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 :
- Less capital in the industry leads to good underwriting profits and increase in revenues and float.
- This attracts new players and existing insurance companies to raise new capital
- This builds up capacity, as companies start out-bidding each other with ever decreasing premiums
- This results in underwriting losses and declines in combined ratios
- As time passes, the weaker , under capitalized , undisciplined insurers suffer and either close or shrink their operations
- 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.
- First, market share is not an important determinant of profitability ( unlike newspaper or grocery business it’s not survival of the fattest)
- Distribution channels are not proprietary and can be easily entered ( you can ramp volume easly YoY )
- 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.
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.