Intelligent Investor Club

Berkshire Annual Letter 2001 (Part 3)

Warren Buffett recommended reading Jack Welch’s book, Jack, Straight from the Gut.

In the words of Warren Buffett, Jack Welch is smart, energetic, hands-on, and expects much of both himself and his organisation.

In investing (just like insurance), you can produce outstanding long term results primarily by avoiding dumb decisions, rather than by making brilliant ones.

…Continue reading » Loss Development in Insurance Accounting

Berkshire Annual Letter 2001 (Part 2)

To understand Berkshire, it is necessary to understand how to evaluate an insurance company.

The key factors are:

1. The amount of float that the company generates.
2. Its cost.
3. The long term outlook of both the above factors.

Usually, it is not the size or brand that determines whether an insurance company is profitably. What is important is whether the company adopts these three principles:

…Continue reading » Principles of Insurance Underwriting

Berkshire Annual Letter 1998 (Part 2)

General Re

On December 21 1998, Berkshire completed the $22 billion acquisition of General Re Corp. This ownership will allow General Re to operate in whatever manner that will maximise its value without worrying about market perception.

For instance, a publicly held reinsurer by the very nature of its role, has very volatile earnings. This volatility can hurt it’s credit ratings and p/e ratios. As a result, an reinsurer might sometimes do things to smoothen the earnings that is actually costly to its core business.

…Continue reading » General Re Corp and GEICO

Berkshire Annual Letter 1997 (Part 5)

Continuing on from Warren Buffett’s discussion on insurance float, we now move on to the most volatile form of insurance, the super-cat (or super-catastrophy) insurance.

Insurance companies and reinsurance companies purchase insurance themselves to limit their losses in the event of a major disaster. A company that is willing to underwrite such policies must have a very strong financial strength.

Berkshire, being in such a position, underwrites super-cats heavily and has a huge involvement in this form of insurance.

…Continue reading » Super-Cat Insurance

Berkshire Annual Letter 1997 (Part 4)

Unless you understand about “float” and how to measure its cost, you will never be able to make a good estimate about Berkshire’s intrinsic value.

Float is money that is held but not owned.

In the insurance industry, there is float because premiums are received before losses are paid. This time interval can sometimes extend to decades. During this time, the money can be invested by the insurer.

…Continue reading » A Discussion on Insurance Float

Berkshire Annual Letter 1996 (Part 4)

GEICO is an extremely valuable asset to Berkshire and is headed by Tony Nicely, a superb business manager.

The strength of GEICO lies in its position as a low-cost operator. With low costs come low prices and good long-term policy holders.

GEICO also gets more than one million referrals (due to their low prices) annually which produces more than half of their business. This lowers than acquisition expensese, which makes their cost even lower.

In 1996, their voluntary auto policy grew 10%, which was an record growth. This is the area that Buffett focuses on and not involutary growth (from assigned risk pools and the like). That kind of growth is unprofitable.

On top of the growth, the underwriting was also profitable. The goal of GEICO is not to increase the profit margin, but to increase the price advantage given to customers. With that, the customer base would be expected to grow even further. …Continue reading » GEICO

Berkshire Annual Letter 1996 (Part 3)

In Berkshire’s super-cat business, they sell policies to insurance and reinsurance companies to protect them from the effects of mega-catastrophes.

As such events occur rarely, Berkshire’s super-cat business will thus show large profits in most years with the occasion huge loss in certain years.

That huge loss year will come – it is only a matter of when. When that happens, shareholders need not panic and sell Berkshire shares. Their after-tax “worst-case” loss from a true mege-catastrophe is probably no more than 3% of their book value (and 1.5% of their market value).

To take things into perspective, the swings in the market price of Berkshire would have been even greater.

Volatility in Berkshire’s earnings isn’t too important either. Warren Buffett would rather earn a lumpy 15% over time than a smooth 12%.

Berkshire has three major competitive advantages in the super-cat business.

1) The parties buying reinsurance from them know that Berkshire has the financial strength to pay under the most adverse of situations.

2) After a mega-catastrophe, insurers might find it difficult to obtain reinsurance even though their needs would be very great at that time. Berkshire will have the capacity to underwrite it when the time comes.

3) They can provide a coverage size that cannot be matched in the industry.

With regards to the pricing, they are made at a level so that eventually 90% of total premiums will end up being paid out in losses and expenses.

It will take a long time to find out whether those prices were correct.

Technorati Tags:

Two Acquisitions of 1996

There were two acquisitions by Berkshire in 1996, both with qualities they seek – excellent business economics and an outstanding manager.

Kansas Bankers Surety (KBS)

This was an insurance company with an extraordinary underwriting record and an outstanding manager, Don Towle. Don has first-hand relationships with hundreds of bankers, and knows every details of the company.

It took Warren Buffett less than one day to look at the financial statements of the company before deciding to buy it.

FlightSafety International

FlightSafety International is a world leader in the training of pilots. The CEO of the company is Al Ueltschi, 79 years old at the time of acquistion.

It took Warren Buffett 60 seconds upon meeting Al to know that he was exactly the kind of manager that Berkshire needed.

If you can recall, I had previously uploaded an interview that Robert Miles had with Al Ueltschi.

Insurance Operations

The results for both primary insurance and super-cat reinsurance business were outstanding in 1996.

What counts in the insurance business is the amount of float generated and the cost of the float.

This is important to understand as float is a major component of Berkshire’s intrinsic value that is not reflected in book value.

In an insurance operation, float is the money held by the company (but they don’t own). It arises because premiums are always collected before losses are paid out.

Typically, the premiums collected by insurers do not cover the losses and expenses they have to pay. This “underwriting loss” 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 incur to obtain the funds.

In Berkshire, the insurance businses has been a big winner as their cost of float has been less than nothing for many years. This access to “free” money has boosted their performance in a major way.

Technorati Tags: warren buffett, benjamin graham, charlie munger, berkshire hathaway, flightsafety international, al ueltschi, kansas bankers surety

Berkshire Annual Letter 1995 (Part 6)

What counts in the insurance business is the amount of float generated (money held but not owned) and the cost of it. There is float because premiums are always paid upfront and it takes time to resolve claims.

Usually, the premiums that an insurer takes in will not cover the losses and expenses that it must pay. This is called an “unwriting loss” and reflects the cost of float.

If this cost of float is lower than market rates for money, then that insurance company is profitable.

At times when there is no underwriting loss, the cost of float is acutually negative, giving “free money”.

In any business, its profitability is determined by three things:

1) What its assets earn;
2) What its liabilities cost; and
3) its utilization of leverage – the extent by which assets are funded by liabilities rather than by equity.

Berkshire has always done well on the first point. What most people don’t realise is that they have also benefited greatly from the low cost of their liabilities.

Often, they are able to generate plenty of float on very advantageous terms.

At the end of 1994, they had $3.4 billion of float. If they had replaced that with $3.4 billion of equity, it would have meant more shares, equal assets and lower earnings attributed to each share.

The acquisition of GEICO will increase their float by $3 billion, with the probability that the cost of the float will be nothing (due to underwriting profits).

Super-Cat Insurance

Berkshire is able to stand out in the field of super-cat and large risk insurance because of:

1) Their unmatched financial strength;
2) Their ability to supply quotes faster than anyone else.
3) Their ability to issue policies with limits larger than anyone else.

The nature of the super-cat insurance business is such that it can show large profits in many years but there could be occassional years of huge losses. Thus, it will take many years to evaluate the profitability.

Both Warren Buffett and charlie Munger are quite willing to accept relatively volatile results in exchange for better long-term earnings.

However, they will never write business at inadequate rates. A bad insurance contract is like hell; you can get surprises from it even 20 years down the road.

Technorati Tags: warren buffett, benjamin graham, charlie munger

Berkshire Annual Letter 1995 (Part 5)

Back when Warren Buffett attended Columbia University under the tutorlege of Benjamin Graham, he found out that Ben was the Chairman of Government Employees Insurance Company (GEICO), an unknown company to him.

One weekend, Warren Buffett took a train to the headquarters of GEICO, where he was met by Lorimer Davison, Assistant to the President (and who was later to become CEO).

Even though Warren’s only credentials at that time was a student of Graham, “Davy” spent four hours teaching him about the ins and outs of the insurance business.

Up to this day, Warren Buffett is thankful to Davy’s generousity with his time, as Berkshire would not have gotten to where it is today without that afternoon meeting.

As Warren found out, GEICO’s strength was in using direct marketing as its method of selling, giving it an enormous cost advantage over competitors who sold through agents.

So in 1951, Warren started to buy shares in GEICO on four occassions using money that he earned as a delivery boy for The Washington Post.

This stake of $10,282 was more than 50% of his networth and was sold in 1952 for $15,259. (The stake if kept to 1995, would have growth to $1.3 million.)

From 1976 to 1980, Berkshire spent $45.7 million to accummulate a 33.3% stake in the company. Because of the aggressive share buybacks by the company, this stake actually grew to 50% of the company.

In 1995, Berkshire paid another $2.3 billion for the other half of the company that it didn’t own, gaining full control of the company and taking it private.

Warren Buffett likes businesses with economic castles protected by unbreachable “moats”. GEICO is one such example.

Technorati Tags: warren buffett, benjamin graham, geico, lorimer davison