Intelligent Investor Club

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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Today’s post looks into insurance operations for “super-cat” coverages, which are the policies that other insurance companies buy to protect themselves against major catastrophic losses. Read on to understand how Warren Buffett views this industry and manages his operations.

Insurance Operations

Due to Hurricane Andrew, Berkshire suffered losses of $125 million, an amount roughly equal to their 1992 super-cat premium income.

The nature of the super-cat insurance is such that in any year, it would “either enormously profitable or enormously unprofitable” (even though both 1991 and 1992 came in close to break even).

Generally, these policies (most of them) are activated subjected to certain conditions.

1) There is a deductible or retention that the policyholder has to absorb before the policy kicks in.

2) Industry wide insured losses from the castastrophe must exceed some minimum amount.

3) Occurrence of second, third or fourth event.

4) Catastrophe of a specific type.

5) Specific geographical region.

It is difficult to price super-cat policies as insurers cannot simply extrapolate past events. For example, slight changes to the world’s climate might produce huge changes in weather patterns.

For some reason, the likelihood of super-cats happening is higher towards the end of the year, when the weather tends to kick up.

Therefore, Warren takes a conservative approach of defering the recognition of revenue until a loss occurs or until the policy expires.

This results in a slight biased in the quarterly results: Large losses may be reported in any quarter of the year, but significant profits will only be reported in the fourth quarter.

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As I read the summary of the performance of the various non-insurance operations like Borsheim, Nebraska Furniture Mart, See’s Candy, Fechheimer, Scott Fetzer and Buffalo News for the umpteen time, I was given the reason by Buffett why these companies continue to do well.

Whatever the reason for their performance, when you invest in a stock, at the end of the day you are looking at the quality of the business. If the company has a good business model and stand above your competitors, then your stock will do well.

Measuring Insurance Performance

The combined ratio represents total insurance costs (losses incurred plus expenses) compared to revenue from premiums: A ratio below 100 indicates an underwriting profit, and one above 100 indicates a loss.

Typical property-casualty insurers can have a ratio of 107-111% and still be profitable because of investment returns from the insurance funds (float).

Exceptions include insurance covering losses to crops (which produce no float at all) and malpractice insurance which has a higher tolerance due to delayed payment caused by lengthy litigation.

Most analysts and managers look to the combined ratio when measuring an insurance business; however Buffett has another method.

He looks at the underwriting loss to float developed ratio (over an extended period of time) and then treats that as the “cost of funds developed from insurance.”

If this cost (including the tax penalty) is higher than that applying to alternative sources of funds, then it’s a poor business. If the cost is lower, it is a good business – and if the cost is significantly lower, the insurance business qualifies as a very valuable asset.

To put it simply, insurance is a place where you can generate funds for investment. If the cost of these funds (after deducting all expenses) are lower than what you pay outside, then you have a good business!

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Share Repurchases

When a company with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, repurchases of the shares by the company provide sure benefits to shareholders.

One benefit involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. Corporate acquisition seldom do as well.

Another less obvious benefit is that when management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, shareholders and potential shareholders usually increase their estimates of future returns from the business. This upward revision, produces market prices more in line with intrinsic business value.

Buffalo Evening News

A point that I managed to pick out was that the economics of a dominant newspaper are excellent, among the very best in the business world. Once dominant, the newspaper itself and not the marketplace determines just how good or how bad the paper will be. And either way, it will prosper. Do you have a dominant newspaper?

Errors in Loss Reserving (Insurance)

The determination of costs is a main problem in the insurance industry. Most of an insurer’s costs result from losses on claims, and many of the losses that should be charged against the current year’s revenue are exceptionally difficult to estimate.

In some cases, dishonest companies that would be out of business if they realistically appraised their loss costs have, in some cases, simply preferred to take an extraordinarily optimistic view about these yet-to-be-paid sums. Others have engaged in various transactions to hide true current loss costs.

In other businesses, insolvent companies will run out of cash. Insurance is different: you can be broke but flush. Since cash comes in at the start 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.

Washington Public Power Supply System (Bonds)

In the past year, there was a purchase of large quantities of Projects 1, 2, and 3 of Washington Public Power Supply System (“WPPSS”).

When Warren buys marketable stocks, he would apply the same criteria that he would use for the purchase of the entire business. This business-valuation approach applies even to bond purchases such as WPPSS.

The interest earned by the bond is treated as operating profits earned by the ‘business’. Such a valuation method means that he will never buy a bond giving a 1% yield! As Benjamin Graham quoted in his book “The Intelligent Investor”, Investment is most intelligent when it is most businesslike.

Dividend Policy

Even though allocation of capital is crucial to business and investment management, dividend policy is seldom explained. It’s often simply stated as a percentage of net earnings.

Inflation causes some or all of the reported earnings to become “restricted” – i.e. if the business is to retain its economic position, cannot be distributed as dividends.

For the rest of the unrestricted earnings, they can either be distributed or retained.

There should only be ONE reason for retention: Unrestricted earnings should be retained only when there is a reasonable prospect that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This means that returns are higher than market rate returns.

Many companies that show good returns both on equity and on overall incremental capital have employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, help to camouflage repeated failures in capital allocation elsewhere.

In Berkshire’s case, no dividend is given out for the simple reason that Warren can generate higher than market returns on those capital!

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Operating Earnings
The percentage of operating earnings as a percentage of beginning equity capital dropped to only 9.8%. One reason was that for partially-owned (<20%), nonoperated businesses, accounting rules dictate that only the dividends received can be reported as earnings.

Even the earnings of 35% owned GEICO were not included. For accounting purposes, the company was treated as a less-than-20% holding as the voting rights had been assigned.

Thus, only the dividends received from GEICO in 1982 of $3.5 million after tax were included in the “accounting” earnings. An additional $23 million that represented Berkshire’s share of GEICO’s undistributed operating earnings for 1982 were totally excluded.

There’s accounting madness at work here. If GEICO had earned less money in 1982 but had paid an additional $1 million in dividends, reported earnings would have been larger despite the poorer business results. Conversely, if GEICO had earned an additional $100 million – and retained it all – reported earnings would have remained unchanged.

Warren prefers using a concept of “economic” earnings. This includes all undistributed earnings, regardless of ownership percentage. The point to bear in mind is that accounting numbers are the beginning, and not the end of business valuation.

To further highlight this point, Berkshire’s share of undistributed earnings from four of their major non-controlled holdings came to well over $40 million in 1982. This number, which is totally unreflected in the earnings report, is much higher than the total reported earnings of $14 million in dividends received from these companies.

The gigantic auction arena of the stock market continues to offer value investors opportunities to purchase fractional portions of businesses at bargain prices. This is possible as long as the market is moderately priced.

For the investor, an over-priced purchase of an excellent company can undo the effects of even a subsequent decade of favorable business developments. Value investors want the market to be cheap, not expensive!

Insurance Industry Conditions
The insurance industry continued to bleed. It is a good example of an industry with substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc).

If prices or costs can be controlled, the ‘bleeding’ can be stopped. This can be carried out legally through government intervention, illegally through collusion, or “extra-legally” through OPEC-style foreign cartelization.

Unfortunately, for the great majority of industries selling “commodity” products, a depressing equation of business economics prevails: persistent over-capacity without controlled prices (or costs). This results in poor profitability.

Over-capacity may eventually self-correct, either as capacity drops or demand expands. When they finally occur, there usually follows an enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment.

What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years.

The insurance industry operates under substantial overcapacity as it can be instantly created by capital and an underwriter’s willingness to sign his name.

Since there can be no surge in demand for insurance policies comparable to one in copper or aluminum, the only way for it to return to profitably is to reduce the supply.

Unfortunately, major sources of insurance capacity are unlikely to turn their backs on very large chunks of business, thereby sacrificing market share and industry significance. Major capacity withdrawals will require a shock factor such as a natural or financial “megadisaster”.

Issuance of Equity
In a merger, the first choice of the buying company is to use cash or debt to fund the purchase. In cases where these are insufficient, the issuance of new equity might be used.

When this happens, you will have to take notice. Why?

Companies often sell in the stock market below their intrinsic business value. But when a company wishes to sell out completely in a negotiated transaction, it usually can receive full business value in whatever kind of currency the value is to be delivered.

If cash or debt is to be used in payment, the seller’s calculation of value received is quite straightforward. If stock of the buyer is to be the currency, the seller’s calculation is still relatively easy: just figure the market value in cash of what is to be received in stock.

If the buyer’s stock is selling in the market at full intrinsic value, using it as currency for the purchase doesn’t pose any problems.

But suppose it is selling at only half intrinsic value. In that case, the buyer will be using a substantially undervalued currency to fund the purchase of a company at full intrinsic business value.

The issuance of shares to make an acquisition amounts to a partial sale of the business. Using it to fund an acquisition means that you sell it at whatever value the market happens to be granting it at that time.

And if the market price is under-valuing the business, you will have to scrutinize the deal carefully no matter what ‘reasons’ the managers might give you.

However, there are three ways to avoid destruction of value for old owners when shares are issued for acquisitions.

One is to have a true business-value-for-business-value merger, with each receiving just as much as it gives in terms of intrinsic business value.

The second route presents itself when the acquirer’s stock sells at or above its intrinsic business value. In that situation, the use of stock may actually enhance the wealth of the acquiring company’s owners.

The third solution is for the acquirer to go ahead with the acquisition, but then subsequently repurchase a quantity of shares equal to the number issued in the merger. This essentially converts it to a “cash for stock” purchase.

Another variable in mergers that is given too much attention is the effects of dilution on earnings. There have been plenty of non-dilutive mergers that were instantly value destroying for the acquirer. And some mergers that have diluted current and near-term earnings per share have in fact been value-enhancing.

What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value.

Finally, there is also a “double whammy” effect on the owners of the acquiring company when value-diluting stock issuances occur. A management that has a record of wealth-destruction through unintelligent share issuances will have a lower stock price for the company as the market accords a lower price/value ratio to them.

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First of all, I have to apologise for the delay in this update. My computer broke down recently and it took a while before I managed to get it repaired.

This letter starts with a simplified lesson on accounting. For a subsidiary company that is more than 50% owned, the earnings, expenses, etc will be fully consolidated into the parent company’s accounts.

If the ownership lies between 20-50%, the earnings will simply be reflected as a one liner based on the percentage ownership of the company.

If the ownership is less than 20%, only dividends received will be reflected in the accounts.

Most of Berkshire’s holdings held by the insurance companies belong to the third category. Conventional acccounting will only allow a small proportion of Berkshire’s earnings to be reported, the rest of it will be hidden from view.

As an example, GEICO was purchased for $47 million in 1976. Based on the present dividends, reported earnings amount to only about $3 million annually. However, Berkshire’s share of their earnings is estimated to be about $20 million annually.

In Warren’s own words, “The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage.“

In the long run, the retained earnings of those non-controlled holdings will be translated into gains in market value.

In another accounting convention, insurance companies are allowed to carry their bond holdings at amortized cost, regardless of the market value. With the recent drop in bond prices, some companies could find even themselves in negative net worth if their bond holdings were valued at market.

It is strange that a significant drop in the stock portfolio of an insurance company will threaten it’s survival, yet a greater drop in bond prices produces no reaction at all. This can lead to a few negative effects:

1) Companies unwilling to sell off the bonds to ‘realise’ the losses even when there are superior ways to deploy the capital.

2) If money is required to pay off insurance claims, stock holdings might be sold off to raise the money instead. This is a case of selling the better assets and keeping the biggest losers.

3) Another way of raising the money to pay off insurance claims is to underwrite new business no matter what the potential underwriting losses are. Unfortunately, this is the preferred option and ultimately leads to suicidal underwriting among the different insurance companies.