Warren Buffett annually issues a letter to the shareholders of Berkshire Hathaway discussing business developments over the year. As is well known, a significant core of Berkshire Hathaway’s business is insurance: property-casualty from National Indemnity, auto from GEICO, and reinsurance, especially usual reinsurance placements.
In his annual letters, Buffett from time to time analyzes the business of insurance – and provides the truest and simplest explanation of the nature of the property-casualty business and its economics. His letter for year 2004 (released in March 2005) focuses on the business models of the three main areas of Berkshire Hathaway’s business. It is available at http://www.berkshirehathaway.com/letters/2004ltr.pdf and in particular see pages 6 through 11.
Before reading the year 2004 letter, however, read Buffett’s letter about 2001, available at http://www.berkshirehathaway.com/letters/2001pdf.pdf and in particular pages 6 through 11. This analysis should be required reading for anyone in the property-casualty business (lawyers included). The 2004 letter is good and interesting; the 2001 letter (which recapitulates points and themes Mr. Buffett has set forth before) is essential to understanding insurance markets and dispelling pervasive myths about the pricing and profitability of insurance companies.
Dear Marc:
I really enjoy reading your blog. However, I don’t see how Warren Buffet’s analysis is inconsistent with the acturial pricing of insurance or the way we teach people how to think about insurance pricing. I think the reason companies get into trouble is because they stray from the principles of insurance pricing and underwriting.
I know I tend to overstate the case that policies are not actuarially priced, but the rhetoric is so far the other way that I’m sometimes driven to the opposite extreme. I don’t think that pricing is totally untethered from the risk of loss, but supply/demand functions overwhelm the actuarial model. Dick Stewart, http://www.stewarteconomics.com, lays out the argument best that pricing is (relatively) untethered from the model we learned about in 6th Grade. Buffett’s analysis is fundamentally congruent with the focus on supply/demand more than actuarial risk, though I understand how it can be read as largely decrying inadequate actuarial pricing. Even so, because of the optimists, winner’s curse, etc., much of the pricing is more driven by competitive pressures. (I might also refer you to a reasonably recent article by Sean Fitzpatrick that was published in The Brief that to a fair amount echoes the Stewart/Buffett/Baker argument.) Buffett’s folks may have the discipline not to jump into the water when others are cutting prices, but most companies would succumb to the pressures to keep the premiums coming in and hope that it all works out ok.
Granted, I come at this all as a lawyer, but my experience is consistent with pricing having little to do with actuarial risk. My clients’ risk portfolio does not change meaningfully yet the pricing and availability of insurance does. I tend to think that policies are underpriced, making it rational to purchase insurance even if one is a large company that could self insure because the internal accrual of reserves would likely exceed, at least over time, the price of insurance (because these would be actuarially set) and accruing a reserve for a 1/1000 chance of a $100,000 loss doesn’t help much when you actually have only the $100 in hand to pay that $100,000 loss if it comes to pass (with marginal utility of money, prospect theory all coming into play on this).