Insurance can be a very good business. It tends to magnify, to an unusual degree, human managerial talent—or the lack of it.
Warren Buffett1
In an uncertain world, those who survived always had their emotional radar—call it instinct if you will—turned on. And Stone Age people, at the mercy of wild predators or impending natural disasters, came to trust their instincts above all else. So for human beings, no less than for any other animal, emotions are the first screen to all information received.
Nigel Nicholson2
Today, around 80% of Berkshire Hathaway’s earnings are derived from the insurance industry. Clearly, Warren Buffett has made this business the centerpiece of his operations.
Yet one wonders why. Buffett says:
Insurance companies offer standardized policies that can be copied by anyone. Their only products are promises. It is not difficult to be licensed and rates are an open book. There are no important advantages from trade marks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition.3
It is, therefore, “cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way.”4 In conclusion, the industry’s economics “are almost certain to be unexciting,” while “they may well be disastrous.”5
This dismal description of the industry’s fundamentals does not seem to square with Buffett’s proclamation that “among all the fine businesses” that Berkshire owns, its insurance operations are those that have the “greatest potential.”6 Nevertheless, he can say this because his insurance companies are managed in a manner entirely distinct from most of the other companies that comprise the industry he so accurately portrays.
For Warren Buffett, there are three redeeming factors of insurance that allow him to thrive as others flounder. The first of these is the presence of the float, or the amount of money that an insurance company gets to invest between the time premiums are taken in and when they are paid out as claims. Any returns earned over the cost of these flow straight to an insurance company’s shareholders.
The second is the fact that, as Buffett says, “distribution channels are not proprietary and can easily be entered [so that] small volume this year does not prevent huge volume next year.”7 This means that when pricing is attractive in the industry, those with the capital to do so can write enormous amounts of business very quickly.
Neither of these is the sole preserve of Warren Buffet’s insurance companies. They are available to all. But the existence of Buffett’s third factor means that, overwhelmingly, they are Berkshire Hathaway’s preserve: Insurance is a behavioral business, characterized like no other by behavioral shortcomings.
While logic would suggest that every effort should be made to generate float at as low a cost as possible, since it is only in this form that it becomes a resource and only in this form that it can overcome the fundamental drawbacks of this industry, the fear of behaving in a manner consistent with this—stepping away from writing business when pricing is poor and doing nothing instead—is too much for most to confront. Which is why they don’t. Which is why they chase prices down and produce the dismal characteristics of the industry that Buffett describes, destroying capital in the process.
It is as well that they do behave like this, however. For when capacity in this industry becomes scarce—when so much capital has been destroyed by the aberrant behavior of its participants that they can no longer write sufficient business to meet demand—that’s when pricing improves. And this is when its unlimited distribution system becomes a most valuable asset to Warren Buffett, a man who has been able to adhere to logic, who is not prone to the fear that the industry contains, and who then strides into the marketplace to allocate as much capital to this sector as he can.
My gut told me that compared to the industrial operations I did know, this business [GE Capital] seemed an easy way to make money. You didn’t have to invest heavily in R&D, build factories, and bend metal day after day. You didn’t have to build scale to be competitive. The business was all about intellectual capital.
Jack Welch8
Warren Buffett’s initial foray into the insurance industry was his purchase in 1967 of two local companies, National Indemnity Co. and National Fire and Marine, which both specialized in underwriting “unusual” risks. To this day, the writing of so-called super-catastrophe (“super-cat”) policies remains Berkshire Hathaway’s principal area of expertise.
On potentially large liabilities, such as insurance against earthquake damage, insurance companies generally like to lay off some of the risk to others in the industry, Berkshire Hathaway being one of them, which agree to pay claims above a specified amount. This is known as reinsurance. Sometimes the reinsurer also wants to do this, so it buys super-catastrophe insurance. That’s where Warren Buffett comes in.
National Indemnity is now the US’s most prominent writer of super-cat policies and forms an integral part of Berkshire’s interest in this business. But Buffett never forgot his introduction to the insurance industry, one Saturday morning in 1951, at the feet of GEICO’s investment officer Lorimar Davidson. GEICO was a writer of auto policies and its chairman was Buffett’s hero, Ben Graham; hence his visit. GEICO became a major holding in Buffett’s personal portfolio, subsequently an investment of Berkshire Hathaway, and eventually, in 1996, a wholly owned subsidiary of that company. It is now the seventh-largest insurer in the US and the eighteenth-largest insurer overall.
Then in 1998, Buffett doubled the size of Berkshire’s float with the acquisition of General Re, whose operations are concentrated in reinsurance.
There is a sense in which Buffett is ideally suited to the insurance industry. His calculator brain and the fact that “he automatically thinks in terms of decision trees and the elementary math of permutations and combinations” make him a natural underwriter of risk.9 Nevertheless, the actuarial calculation of the price of risk is not where Warren Buffett’s competitive advantage lies. Sat in a darkened room and asked to assay the appropriate price for a particular risk, Buffett would not fare materially better than any other competent underwriter in the industry (although he might be the quickest to produce the answer). Aside from Ajit Jain, a special case whom we’ll talk about in Chapter 9, nor would any underwriter he employs.
However, the fact is that underwriters do not ply their trade in darkened rooms. Prices are not set in isolation; they are set in the distracting hubbub of the marketplace. They are subject to the frailties of our cognitive apparatus. And this is where Buffett’s competitive advantage comes from: the intellectual capital that sets him apart.
When Warren Buffett measures the profitability of an insurance company, he compares its underwriting loss to the size of its float.10 Taken over a number of years, this ratio provides an indication of the cost of funds generated by insurance operations. “A low cost of funds signifies a good business: a high cost translates into a poor business.”11
If an insurance company can maintain high standards in its underwriting practices, it can consistently generate low-cost capital, which it can then deploy elsewhere. In effect, it is provided with permanent access to a very low-cost loan if it does this. That is exactly the strategy Buffett pursues: borrowing cheaply (for nothing, if possible) and growing the size of the borrowed funds (in his case) at a compound growth rate of 25.4%.
This is Warren Buffett’s bank, the fortress wherein resides his capital, the position of strength from which he allocates it, not only in the insurance industry itself but also elsewhere, and the alchemist’s lab wherein he transforms it from low cost to high return.
It is not a bank that is available to all, however. The characteristics of the industry see to that.
In commodity industries such as insurance, one factor above all others destroys profitability: excess capacity. And capacity in the insurance industry is of a particular nature, with a behavioral component setting it apart from almost any other business.
“In most industries, capacity is described in physical terms,” says Buffett.12
In the insurance world, however, capacity is customarily described in financial terms; that is, it’s considered appropriate for a company to write no more than X dollars of business if it has Y dollars of net worth. In practice, however, constraints of this sort have proved ineffective. Regulators, insurance brokers, are all slow to discipline companies that strain their resources. They also acquiesce when companies overstate their true capital. Hence, a company can write a great deal of business with very little capital if it is so inclined. At bottom, therefore, the amount of industry capacity at any particular moment depends on the mental state of insurance managers [emphasis added].13
“Capacity,” says Buffett, “is an attitudinal concept, not a physical fact.”14 In the insurance industry, capacity is created at the speed of thought.
So saying, the industry is condemned to mediocrity. The attitudinal concept to which Buffett refers is conditioned within humans by emotions and cognitive biases ensuring that, in the insurance industry as in no other, capacity is created on the basis of fear, not economic logic.
We believe it is true that virtually no major property-casualty insurer—despite protests from the entire industry that rates are inadequate and great selectivity should be exercised—has been willing to turn down business to the point where cash flow has turned significantly negative.
Warren Buffett15
At Berkshire we will never knowingly write policies containing promises we can’t keep.
Warren Buffett16
Buffett says that there are
three basic rules in running an insurance company:
1 Only accept risks you are able to properly evaluate… and confine your underwriting to business that, after an evaluation of all relevant factors, including remote loss scenarios, carries the expectancy of profit;…
2 Limit the business accepted in a manner that guarantees you will suffer no aggregation of losses from a single event or from related events that will threaten your solvency; and
3 Avoid business involving moral risk: No matter what the rate, you can’t write good contracts with bad people. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive.17
Guided by these principles, Buffett told his shareholders in 1989 that Berkshire’s insurance businesses would be “perfectly willing to write five times as much business as we write in 1988—or only one-fifth as much.”18 Nothing has changed since then. “We cannot control market prices,” says Buffett. “If they are unsatisfactory, we will simply do very little business. No other major insurer acts with equal restraint.”19
In the commodity industry that is insurance, Warren Buffett distinguishes himself by his “total indifference to volume.”20 This is logical. If this business is to act as his bank, the first thing he must do is preserve his capital and source it at low cost. This cannot be achieved by accepting business at any price: You have to possess the mental resolve to turn it away when it is poorly priced.
Would that this were easy, but ceding (even unprofitable) business to the competition is something that does not come naturally. Even Buffett has to gird his loins against the part of human nature that prizes more highly something that is under threat of being taken from us. Says Buffett:
As markets loosen and rates become inadequate, we again will face the challenge of philosophically accepting reduced volume. Unusual managerial discipline will be required, as it runs counter to the normal institutional behavior to let the other fellow take away business—even at a foolish price [emphasis added].21
The institutional dynamic at play here is mediated by psychological reactance, or what Charlie Munger calls “deprival super-reaction syndrome.” This is the feeling that you get, in Charlie’s words, “(A) when something you like is taken away from you and (B) when you almost have something you like and ‘lose’ it.” Either way, says Charlie, the result is a “powerful, subconscious, automatic” emotion that “distorts your cognition.”22
It does so by making you want it more. It is a feeling that is extremely difficult to tolerate. The same instinct that tells a two-year-old to go after a toy snatched from it compels companies to hang on to, or fight for, the business within its grasp. And most do.
Typically (in adults) this feeling is mediated by justifications that make the item appear more valuable than it was previously.23 One of these is created by the notion of scarcity. Most insurance companies are afraid to pass up business to another, says Buffett, for fear that they will never get it back. They envisage their slice of market share as a scarce resource, and humans always value items that are difficult to get more highly than those that are abundant. In addition, it has been found in experiments on this subject that we value scarce items most highly when we have to compete for them—exactly the emotion that Buffett has recognized as being in play when one insurance company contemplates watching “another fellow taking away its business.”24
Since few are willing to let business go, overcapacity is normally the result—pricing deteriorates and profitability follows suit (with a lag that depends on the nature of the policies written). The downside of this is that, as profitability deteriorates, the weakest players in the industry are tempted to patch up the growing hole in their businesses by writing more policies at inadequate rates just to get the cash today. It’s only human nature that they should do this. Writing insurance policies is an exercise in temporal discipline. In theory, insurance companies should be happy to forgo the small early reward of the premium, however set, in preference to the large late reward that takes the form of profit accruing on a well-priced risk. That’s how low-cost float is generated.
In practice, in the same way as many of us decide before dinner to skip dessert (a small early reward) in order to lose weight (a large late one), only to succumb to temptation when the waiter brings the dessert menu, at times it appears that any business will do, as long as it brings in cash flow today. (Tomorrow, when the claim is made, will look after itself.)25
Buffett bemoans the existence of “cash flow” underwriting, as it is known, since he recognizes that “in a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor.”26 This is when the red ink in the industry really starts to flow and, says Buffett, “some unattractive aspects of human nature have manifested themselves in the past when this has happened.”27
Sensing trouble, some insurance companies succumb to Shefrin’s “get-evenitis” and up the ante. In other words they take on even more risk in the hope that they can break even—“scrambling for business when underwriting losses hit record levels—it is likely to cause them at such a time to redouble their efforts,” observes Buffett.28 “These companies,” he continues, “hope that somehow they can get lucky on the next batch of business and thereby cover up earlier shortfalls,” and this further exacerbates the problems of the industry.29
However, in a self-correcting process, the aberrant behavior described above eventually erodes the capital of the industry to the point where it can no longer provide sufficient cover to meet demand. As the industry becomes capacity constrained, so pricing improves—holding out the possibility of returning to levels consistent with making profits.
The flowers that bloom in this desert can nevertheless be short-lived. Says Buffett:
When over-capacity finally corrects itself, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment.30
This is a cycle of behavior that, if not as predictable as the migration of wild animals, is certainly as periodic. Just like migratory animals, insurance companies move in herds; it’s safer that way.
It is the anonymity of the crowd that allows insurance companies to coalesce in the downside of the industry’s cycle (even those that recognize that they are fooling themselves in ascribing higher value to business under threat of being taken away than it actually warrants). This instinctive behavior—instinctive because it is evolutionarily sound, if not economically logical—is more powerful when:
Peer perceptions of ability are important (about which, handily, Buffett does not care: “I keep an internal score card. If I do something that others don’t like but I feel good about, I’m happy. If others praise something I’ve done, but I’m not satisfied, I feel unhappy”31).
The willingness to admit errors in judgment to peers is a factor (which, it just so happens, is the inverse of Buffett’s attitude to oversights: “Of course, it is necessary to dig deep into our history to find illustrations of… mistakes—sometimes as deep as two or three months back”32).
One’s willingness to take a risk is modified by the prospect of looking stupid if the decision goes against you (which Warren Buffett, not unsurprisingly, is content to risk: “[Charlie and I] are willing to look foolish as long we don’t feel we have acted foolishly”33).
Thus herding is not a form of conduct in which Warren Buffett seeks shelter. He doesn’t feel the need. He doesn’t key his behavior off the behavior of others. Standing alone holds no fear for him; it never has. This is why he has the resolve to step away when prices deteriorate, why he glories in the loneliness of being logical.
This element of his wiring is a genetic gift and there are numerous examples of this trait in his personal life, which would be trivial if they did not signify more consequential behavior. He eats hamburgers or steak in any restaurant he visits, for instance.34 He quaffs Coca-Cola instead of wine at dinner in fancy restaurants with fine company, and this septuagenarian chairman of a major public corporation snacks continuously on See’s candies and Dairy Queen ice creams on the dais at his annual general meetings.35
In high school he wore sneakers all year round even when it was snowing—“most of us were trying to be like everyone else,” said a friend at the time, “I think he liked being different”—while in later years he bought suits, five at a time, all in the same “style,” which was no style at all.36
However, the most extraordinary example of Buffett’s refusal to bow to social influence on behavior can be found in his living arrangements. Here he flouts one of the most fundamental of human conventions: He is married to one woman, lives with another, and conducts public relationships with both.37
If Warren Buffett is not troubled by standing out from the crowd, this is also a quality that he looks for in the behavior of the insurance companies he acquires. “We hear a great many insurance managers talk about being willing to reduce volume in order to underwrite profitably, but we find that very few actually do so,” he says.38 In Phil Liesche at National Indemnity, for example, Buffett found an exception:
If business makes sense, he writes it: if it doesn’t, he rejects it… Jack Ringwalt, the founder of the National Indemnity Company, instilled this underwriting discipline at the inception of the company, and Phil Liesche has never wavered in maintaining it. We believe such strong-mindedness is as rare as it is sound—and absolutely essential to the running of a first-class casualty insurance operation.39
Nor is Buffett given to myopia. He calculates the value of a dollar spent today against the opportunity cost of not investing it personally.40 When you can compound the value of your savings at a rate of 20%+ per annum, the jam today vs. jam tomorrow decision is made for you.
Equally, Buffett is aware of the human tendency to discount the value of late rewards so heavily that they pale in comparison to rewards in the present. Classically, in his own diet he too is confronted with the dessert–willpower challenge. And just as Pinker notes that we will place the alarm clock across the room so we will not turn it off and go back to sleep, or put tempting snacks out of sight and mind,41 Buffett goes to similar lengths. When he strives to lose weight, he incentivizes himself with money—not to receive a sum if he maintains his diet, but to lose it if he does not (playing on his own loss aversion; this guy is really wired), and customarily he will write a substantial check to his daughter, payable on a specified date in the future unless his weight has dropped by that time.42
Buffett puts a mental cudgel in place at his insurance companies in order to ensure that they keep their eyes firmly fixed on the long term. A major part of Berkshire’s insurance managers’ remuneration package is premised on the ultimate cost of their float. So even as they tuck into their main course, one eye on the dessert trolley in the corner, they know that their bonus will not be proportionate to the volume of food they consume but inversely proportionate to their weight when they get on the scales. They, too, stand to lose if they over-eat.
Of course, an insurance company’s dogged resolution to stick with writing policies, even when prices are depressed, describes nothing other than the institutional imperative at work; it’s entrapment. But there is another form of entrapment that can lie in wait in these situations, illustrated by Martin Shubik.43 In his game “How Much Would You Pay for a Dollar?” Shubik auctions a dollar bill to the highest bidder, drawn from a class of students. No communication is allowed between bidders and the two highest bidders have to pay what they bid, even though only the highest wins.
Consider, therefore, the predicament of someone who has just bid 95 cents, only to have the only other player left in the game bid $1. If that person quits at this point, he or she is sure to lose 95 cents—but this loss can be reduced to only 5 cents by raising the bid to $1.05 (if this wins the auction). The problem is that the other person faces the same calculation. Caught “knee deep in the big muddy,”44 in order to minimize their losses opponents in situations such as these usually continue clobbering each other until one of them gives up, and the bidding often reaches a few dollars.
This situation is analogous to that in the insurance industry. Companies are selling a commodity product, differentiated chiefly by price. Thus when they set their prices, they are, in effect, bidding for customers. An insurance company’s loss, if it does not win the contest, is similar to that of the loser in Shubik’s game, except that in this case, its loss is measured by the market share, scale, and psychic and material benefits that go hand in hand with corporate size, and that accrue to their chief executives. So they, too, can get caught knee deep in the big muddy, clobbering each other into submission.
Not Warren Buffett. Importantly, Buffett makes no such psychic and material commitment to the industry, so he is able to walk away when the fighting starts, and he derives no psychic or material benefit from Berkshire’s size. The calculation he performs is not insurance centric, it’s global. He measures his use of capital against all other possible uses and thus if the pricing environment in the insurance industry is unfavorable, the numbers won’t add up for him in the way that they might for others who do not share his perspective. And if the price is not right, he is happy to do nothing.
One English statesman attributed his country’s greatness in the nineteenth century to a policy of “masterly inactivity.” This is a strategy that is far easier for historians to commend than for participants to follow.
Warren Buffett45
Peter Ustinov, the actor, raconteur, and wit, tells a story of the time he went to watch the performance of a screen actor in a stage play. This particular individual had been schooled in the art of “method acting,” a form of performance suggesting that he should fret about the stage giving physical expression to every emotion he was attempting to portray. Ustinov found this a great distraction. After some time, he could stomach no more and cried from the balcony: “Don’t just do something. Stand there!”
Recall that the attribution error suggests that for those on the outside looking in (Mr. Ustinov, your peers, board, and shareholders, for instance), the characteristics of your performance will be ascribed not to the situation in which you find yourself (to which you will attribute your performance), but to your personal qualities.
On the inside, all of us who are monitored in our work instinctively know this, which is why we feel uncomfortable when it looks as though we are doing nothing.
Thus, with the best will in the world, even if, like Buffett, an underwriter possesses the discipline not to herd and/or the capacity not to succumb to myopia, writing business—any business—is far, far easier than writing none at all. Insurance companies are frightened of standing still. It’s deeply unconventional to do so. And it also invites a volatility in corporate results that shareholders loathe.
However, as Ben Franklin once said: “Never confuse motion for action.” Warren Buffett doesn’t. “The trick is,” he says, “when there is nothing to do, do nothing.”46
Never was a man so content to appear to be doing nothing as is Warren Buffett. Never has a man been so content to do the unconventional. And never was an insurance executive so willing to embrace what others are afraid of: “Berkshire happily accepts volatility,” says Buffett, “just as long as it carries with it the expectation of increased profits over time.”47
Concomitantly, never has a manager been so content for those working for him also to do nothing. Buffett attributes that act properly to the situation, and not improperly to the individual. When volume shrinks in Berkshire’s insurance operations, its managers “will hear no complaints from corporate headquarters,” says Buffett, “nor will employment or salaries suffer.”48
In fact, Buffett has made this a rule, a specification carefully designed to elicit the behavior he is looking for—this one recognizing that humans tend to make the best of what is available to them (we are “resourceful, evaluative maximizers,” as Michael Jensen would have it49). Comments Buffett:
We don’t engage in layoffs when we experience a cyclical slowdown at one of our generally profitable insurance operations. This no-layoff policy is in our own self-interest. Employees who fear that large layoffs will accompany sizeable reductions in premium volume will understandably produce scads of business through thick and thin (mostly thin).50
Though certain long-tail lines may prove profitable at combined ratios of 110 or 115, insurers will invariably find it unprofitable to price using those ratios as targets. Instead, prices must provide a healthy margin of safety against the social trends that are forever springing expensive surprises on the insurance industry.
Warren Buffett51
In theory, pricing in the insurance industry should be relatively straightforward. Gauging risk in this arena is akin to a scientific process in which statistical measures that have been tried and tested for over 200 years can be brought to bear.
In practice, while all insurance companies possess the skills necessary to rate risks properly, the correct price for policies written in the future has to be judged not merely in relation to an actuarial calculation, but also in relation to an estimate of the actual profitability of policies currently in force. To do this, an insurance company has to estimate the size of the reserves it should set aside to cover the expected liability stemming from claims that are in process, but not yet settled. Whereas actuarial assessments of probability frequencies are objective, the estimation of reserves is far more subjective.
Proper reserving is an essential element in the economics of an insurance business because claims account for the vast majority of its overall operating costs. An insurance company therefore needs to make an accurate calculation of required reserves if it is to have an idea of its costs—which it then uses as a basis to judge the expected profitability of the new business it is writing. If it gets this calculation wrong, it will get its pricing wrong.
Given the subjectivity involved in this process, however, estimates of reserves are always wrong—but normally in the direction of setting them too low. Typically, insurance companies delude themselves that reserves are adequate when in fact they are not, which means that they routinely underestimate the costs of their business and on this basis set their prices too low, as Buffett witnessed at GEICO. He says:
When insurance executives belatedly establish proper reserves, they often speak of “reserve strengthening,” a term that has a rather noble ring to it. They almost make it sound as if they are adding extra layers of strength to an already-solid balance sheet. That’s not the case: instead the term is a euphemism for what should more properly be called “correction of previous untruths” (albeit non-intentional ones).52
And such “self-delusion in company reserving almost always leads to inadequate industry rate levels,” says Buffett. “If major factors in the market don’t know their true costs, the competitive “fall-out” hits all—even those with adequate cost knowledge.”53
Smart, hard-working people aren’t exempt from professional disasters from overconfidence. Often they just go around in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods.
Charlie Munger54
There are several cognitive reasons for insurance companies getting this calculation wrong, generally in the direction of under- rather than over-reserving. I will deal with one of these here—overconfidence—and leave the others until later in the book, since they affect the quality of all decisions made under general conditions of uncertainty, not just those in the insurance industry.
Charlie Munger observes that most people consider themselves to be above-average drivers, even though, in the aggregate, this cannot be the case.55 Such overconfidence has been found in tasks of far greater moment than a person’s assessment of his or her driving skills, however. It is a condition found in any situation in which humans have to make a judgment as to their abilities relative to others.
Typically when they design experiments to test for overconfidence, psychologists set a series of questions—often trivia—and ask respondents to choose a range for each answer such that they are 90% confident that the correct answer will lie within it. The common finding on these tests is that way in excess of 10% of the answers lie outside the stipulated range.
In similar fashion, when they come to estimate the reserves that should be set aside against claims, most insurance companies are aware of the prudence of being conservative and (implicitly) will choose a range of estimates designed to capture the actual outcome. But even as they strive for this and set their confidence limits accordingly, more than likely they will exhibit the same overconfidence that most of us do in all walks of life (which explains why books, including this one, never get finished on time). What they believe is conservatism turns out not to be. They aim too low and subsequently price too low.
Buffett faces the same challenge of estimating reserves correctly—and he fails it on a regular basis too, normally missing on the low side. However, in understanding his own cognitive apparatus, Buffett may be alone in the industry in comprehending the nature of over-confidence and incorporating this truth into the conduct of the managers of his insurance subsidiaries. Business that looks profitable to most is business that Berkshire Hathaway will turn away.
At Berkshire we have estimated our September 11 insurance loss was $2.2 billion… huge. Nevertheless, it’s one Berkshire can easily bear. We have long been in the super-cat business and we have been prepared, both financially and psychologically, to handle them when they occur. This won’t be our last hit.
Warren Buffett56
Buffett also carries another psychological principle with him when he goes into bat in the insurance industry. He uses one of those cognitive biases that ruins pricing in this business to his own ends, once it has been ruined. That bias is scarcity.
True scarcity—rather than its imagined variety, the fear that business ceded will never be regained—is what Warren Buffett waits for (in more normal times).
It occurs when the claims experience of insurance companies debilitates them so badly that they lack the financial resources to supply the capacity the market needs; on a regulatory and/or fiduciary basis, they simply cannot absorb sufficient risk. This can happen because pricing has been too low for several years and the chickens have come home to roost, or because a major catastrophe or series of catastrophes has overwhelmed the industry, taking those who mispriced these risks with them.
On September 11, 2001, with the felling of New York’s twin towers, that scarcity was delivered in the most awful way, one that Warren Buffett could neither have imagined nor welcomed.
Unpalatable to contemplate, disasters of this nature nevertheless call forth the premise on which Buffett writes all of his insurance policies. Because he and his managers refuse to write business that does not hold out the promise of being profitable, Berkshire’s financial strength remains intact during those periods when others are threatened with going to the wall. When capacity has been drained from the industry, Warren Buffett stands ready to provide cover.
Naturally, given the circumstances, he will be able to do so at prices that now offer the prospect of profitability. Capacity shortages in commodity industries push up pricing. The more than $40 billion hit that the insurance industry took in the wake of the terrorist attack on the US will have no less an effect.
Buffett said in the wake of September 11:
Near-term prospects—very near-term—for this business are good. We are the Fort Knox of the insurance business at a time when financial strength is a top priority for buyers of reinsurance.57
When capacity is short in the catastrophe market, Berkshire Hathaway provides an oasis of protection. Buffett’s customers who still need to lay off some of their risks are drawn to him as never before. What they once had in abundance has suddenly dried up. And if humans are wired to value items more highly when they are made scarce by the process of social competition, we have been conditioned to value them even more highly when what was once in abundance disappears.58 As this emotion overwhelms those in need of cover, they become even more willing to pay for it. In the wake of September 11, therefore, pricing in reinsurance markets rose by between 35% and 50%.
Similar scarcity manifested itself in a much more normal and far more acceptable fashion in the mid-1980s. Back then, Buffett was in his element. In 1984 he told his shareholders:
For some years I have told you that there could be a day coming when our premier financial strength would make a real difference in the competitive position of our insurance operation. That day may have arrived. We are almost without question the strongest property/casualty insurance operation in the country, with a capital position far superior to that of companies of much greater size.59
In the following year, Berkshire was still in the catbird seat and volumes were going through the roof:
In past reports, I have told you that Berkshire’s strong capital position—the best in the industry—should one day allow us to claim a distinct competitive advantage in the insurance market. With the tightening of the market, that day has arrived. Our premium volume more than tripled last year… Berkshire’s financial strength (and our record of maintaining unusual strength through thick and thin) is now a major asset for us in securing good business.60
Customers were beating a path to its door:
We correctly foresaw a flight to quality by many large buyers of insurance and reinsurance who belatedly recognized that a policy is only an IOU—and who, in 1985, could not collect on many of their IOUs. These buyers today are attracted to Berkshire because of its strong capital position. But, in a development we did not foresee, we are also finding buyers drawn to us because our ability to insure substantial risks sets us apart from the crowd.61
Buffett’s understanding of human behavior was such that he manipulated the situation somewhat. In 1985 he told his shareholders that “our largest insurance company, National Indemnity Company, broadcast its willingness to underwrite large risks by running an advertisement in three issues of an insurance weekly. It solicited policies of only large size: those with a minimum premium of $1m and, remarkably, produced 600 replies and yielded premiums totalling about $50m.”62 What Buffett did not tell his shareholders, however, was that the advertisement stipulated that respondents had to name their price. If Buffett did not like the price, the understanding was that they would not get a second chance.63 Therefore he created an even greater illusion of scarcity. (There was no such manipulation post-September 2001.)
Buffett also knows that Berkshire’s financial strength pays off not just under conditions of scarcity but also under conditions of anticipated scarcity. He told his shareholders in 1996:
After a mega-catastrophe, insurers might well find it difficult to obtain reinsurance even though their need for coverage would then be particularly great. At such a time, Berkshire would without question have very substantial capacity available—but it will naturally be our long-standing clients who have first call on it. That business reality has made major insurers and reinsurers throughout the world realize the desirability of doing business with us. Indeed, we are currently getting sizeable “stand-by” fees from reinsurers that are simply nailing down their ability to get coverage from us should the market tighten.64
And again:
Periodically… buyers remember Ben Franklin’s observation that it is hard for an empty sack to stand upright and recognize their need to buy promises only from insurers that have enduring financial strength. It is then that we have a major competitive advantage. When a buyer really focuses on whether a $10 million claim can easily be paid by his insurer five or ten years down the road, and when he takes into account the possibility that poor underwriting conditions may then coincide with depressed financial markets and defaults by reinsurers, he will find only a few companies he can trust.65
Indeed, it was to capitalize on this competitive advantage that Buffett made the acquisition of General Re. It is curious, however, that in doing so he should end up diluting, rather than fortifying, Berkshire Hathaway’s competitive advantage (at least in the medium term).
In order to explore why this is so, we should move on to Part II of this book, which will discuss the General Re acquisition in more detail, extract some of the lessons associated with this debacle, and pave the way for presenting in detail Warren Buffett’s model for the management of capital.