Billionaire investor’s letter to shareholders is no ordinary filing
Despite a catastrophe-filled year that cost his company $2.6bn, Warren Buffett has maintained his enthusiasm for the insurance business and the “terrific managers running some extraordinary insurance operations” at Berkshire Hathaway.
Buffett’s annual letters to shareholders are always eagerly anticipated for their warmth, humour and pearls of wisdom. This year was no different.
A sound insurance operation, he says, must adhere to four disciplines. It must:
- Understand all exposures that might cause a policy to incur losses;
- Conservatively evaluate the likelihood of any exposure actually causing a loss and the probable cost if it does;
- Set a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and
- Be willing to walk away if the appropriate premium can’t be obtained.
It is the fourth discipline that many insurers “flunk”, according to Buffett. “They simply can’t turn their back on business that their competitors are eagerly writing. That old line, ‘The other guy is doing it so we must as well,’ spells trouble in any business, but in none more so than insurance.”
“Indeed, 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.’
As usual, and despite his business incurring a loss of $714m for the year, he was full of admiration for Ajit Jain, president of Berkshire Hathaway Reinsurance.
There are a lot of ways to lose money in insurance, and the industry is resourceful in creating new ones’
He credits Jain for creating a $34bn insurance float for Berkshire (half the company’s total insurance float), noting that it is “a feat that no CEO of any other insurer has come close to matching”.
“By these accomplishments, he has added a great many billions of dollars to the value of Berkshire. Charlie [Munger] would gladly trade me for a second Ajit. Alas, there is none.”
One of India’s business icons, Jain is admired throughout the industry for his calculated risk-taking and, in Buffett’s words, avoiding “foolish losses”.
“He never exposes Berkshire to risks that are inappropriate in relation to our resources,” says Buffett. “Indeed, we are far more conservative in that respect than most large insurers.”
“For example, if the insurance industry should experience a $250bn loss from some mega-catastrophe - a loss about triple anything it has ever faced - Berkshire as a whole would likely record a moderate profit for the year because of its many streams of earnings. Concurrently, all other major insurers and reinsurers would be far in the red, and some would face insolvency.”
He points out that US insurer State Farm has recorded an underwriting loss in eight out 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,” he quips.
The value of Berkshire’s float is one reason Buffett believes Berkshire’s intrinsic business value substantially exceeds book value.
“Let me emphasise 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 adds.
Could Jain be the heir?
Many experts have posited that Buffett’s heir could indeed be Jain, who he has always praised highly.
In his letter, the 81-year-old Sage of Omaha reassured shareholders that the Berkshire board had decided on his (as yet unnamed) successor, with two back-ups to ensure “Berkshire’s prospects will remain bright” when he eventually steps down.
Not that he is planning on retirement just yet. “Do not infer from this discussion that Charlie [Munger, Berkshire’s vice chairman] and I are going anywhere,” he wrote. “We continue to be in excellent health, and we love what we do.”