In his reliably entertaining and lucid annual shareholder letter, Berkshire Hathaway Chairman Warren Buffett warns that the soft pricing environment for insurance is in many ways a self-inflicted wound.
With GEICO, BH Reinsurance and General Re accounting for a large portion of the Omaha, Neb.-based conglomerate’s revenues, Buffet’s affinity for insurance is well known. In the letter, Buffett praised the performance of his insurance business units but said the insurance industry needs to exercise greater restraint and not write business with insufficient premiums.
“At bottom, a sound insurance operation requires four disciplines: (1) An understanding of all exposures that might cause a policy to incur losses; (2) A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) The willingness to walk away if the appropriate premium can’t be obtained,” the letter states. “Many insurers pass the first three tests and flunk the fourth. The urgings of Wall Street, pressures from the agency force and brokers, or simply a refusal by a testosterone-driven CEO to accept shrinking volumes has led too many insurers to write business at inadequate prices. “The other guy is doing it so we must as well” spells trouble in any business, but none more so than insurance.”
Reflecting on the current states of the financial services industry, Buffett warned of the ongoing use of excessive leverage. “Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”