The Property Casualty Insurers Association of America (PCI) reported full year 2008 results for the industry yesterday and it was not a pretty picture. While PCI reported that insurers remain well capitalized when one considers levels of statutory net worth and loss reserves, the operating results from 2008 show considerable strain on the industry in general when one considers unsatisfactory levels of underwriting losses and declines in statutory net worth during the year. I found these results for the overall industry to contrast sharply with Berkshire Hathaway’s excellent insurance operating results for 2008. Let’s take a look at a few notable aspects of the PCI’s report.
Underwriting Results
The PCI report indicates that insurers suffered $21.2 billion in underwriting losses in 2008 and the combined ratio soared to 105.1 percent from 95.5 percent in 2007. The combined ratio is the sum of the claims ratio and the loss ratio and essentially compares the premiums received during a given year to the claims experience as well as all operating expenses. A combined ratio less than 100 indicates that a company generated underwriting profits while a ratio above 100 indicates a loss. Examination of the combined ratio is the best way to determine how well an insurance operation is managed since it accounts for both operational efficiency and the quality of underwriting.
In contrast to the overall industry, Berkshire Hathaway earned underwriting gains of nearly $2.8 billion in 2008 and had a combined ratio of 89.1 percent (this figure is for all insurance lines at Berkshire). Moreover, Berkshire has demonstrated consistency in generating underwriting gains over time, as one can see from the ten year track record I have prepared.
Why is Berkshire different? Let’s see what Warren Buffett had to say about this in his latest shareholder letter:
Over time, most insurers experience a substantial underwriting loss, which makes their economics far different from ours. Of course, we too will experience underwriting losses in some years. But we have the best group of managers in the insurance business, and in most cases they oversee entrenched and valuable franchises. Considering these strengths, I believe that we will earn an underwriting profit over the years and that our float will therefore cost us nothing. Our insurance operation, the core business of Berkshire, is an economic powerhouse.
Indeed, the industry has experienced substantial underwriting losses over long periods of time as noted by PCI in this excerpt from the report:
The 105.1 percent combined ratio for 2008 is the worst full-year underwriting result since the 107.3 percent combined ratio for 2002. And the combined ratio for 2008 is one percentage point worse than the 104 percent average combined ratio since the start of ISO’s annual data in 1959.
How does Berkshire post superior underwriting results over long periods of time? Essentially, Berkshire manages to avoid the types of underwriting losses experienced by the industry in 2008 by exercising underwriting discipline when prevailing rates are insufficient to adequately compensate for risks. One way in which this is accomplished is by having the right incentives in place within the subsidiaries and not paying merely for volume of premiums written but based on underwriting profitability. The end result is that Berkshire’s policyholder float is consistently available at no cost, or even at negative cost in times of underwriting gains.
Investment Results
The PCI reports that industry-wide net investment gains (the sum of net investment income and realized capital gains/losses) for the industry fell to $31.4 billion in 2008 from $64 billion in 2007. This was due primarily to $19.8 billion in realized capital losses that detracted from the $51.2 billion of net investment income.
In terms of evaluating an insurance company, Warren Buffett entirely separates the underwriting results from the investment results. This is primarily to draw a distinction between the core function of an insurance underwriting operation which is distinct from the act of investing policyholder float to generate investment returns.
In 2008, Berkshire recorded $3,497 million in net investment income along with realized investment and derivatives losses of $4,646 million. Buffett always notes that the level of realized gains and losses during any particular period are not necessarily meaningful, particularly for companies that have a large amount of unrealized gains on the books. This is particularly true due to the mark to market rules associated with Berkshire’s widely misunderstood derivatives portfolio.
Implications for 2009
I found this excerpt from the PCI report interesting when looking forward to 2009 results:
Written premiums have now declined versus year-ago levels for a remarkable seven successive quarters. The declines that started in second-quarter 2007 were initially a reflection of intensifying competitive pressures in insurance markets but now also reflect the impact of the recession on the demand for insurance,” said Sampson. “Prior to this unprecedented string of declines, ISO’s quarterly data extending back to 1986 shows that written premiums declined in just two other quarters – falling 0.1 percent in fourth-quarter 1991 and 4.8 percent in third-quarter 2005 – with the decline in third-quarter 2005 resulting from a special transaction in which one insurer ceded $6 billion in premiums to its foreign parent.
This is type of environment in which many insurers may be willing to compromise underwriting standards in order to capture market share in an environment where there is a shrinking volume of business.
This is deadly in terms of the long term impact on the combined ratio. Underwriters who are compensated based on premium volume will be tempted to lower standards in this environment. For Berkshire Hathaway shareholders, this should not be a concern given the clearly demonstrated ability of management to sacrifice unprofitable business when justified.
A great example of Berkshire’s willingness to sacrifice volume when needed was covered in Charlie Munger’s latest letter to Wesco Financial Shareholders. Wesco is a 80% owned subsidiary of Berkshire Hathaway. Earlier this month, I wrote about Munger’s willingness to dramatically shrink the premium volume at Kansas Bankers Surety Company rather than to accept unprofitable business.
There is no way to accurately predict what will happen in the industry during 2009, and even Berkshire can suffer years of underwriting losses. However, Berkshire shareholders can be confident that at least management incentives are aligned with shareholder interests regarding obtaining float only at zero or negative cost over the long run. There is no point in growing float for investment purposes if the cost of that float is ruinous.