Thoughts on Business and Technology

Notes : Berkshire Annual Letter – 1986

Performance Highlights :

  • Net Worth $492.5
  • Book value $2073.6 ( 23.5% compounded annually )
  • No opportunities to invest in stock market.
  • Expected Return on Equity going forward – 15%

Business Value = Book Value + Goodwill (  Pricing power + Moat )

Three unique factors of Berkshire that make capital allocation challenging :

  • We earn more money than average
  • We retain all that we earn
  • We own businesses that need little incremental capital to stay competitive & grow

Insurance –  key metrics to watch :

Combined Ratio ( after policy holder dividends ) :

Total insurance costs ( losses incurred plus expenses) to revenue from premiums. The combined ration below 100 indicates an underwriting profit and a ratio above 100 indicates loss. When the investment income an insurer earns from holding onto policy holder’s fund (“The Float”) is taken into account,A ratio in the range of 107-111 represents overall break even results, exclusive of funds provided by shareholders.

Premium volume :The funds received by insurance companies by collecting periodic premiums from it’s customers.

we expect the industry’s incurred losses to grow at an average of 10% annually, even in periods when general inflation runs considerably lower.(Over the last 25 years, incurred losses have in reality grown at a still faster rate, 11%.) If premium growth meanwhile materially lags that 10% rate, underwriting losses will mount, though the industry’s tendency to under-reserve when business turns bad may obscure their size for a time.

Loss Reserves : Reserves held by insurers to protect against insurance liabilities

Reserve Strengthening : Correction of previous miscalculations regarding required loss reserves.

Percentage of underwriting expense & loss adjustment expense of Premiums. ( it’s 16% for GIECO in 1986 while it was close to 30% for others )

The Float : Overall return of equity in the investment portfolio

Insurers profitability : In years when the industry’s annual gain in revenues (premiums) pokes along at 4% or 5%, underwriting losses are sure to mount.- The social & judicial inflation is the culprit.

Industry’s revenues must grow at about 10% annually for it to just hold its own in terms of profitability, even though general inflation may be running at a considerably lower rate.

Social & Judicial costs on Insurers :

  • Cost of entering a courtroom has simply ballooned ( skyrocketing verdicts)
  • Tendency of judges and juries to expand the coverage of insurance policies beyond that contemplated by the insurer when the policies were written

Insurance profit cycles :

  1. Less capital in the industry leads to good underwriting profits and increase in revenues and float.
  2. This attracts new players and existing insurance companies to raise new capital
  3. This builds up capacity, as companies start out-bidding each other with ever decreasing premiums
  4. This results in underwriting losses and declines in combined ratios
  5. As time passes, the weaker , under capitalized , undisciplined insurers suffer and either close or shrink their operations
  6. This results in shortage in capital in the market, which leeds to underwriting profits and the cycle continues…

The curse of insurance industry :

  • Lots of competition – hundreds of competitors
  • Ease of entry – Low barrier to entry
  • Commodity-business – a product that cannot be differentiated in any meaningful way

Moat in Insurance Industry :

  • Very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels.

Berkshire’s moat in insurance Industry :

  • Financial Strength ( means less in personal / auto insurance sector )
  • Total indifference to volume – (We follow a price-based-on-exposure, not-on-competition policy because it makes sense for our shareholders.)

Float to Premium Volume : Higher ratio of float to premium volume will result in higher profitability even if combined ratio is unchanged or slightly higher.

Unique business conditions of Insurance Industry :

Three conditions that prevail in insurance, but not in most businesses, allow us our flexibility.

  1. First, market share is not an important determinant of profitability ( unlike newspaper or grocery business it’s not survival of the fattest)
  2. Distribution channels are not proprietary and can be easily entered ( you can ramp volume easly YoY )
  3. Idle capacity ( people ) – does not result in intolerable costs ( i.e. we can operate at quarter-speed much of the time and still enjoy long-term prosperity.)

Long Tail insurance : Policies generating claims that often take many years to resolve.With a business mix like this, one year of reserve development tells you very little.

Other Topics

On Currency : In the long term the behavior of our currency depends on the behavior of our legislators.

On Commodity markets : Businesses make profits when there is shortages but those periods usually don’t last long.

On Stock & Bond price fluctuations : Higher interest rates will depress both stocks and bond prices, but common stocks will be more impacted.

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