Analysing Insurance Operations
In the past, Warren Buffett uses a measurement known as the “combined ratio” to evaluation the performance of the insurance industry. This ratio compares the total insurance cost (which includes payouts and expenses) to the revenue from premiums.
A ratio of over 100% represents an underwriting loss, which actually happens quite frequently. How then do insurers stay in business?
The reason for this is simple.
Premiums for most policies are paid upfront, while resolving claims often takes time. Insurers are thus able to hold their policyholders’ money for some time before paying it out. Using these funds that are earmarked to be paid in the future (or “the float”), insureres can invest them. Taking into account the investment earnings from this float, it is therefore possible for insurers to be profitable with a combined ratio of over 100%.
Things are however, not so staightfoward. Often, underwriting losess are usually estimated and have to be corrected later on. Furthermore, no one knows the exact future liabilities owed to the premiums that are collected today.
In this year’s letter, Warren Buffett uses another measure to evaluate the performance of the insurance industry. The reason for this is that interest rates has fallen so the combined ratio method is no longer useful for comparing the profitably from one year to another.
For example, a company writing at the same combined ratio in the 1980s as compared to the 1990s is much more attractive because the interest rates were higher then.
So, the analysis has to take into account both the underwriting results as well as the risk-free rate.
(The actual investment returns from the float should of course be of another major importance. But that is a separate analysis from the one that is dicussed here.)
This is how the figures (In $ Millions) looks like for Berkshire’s insurance business:
(1) (2)
Yield
Underwriting Approximate on Long-Term
Loss Average Float Cost of Funds Govt. Bonds
------------ ------------- --------------- -------------
(Ratio of 1 to 2)
1967 profit $ 17.3 less than zero 5.50%
1968 profit 19.9 less than zero 5.90%
1969 profit 23.4 less than zero 6.79%
1970 $ 0.37 32.4 1.14% 6.25%
1971 profit 52.5 less than zero 5.81%
1972 profit 69.5 less than zero 5.82%
1973 profit 73.3 less than zero 7.27%
1974 7.36 79.1 9.30% 8.13%
1975 11.35 87.6 12.96% 8.03%
1976 profit 102.6 less than zero 7.30%
1977 profit 139.0 less than zero 7.97%
1978 profit 190.4 less than zero 8.93%
1979 profit 227.3 less than zero 10.08%
1980 profit 237.0 less than zero 11.94%
1981 profit 228.4 less than zero 13.61%
1982 21.56 220.6 9.77% 10.64%
1983 33.87 231.3 14.64% 11.84%
1984 48.06 253.2 18.98% 11.58%
1985 44.23 390.2 11.34% 9.34%
1986 55.84 797.5 7.00% 7.60%
1987 55.43 1,266.7 4.38% 8.95%
1988 11.08 1,497.7 0.74% 9.00%
1989 24.40 1,541.3 1.58% 7.97%
1990 26.65 1,637.3 1.63% 8.24%
1991 119.59 1,895.0 6.31% 7.40%
1992 108.96 2,290.4 4.76% 7.39%
1993 profit 2,624.7 less than zero 6.35%
In the event of an underwriting profit, the cost of the float would be negative. Most years, you can see that the cost of the float is less than the risk-free rate. This looks extremely good.
Warren however, cautions looking at the figures in isolation for any single year. The reason is that they write a fairly large amount of “super-cat” policies. When a super catastrophic event occurs, the losses for that year could very well equal three to four times of their underwritiing profits in good years.
This is no way for them to know the true odds on super-cat coverage and it would take them decades to know whether their underwriting rates had been sound.
However, Warren believes that overall, they have a first class insurance business. While results might be highly volatile, their intrinsic value far exceeds their book value.
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