Nick Prettejohn, Lloyd's CEO, exhorted the insurance industry to make an underwriting profit "on more than an occasional basis," repeating a prayer heard often from "thought leaders" in the insurance industry. "Stop destroying value" was how he put it, noting that the insurance industry made an overall underwriting profit (a combined ratio over 100) in 2004 for the first time since 1978. He contended that a return on underwriting is essential for return on capital to be equal to or greater than cost of capital.
Blaming the insurance business cycle was not satisfactory, Prettejohn went on. The cycle "is not an alibi for management inaction." Somehow (he does not say how) industry management should "make return on capital the single most important performance measure for underwriters as well as investors."
The full text of his remarks at at Lloyd's website. Strategic challenges facing the general insurance industry
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Warren Buffett, in his 2004 Annual Report Letter to Shareholders, reminds the owners of Berkshire Hathaway of the value of "float," money held by insurers that must eventually be paid to others (policyholders and claimants). He consistently reminds shareholders that the cost of float is a function of the operating ratio, and that even when the ratio is below 100 (an underwriting loss), the cost of float can be below the return obtainable by investing that float wisely. Of course, Berkshire has a long history of investing that float to yield an average annual return about twice that of the S&P 500, largely by a "buy and hold" approach to acquiring substantial stakes in profitable businesses.
Buffett extols the virtues of an underwriting profit, pointing to the 25-year record of National Indemnity Company ("NICO"), one of Berkshire's flagship insurance subsidiaries. A table in the 2005 annual report shows that in all but 5 of those 25 years, National Indemnity produced an underwriting profit. The exceptions were the nasty years in the early 1980's and the infamous 2001.
Where he is more specific than Prettejohn, is in describing the unusual business model that enables National Indemnity to achieve that consistent underwriting profit. That is the willingness to allow a decline in revenue during "soft" markets (when competitors are pricing below cost to gain or maintain market share) and to write fully-priced business when the market is "hard." The 25-year chart in the annual letter shows this history with classic Buffett clarity.
National Indemnity's written premium dwindled in the early 1980's to a low of $58 million in 1983, in the depths of the "soft" market, generating an 18.7% underwriting loss. The next year, the market began to "harden," as below-cost "cash flow underwriting" insurers exited the marketplace, either feet first as insolvents or voluntarily. National Underwriter was ready with capacity and by 1986 wrote $366 million in premium at a 30.7% underwriting profit.
As always, those profit levels attracted new and renewed entrants into the market, which began the long softening that ended only with the disaster of September 11, 2001. National Indemnity's written premium dropped to $232 million in 1987, to $140 million in 1988 and then steadily dropped to a mere $54.5 million in 1999, the underwriting profit steadily dropping (without flipping to a loss).
In most any other company, such a long, steady decline in sales and cash flow into the organization would have been intolerable to management and Wall Street. Yet National Indemnity (like other Berkshire subsidiaries) was able to survive because of what Buffett called "real fortitude -- embedded deep within a company's culture --to operate as NICO does." Buffett notes that insurance prices are now falling, and that NICO's volume will decline, and that as it does, Buffett and his partner Charlie Munger "will applaud ... ever more loudly."
So, if the most consistently successful insurer/investor in modern history is so plain about his business model, why do more insurers not emulate it? A recent article by Sean M. Fitzpatrick in the Connecticut Insurance Law Journal suggests some answers. Sean is a Lecturer in Law at the University of Connecticut School of Law and Senior Vice President and Special Counsel at Chubb & Son, Inc. In "Fear is the Key: A Behavioral Guide to Underwriting Cycles," 10 Conn.Ins.L.J. 255 (2003-2004), he reviews several conventional attempts to explain the insurance business cycle (pricing uncertainty, interest rates and reinsurance pricing) and proposes a behavioral approach that includes three additional components that are rarely voiced out loud, let alone in publication.
The first behavioral component, the compensation structures of insurers, may strike a cord with Lloyd's Prettejohn. Insurers compensate underwriters not on the profitability of the business they write, but on the volume of premiums they write. One reason for this is that ultimate profitability of insurance requires years to determine, and good underwriters want and need compensation and bonuses sooner than that. "Good producers" have the ability to "write and run," to generate and be rewarded for significant growth in premium estimated to be ultimately profitable, then leverage that success to move to another high paying position before the actual profits (or losses) are known.
Another factor is the linkage between profitability and power in the internal bureaucracy of an insurer. Underwriters, claim managers and actuaries have different perspectives on the insurance business than do financial analysts. When financial results are good, conservative viewpoints gain power, but as financial results fall, more liberal voices take prominence and prices tend to be cut.
Fitzpatrick's third factor is the influence of brokers, which have a natural concern that they will lose their customer to another broker with a lower price. So, they constantly play insurers against each other, steadily working prices down and down, eventually below cost. Recent investigations by Atty. General Eliot Spitzer and others have revealed some of the power of brokers to twist even the largest and most powerful of insurers, confirming the power noted by Fitzpatrick.
Fitzpatrick notes that each of these influences reflects rational business managers making rational decisions based on the incentives and constituencies before them. He concludes that "cycles are at root the result of personal judgments ... made each day by individuals. ... If one places these questions in a human context, it becomes clear that underwriting cycles are first and foremost the result of the inconvenient collision of human nature with the essential indeterminancy of risk."
Like Prettejohn, Fitzpatrick closes with an exhortation that: "Insurers need to focus their employees on long-term profitability, brokers need to focus theirs on maintaining stable sources of capacity rather than on obtaining the lowest possible prices, and consumers of insurance need to be willing to forgo short term price reductions in return for a more dependable and consistent market for insurance products."
What he does not address is how to change the deep-seated behavioral patterns in so many managers, brokers and consumers that will be required to achieve the breakthrough state of enlightenment for which he calls. Until some practical way of changing human nature is found, the National Indemnity Companies of this world may continue to quietly outperform, as insurance leaders continue to pray fervently that their congregation and the world about them turn away from temptation.
Posted by dougsimpson at April 9, 2005 03:49 PM