%. The willingness
of the largest player in the industry to tolerate such a cost
makes the economics difficult for other participants.