Many people are aware that Warren Buffett's company, Berkshire Hathaway, is a vast conglomerate with dozens of companies in its holding company system. It is simply huge, and Mr. Buffett is oftentimes referred to as the "Oracle of Omaha" to reflect his investment prowess.
Within Berkshire Hathaway, however, there are three insurance entities: GEICO (Government Employees Insurance Company), General Re, and Berkshire Hathaway Re. The latter two are reinsurers.
What makes an insurance company so attractive to Mr. Buffett? He has indicated he loves the financial structure of insurance entities.
1 Why? Let's explore!
How Do Insurance Companies Make Money?
Paramount to Mr. Buffett's interest is the way an insurance company makes money. In simplistic terms, the following are three main ways an insurance company makes money.
This is the most obvious method. At its core, underwriting profit is the amount of money left over after paying out claims and expenses. If an insurance company collects $100 in premium and pays $95 in losses and expenses, the net result, or underwriting profit, is $5.
It is way more complicated than this, so let's dive into some insurance terminology to help illustrate. Two primary calculations in the insurance industry include the loss ratio and combined ratio. The IRMI Glossary of Insurance and Risk Management Terms defines both as follows.
Loss ratio. "Proportionate relationship of incurred losses to earned premiums expressed as a percentage. If, for example, a firm pays $100,000 of premium for workers compensation insurance in a given year, and its insurer pays and reserves $50,000 in claims, the firm's loss ratio is 50 percent ($50,000 incurred losses/$100,000 earned premiums)."
Combined ratio. "The sum of two ratios, one calculated by dividing incurred losses plus loss adjustment expense (LAE) by earned premiums (the calendar year loss ratio), and the other calculated by dividing all other expenses by either written or earned premiums (i.e., trade basis or statutory basis expense ratio). When applied to a company's overall results, the combined ratio is also referred to as the composite, or statutory, ratio. Used in both insurance and reinsurance, a combined ratio below 100 percent is indicative of an underwriting profit."
Insurance companies manage to a low loss ratio to control expenses. Lower expenses mean the opportunity for more profits. The combined ratio calculates true underwriting profit; if lower than 100 percent, the company generates underwriting profit.
Why do combined ratios sometimes exceed 100 percent; does that mean insurance companies are losing money? From an underwriting perspective, yes! That doesn't mean, however, they are unprofitable. Let's explore further.
Insurance companies are one of the largest institutional investors in the world, generating many profits through investment yield. To understand how investment yield supports insurers, one must first understand an insurance company's balance sheet. For most insurance policies, a customer (could be a person or a business) is quoted a "premium," which is the cost to secure insurance coverage for a period of time. An insurance company collects all premium up front (exceptions apply) but will not pay a loss for a period of time, if ever.
To illustrate, a personal lines insurance company quotes a person $1,000 for a homeowners insurance policy. If the person consents, they make payment to the insurance company, and the insurance company issues a policy. To amplify the example, let's assume the customer renews for 10 years at the same cost. After 10 years, the insurance company would have collected $10,000 in premiums and might not have paid out a single $1 in an insurance claim.
What does an insurance company do with that $10,000? In simplified form, a portion of the premium goes to pay overhead expenses (e.g., real estate costs, salaries, or employee benefits), but a portion of that money is categorized as "loss reserve" to pay future claims based on actuarial probability calculations. An insurance company can invest its reserves, which enables security purchases (usually bonds) to generate a stable yield. In other words, it invests collected money/premium and generates returns for a period of time.
So, if an insurance company has a combined ratio above 100 percent, it can still be profitable due to a profitable investment portfolio.
There's a wide spectrum of services an insurance company can provide to the marketplace, including risk consulting or administrative services. For example, insurance company engineers could, for a fee, consult with individuals and businesses to provide loss mitigation advice and counseling. In addition, an insurance company could adjudicate claims for a fee for another insurer or a self-insured organization. There are many other examples depending on a host of factors, but fee income can be a source of revenue.
So Why Does Mr. Buffett Like Insurance Companies?
Mr. Buffett refers to insurance "float," the stable flow of premiums to an insurance company that can be used to fuel investment and acquisitions. Plain and simple, it generates cash, at a low capital cost, to use for other revenue-producing endeavors. Berkshire's insurance "float has grown from just $39 million in 1970 to about $91.6 billion in 2016."
2 That's a lot of money that can be used to expand and invest!
The challenge with investing and overall management of an insurance company's obligations is to avoid asset and liability mismatching. An insurance company must have the available cash to pay claims when a claim strikes, which is exacerbated in times of natural catastrophes. Insurance companies off-load a lot of risk through purchasing reinsurance, but certain investment vehicles, such as bonds, allow a predictable cash flow to match assets (cash) with liabilities (claim obligations).
In healthy equity and bond markets, insurance companies can tolerate a higher combined ratio as investment income supports profits. As markets deteriorate, such as during the Great Recession of 2007/2008 and ensuing years, insurance companies must exhibit stronger underwriting discipline. This allows the combined ratio to decrease and generate better underwriting profits. There are myriad of ways to exhibit such discipline to influence the combined ratio, which includes generating a higher rate (premium) for exposure, better risk selection that helps avoid costly loss payouts, purchasing reinsurance, reducing overhead expenses (headcount and travel expenses), and other measures.
The insurance industry has a unique financial model that is very different from other industries. Most manufacturers have up-front costs to build a product: labor, a manufacturing building or facility, supplies, etc., whereas the bulk of insurance company costs are postissuance (e.g., at the time of claim and loss payout). This financial structure, when used effectively, can create significant investment opportunities to support the overall strategy and profitability of an insurance company. Mr. Buffett's conglomerate is perhaps the best illustration of how this financial model can prove to be quite effective and profitable.
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