Posted on 04 Mar 2013 by Neilson
"Dim prospects" are ahead for the insurance industry, which faces the double challenge of dealing with unprofitable underwriting and a low interest rate environment, said Warren E. Buffett, chairman of Berkshire Hathaway, in his annual letter to shareholders. Buffett also talked about how the company handled Hurricane Sandy, which racked up after-tax losses for Berkshire Hathaway of $725 million, according to a company filing.
Its automobile writer Geico was hit with more than three times the losses from Sandy than it sustained from Hurricane Katrina, the previous record-holder, Buffett said. Geico insured 46,906 vehicles that were destroyed or damaged in the storm, he said.
A sound insurance operation needs to adhere to four disciplines, Buffett said understanding exposures that might cause a policy to incur losses; assess the likelihood of any exposure causing a loss and the probable cost if it does; setting a premium that will deliver a profit after both prospective loss costs and operating expenses are covered; and be willing to walk away if the appropriate premium can't be obtained.
"Many insurers pass the first three tests and flunk the fourth. They simply can't turn their back on business that is being eagerly written by their competitors," Buffett said. "That old line, 'The other guy is doing it, so we must as well,' spells trouble in any business, but none more so than insurance."
Buffett touted the performance of Berkshire Hathaway, the parent company of Berkshire Hathaway Reinsurance Group, General Re and Geico, with posting a 2012 year-end net underwriting profit of $1.6 billion, up from $248 million for 2011.
"Our insurance operations shot the lights out last year," Buffett said. "While giving Berkshire $73 billion of free money to invest, they also delivered a $1.6 billion underwriting gain, the 10th-consecutive year of profitable underwriting. This is truly having your cake and eating it, too."
Buffett credited Geico with leading the company's insurance profits, saying it continuing to gobble up market share without sacrificing underwriting discipline. Since 1995, when Berkshire acquired Geico, the company has grown from 2.5% to 9.7%. Premium volume increased from $2.8 billion to $16.7 billion.
"Much more growth lies ahead...when I count my blessings, I count Geico twice," Buffett said.
Geico earned its underwriting profit despite the company suffering its largest single loss in history from Sandy.
He called insurance the "engine" that has propelled the company's expansion.
"When such a profit is earned, we enjoy the use of free money and, better yet, get paid for holding it. That's like your taking out a loan and having the bank pay you interest," Buffett said in the letter.
"Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss," Buffett said.
This loss is what the industry pays to hold its float, he said. For example, State Farm, by far the country's largest insurer and a "well-managed company besides," Buffett noted, incurred an underwriting loss in eight of the 11 years ending in 2011. State Farm's after-tax net income surged in 2012 to $3.2 billion, from $800 million in 2011, as better underwriting performance helped to shore up the bottom line.
"There are a lot of ways to lose money in insurance, and the industry never ceases searching for new ones," Buffett said.
There is very little Berkshire-quality float existing in the insurance world, he said. In 37 of the 45 years ending in 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," Buffett wrote.
"A further unpleasant reality adds to the industry's dim prospects: insurance earnings are now benefitting from 'legacy' bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years and perhaps for many years beyond that. Today's bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over," he said.
He credited his reinsurance companies with strong underwriting.
Last month, a Berkshire Hathaway Inc. company has agreed to reinsure Cigna's Corp.'s variable annuity guaranteed minimum death benefits and guaranteed minimum income benefits in which Berkshire will reinsure 100% of Cigna's exposure up to $4 billion on future claims on these businesses, which have been in run-off since 2000.
Under the agreement with Berkshire Hathaway Life Insurance Company of Nebraska, Cigna is paying for the transaction with an incremental $100 million of parent company cash, about $1.8 billion of investment assets supporting the run-off businesses, and a roughly $300 million tax benefit associated with the deal. Cigna will record a charge of $500 million, after tax, in the first quarter, representing the amount of payment to Berkshire that is more than Cigna's recorded reserves. The company's exit of these run-off businesses in its reinsurance segment took effect Feb. 4.