If you read our most recent article, “Dinner With Warren Buffett,” you’ll already know that I’ve truly earned the title “insurance nerd” after dreaming about hours-long insurance conversations. After I woke up, we started this series to share Warren Buffett’s insurance industry wisdom from his annual letters to shareholders. Last week, we talked about the fundamentals; today, we’re going to share three challenges of the industry and two of its strengths.
Challenges of the Insurance Industry
1. Dismal Economics:
In the 1987 letter, Buffett explains that the insurance industry is “cursed” with “dismal economic characteristics” because there are hundreds of competitors, easy entry and a product that cannot be properly differentiated for a durable competitive advantage. This makes personal lines insurance a “commodity-like” business where, in his opinion, only a company that enjoys a cost advantage or one that operates in a very small niche can sustain high profitability levels in the long term.
He goes on to explain that Berkshire’s differentiator is its ability to be the low-cost provider in personal lines through Geico and its financial strength for large specialized commercial lines and reinsurance. Competing on cost is always challenging in our industry, and maintaining financial strength in a turbulent world is also a feat not to be taken lightly.
We think it’s funny that he talks about dismal economics when he has made most of his billions in our beloved industry, and he’s very clear in the letters that Berkshire will always be heavily invested in insurance. However, we love insurance not because it’s a great investment but rather because it’s a great place to work, one that’s interesting and rewarding and one where we are being a positive influence in the world. In that sense, we are very different from Uncle Warren, who sees insurance simply as an investment vehicle. If you see it only as a financial investment, some of its characteristics would make it tough.
2. Commoditization of the product can lead to poor returns:
“Insurers have generally earned poor returns for a single reason: They sell a commodity-like product. Policy forms are standard, and the product is available from many suppliers, some of whom are mutual companies (‘owned’ by their policyholders rather than stockholders) with profit goals that are limited. Moreover, most insureds don’t care from whom they buy. Customers by the millions say, ‘I need some Gillette blades’ or ‘I’ll have a Coke,’ but we wait in vain for ‘I’d like a National Indemnity policy, please.’ Consequently, price competition in insurance is usually fierce.” — 2004 letter, page 5.
We’ve written about the commoditization of insurance before. Personal lines insurers are particularly aware of the struggles in that arena. Agents fight against it, regularly, and some companies are actively innovating to move away from this strategy. Some of the bigger companies add features to their policies that they hope others will be slow to follow, and newer companies, like MetroMile, aim to change the industry, but ultimately policies and endorsements must be filed and thus can be copied by competitors. Ironically, Buffett’s own billions in advertising spending for Geico, almost exclusively focused on price, have done more to commoditize our industry in the eyes of the customer than anything else in its ingrained characteristics.
3. Maintaining underwriting discipline at the expense of growth is a challenge unique to the insurance industry:
“Most American businesses harbor an ‘institutional imperative’ that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract this year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed. […] Finally, there is a fear factor at work, in that a shrinking business usually leads to layoffs. To avoid pink slips, employees will rationalize inadequate pricing, telling themselves the poorly priced business must be tolerated in order to keep the organization intact and the distribution system happy. […] [Underwriting] is not labor-intensive, and… we can live with excess overhead. We can’t live, however, with underpriced business and breakdown in underwriting discipline that accompanies it.” — 2004 letter, page 5-7.
Stock companies, particularly, will have challenges in maintaining underwriting discipline. If certain markets cannot show growth because of underwriting or capacity restraints, it requires that a clear picture be painted for stockholders to justify why the company has exercised this restraint. In addition, companies should be wary of laying off employees because of a temporary downturn.
We think this one long paragraph really captures the spirit of the insurance industry and the innate contradictions of always pursuing growth. Uncle Warren’s professed philosophy for the Berkshire companies is to only write business that is expected to be profitable and to always be willing to stand by and accept premium declines if the market is soft and proper rates can’t be secured. We love that he professes to be willing to carry excess staff during quiet times, instead of endless waves of rightsizing and rehiring, and we think all insurance companies should consider similar policies.
Advantages of the Insurance Industry
1. Profits can be outstanding if you manage your business well.
“It is not easy to buy a good insurance business, but our experience has been that it is easier to buy one than create one. However, we will continue to try both approaches since the rewards for success in this field can be exceptional.” — 1978 letter, page 5.
Whether one buys or creates an agency or a carrier, managing the insurance portfolio well will typically lead to high payouts. The business also has the opportunity to truly provide for its customers, and it is very rewarding beyond the financial aspect at that time of need. On the carrier side, where Buffett focuses, ultimately it comes down to float: Premiums are received up front, and losses aren’t paid until later, sometimes much later, allowing him to invest and multiply those funds.
2. You will never be bored.
“You can get a lot of surprises in insurance.” — 1978 letter, page 6.
Finally, the element of surprise in insurance is exciting! Most people think of it as a boring, unchanging industry. But, particularly now, the industry is ripe for disruption. Beyond that, if you work for a carrier, you never know what your agents will call you with, and if you’re an agent or service representative, you never know what your customer will call you for. We are learning something every day and know that we will to do so throughout our careers! It is one of the best aspects of the profession.