How to run an insurance company - the Berkshire Hathaway way

​Berkshire Hathaway insurance business has always been run with an iron discipline approach. Warren Buffett and Charlie Munger would rather shrink the business than take on poorly priced insurance risk. Thus, in the years preceding 1985 Berkshire was the slowest-growing large US insurer. In fact, it shrank.
It wasn’t that it withdrew from the market. Indeed, it was the industry’s most steadfast provider, but it would only quote premiums that “we believe to be adequate” (1986 letter) said Buffett.  There are times, such as the lead up to 1985, when other insurers slash prices to bargain levels to maintain volume. Naturally, clients leave Berkshire and go to them during these times.
Then the cycle turns, as rivals run out of capital or become frightened by the losses generated by low premiums exit the market, and customers flood back to Berkshire. “Our firmness on prices works no hardship on…our employees: we don’t engage in layoffs when we experience a cyclical slowdown at one of our generally-profitable insurance operations.  This no-layoff practice is in our self-interest.  Employees who fear that large layoffs will accompany sizable reductions in premium volume will understandably produce scads of business through thick and thin (mostly thin).” (1986 letter)
This policy produced huge swings in volume of primary insurance business. For example, monthly volume of $5m premiums in the final quarter of 1984 jumped to about $35m in the first quarter of 1986.
A similar discipline, and therefore volume variability, pervaded the reinsurance business.
A low cost of float, not a no cost of float
The target of achieving profitability on underwriting, i.e. a combined ratio under one, is a harsh one. Most insurers are content to make small losses on underwriting which they make up for by investing the float. Even Buffett does not require a profit on underwriting, preferring the metric which compares the percentage underwriting loss on float with the rate of interest available on risk-free investments – see Table.
Profit record of Berkshire Hathaway Insurance businesses 1967-1995
(1)                           (2)                                                                        Yearend Yield
Underwriting                                                            Approximate          on Long-Term
Loss                    Average Float                            Cost of Funds         Govt. Bonds
------------                    -------------                             ---------------             -------------
(In $ Millions)                                           (Ratio of 1 to 2)
1967 .........   profit                 $17.3                                     less than zero         5.50%
1968 .........   profit                 19.9                                       less than zero         5.90%
1969 .........   profit                  23.4                                       less than zero         6.79%
1970 .........    $0.37                32.4                                                 1.14%             6.25%
1971 .........   profit                 52.5                                       less than zero         5.81%
1972 .........   profit                 69.5                                       less than zero         5.82%
1973 .........   profit                 73.3                                       less than zero         7.27%
1974 .........     7.36                 79.1                                                 9.30%             8.13%
1975 .........    11.35                87.6                                               12.96%            8.03%
1976 .........   profit                 102.6                                     less than zero         7.30%
1977 .........   profit                 139.0                                     less than zero         7.97%
1978 .........   profit                 190.4                                     less than zero         8.93%
1979 .........   profit                 227.3                                     less than zero         10.08%
1980 .........   profit                 237.0                                     less than zero         11.94%
1981 .........   profit                 228.4                                     less than zero         13.61%
1982              21.56                 220.6                                            9.77%                10.64%
1983              33.87                231.3                                           14.64%                11.84%
1984             48.06                 253.2                                         18.98%                11.58%
1985             44.23                 390.2                                         11.34%                   9.34%
1986             55.84                 797.5                                          7.00%                    7.60%
1987              55.43              1,266.7                                          4.38%                   8.95%
1988              11.08               1,497.7                                          0.74%                  9.00%
1989              24.40             1,541.3                                            1.58%                    7.97%
1990              26.65              1,637.3                                            1.63%                  8.24%
1991              119.59              1,895.0                                         6.31%                    7.40%
1992             108.96             2,290.4                                         4.76%                    7.39%
1993               profit              2,624.7                                  less than zero              6.35%
1994              profit               3,056.6                                   less than zero             7.88%
1995              profit                3,607.2                                less than zero               5.95%
Buffett is comparing what he calls the “cost of float” with a rough proxy of what Berkshire would obtain if it invested all float in long-term government bonds.
Another way of looking at it i………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1