The insurance industry has carefully crafted arguments, and then used their influence, to convince our government to bring in the ‘minor injury cap’ in 2004. The argument of the insurers was largely that they simply could not go on underwriting losses which were caused by numerous automobile claims for ‘soft tissue’ injuries. What follows is an extract from this years’ Berkshire Hathaway report to shareholders that explains how, in reality, underwriting losses have little bearing on the profitability of insurance companies.
Insurance
Let’s look first at insurance, Berkshire’s core operation and the engine that has propelled our expansion
over the years.Property-casualty (“P/C”) insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float. And how we have grown, as the following table shows:
Year Float (in $ millions)
1970 $ 39
1980 237
1990 1,632
2000 27,871
2010 65,832
2011 70,571It’s unlikely that our float will grow much – if at all – from its current level. That’s mainly because we already have an outsized amount relative to our premium volume. Were there to be a decline in float, I will add, it would almost certainly be very gradual and therefore impose no unusual demand for funds on us. If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit occurs, we enjoy the use of free money – and, better yet, get paid for holding it. 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. For example, State Farm, by far the country’s largest insurer and a well managed company besides, has incurred an underwriting loss in eight of the last eleven years. There are
a lot of ways to lose money in insurance, and the industry is resourceful in creating new ones.As noted in the first section of this report, we have now operated at an underwriting profit for nine consecutive years, our gain for the period having totalled $17 billion. I believe it likely that underwrite profitably in most – though certainly not all – future years. If we accomplish that, our float will be better than cost-free. We will profit just as we would if some party deposited $70.6 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit.
So how does this attractive float affect intrinsic value calculations? Our float is deducted in full as a liability in calculating Berkshire’s book value, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to view float, which should instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this liability is far lower than the accounting liability. Partially offsetting this overstated liability is $15.5 billion of “goodwill” attributable to our insurance companies that is included in book value as an asset. In effect, this goodwill represents the price we paid for the float-generating capabilities of our insurance operations. The cost of the goodwill, however, has no bearing on its
true value. If an insurance business produces large and sustained underwriting losses, any goodwill asset attributable to it should be deemed valueless, whatever its original cost.Fortunately, that’s not the case at Berkshire. Charlie and I believe the true economic value of our insurance goodwill – what we would pay to purchase float of similar quality – to be far in excess of its historic carrying value. The value of our float is one reason – a huge reason – why we believe 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. 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…
Complete document here.
Just remember that insurance companies sole reason for existence is to make a profit from you. It doesn’t matter whether we are talking about the other drivers’ insurer or your own insurer. Don’t ever assume that they are acting in your best interests.