Insurance Highlights from Buffett’s 2011 Letter to Berkshire Shareholders

By | February 27, 2012

Warren E. Buffett thinks that among large insurance operations, those owned by his Berkshire Hathaway are the “best in the world.”

Buffett is chairman of the board of Berkshire Hathaway, which owns Berkshire Hathaway Reinsurance Group, personal lines powerhouse GEICO and General Reinsurance Corp. among other insurance operations. Every year Buffett issues a letter to shareholders in which he discusses the economy, investing and the performance of Berkshire Hathaway and its various companies.

Buffett typically has good things to say about insurance and his annual letter on 2011 results that was issued last Friday continued that tradition.

He said that while property/casualty (P/C) industry is suffering losses overall, his P/C insurance operations are managing to profit in part because they are willing to walk away from business that isn’t adequately priced.

Buffett calls the insurance operations “Berkshire’s core operations and the engine that has propelled” the expansion of Berkshire Hathaway over the years.

Buffett said that while Berkshire’s insurers are bound to have underwriting losses from time to time, they have now had nine consecutive years of underwriting profits, totaling about $17 billion.

While underwriting profits are welcome, Buffett really values insurance operations for the float they generate, money from holding premiums that he terms “costless capital.”

“Our insurance operations continued their delivery of costless capital that funds a myriad of other opportunities. This business produces ‘float’ – money that doesn’t belong to us, but that we get to invest for Berkshire’s benefit,” Buffett wrote.

“And if we pay out less in losses and expenses than we receive in premiums, we additionally earn an underwriting profit, meaning the float costs us less than nothing.”

Over the past nine years the float Berkshire has had to invest has increased from $41 billion to its current record of $70 billion.

“Insurance has been good to us,” he said.

Buffett said it’s “unlikely” that Berkshire ‘s float will grow much – if at all – from its current level mainly because it has already reached an outsized amount relative to premium volume.

He said the P/C industry is in a period of “intense competition” that is causing the P/C industry as a whole to operate at a significant underwriting loss. He noted that the country’s largest insurer, State Farm, which he termed a “well-managed company,” has incurred an underwriting loss in eight of the last 11 years.

“There are a lot of ways to lose money in insurance, and the industry is resourceful in creating new ones,” Buffett quipped.

He said that the value of its insurance float is “a huge reason” he believes Berkshire’s intrinsic business value substantially exceeds book value.

“Let me emphasize once again that cost-free float is not an outcome to be expected for the P/C industry as a whole: We don’t think there is much ‘Berkshire-quality’ float existing in the insurance world,” he said.

“In most years, including 2011, the industry’s premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue. Berkshire’s outstanding economics exist only because we have some terrific managers running some extraordinary insurance operations.”

In his letter to shareholders, Buffett praises the performance of each of Berkshire’s major insurance units.

The biggest contributor to float is Berkshire Hathaway Reinsurance Group, run by Ajit Jain, who Buffett said has created an insurance business with float of $34 billion and significant underwriting profits, “a feat that no CEO of any other insurer has come close to matching.”

General Re, managed by Tad Montross, is another major Berkshire insurance operation.

According to Buffett, General Re’s strength is that it has been willing to walk away from business where an appropriate premium cannot be obtained.

“[A] good underwriter needs an independent mindset akin to that of the senior citizen who received a call from his wife while driving home. ‘Albert, be careful,’ she warned, ‘I just heard on the radio that there’s a car going the wrong way down the Interstate.’ ‘Mabel, they don’t know the half of it,’ replied Albert, ‘It’s not just one car, there are hundreds of them.’

Buffett said that in the first few years after Berkshire acquired it, General Re was “a major headache but [n]ow it’s a treasure.”

The third leg on Berkshire’s insurance stool is direct writer GEICO, the insurer on which Buffett says he cut his teeth 61 years ago. GEICO is run by Tony Nicely, who joined the company at 18 and completed 50 years of service in 2011.

Buffett said that GEICO’s “much-envied record” is a result of Nicely’s “brilliant execution of a superb and almost impossible-to-replicate business model.”

In Nicely’s 18-year tenure as CEO, GEICO’s market share has grown from 2.0 percent to 9.3 percent and its premium volume now tops $15 billion. Buffett said GEICO’s not through growing.

“There is still more than 90 percent of the auto-insurance market left for GEICO to rake in. Don’t bet against [GEICO} acquiring chunks of it year after year in the future,” he wrote.

Buffett extols the virtues of GEICO’s online sales model — and its ubiquitous mascot — over companies like Progressive and others that use agents and real people.

“Our lizard has another endearing quality: Unlike human spokesmen or spokeswomen who expensively represent other insurance companies, our little fellow has no agent,” he wrote.

In addition to its three major insurance operations, Berkshire Hathaway also owns a group of smaller companies, the results of which have in the aggregate been profitable, according to Buffett.

At year-end, Buffett acquired Princeton Insurance, a New Jersey writer of medical malpractice insurance that brings with it more than $600 million of float.

In summary, Buffett said he believes Berkshire’s insurance operations are second to none.

“Among large insurance operations, Berkshire’s impresses me as the best in the world,” he wrote.

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