Warren Buffett on the importance of underwriting discipline
Source: Asia Insurance Review | Apr 2015
Asound insurance operation needs to adhere to four disciplines but many insurers pass three of the disciplines and fail the fourth, said Mr Warren Buffett in his annual letter to shareholders for 2014.
The four disciplines are: 1) understanding all exposures that might cause a policy to incur losses; 2) conservatively assessing the likelihood of any exposure actually causing a loss and the probable cost if it does; 3) setting a premium that, on average, would deliver a profit after both prospective loss costs and operating expenses are covered; and 4) be willing to walk away if the appropriate premium cannot be obtained.
He said: “They simply can’t turn their back on business that is being eagerly written by their competitors.” He said the perennial pressure from industry peers to follow the example of another “spells trouble in any business”, however “in none more so than insurance”.
P&C industry operates at significant underwriting loss frequently
Recounting the benefits of the property-casualty business – which were its financial characteristics – Mr Buffet said that as P&C insurers received premiums upfront and paid claims later, they had the opportunity to use the resultant large sums (or “float”) held “to invest for their benefit”. Further, when premiums received exceed the total of operating expenses and eventual losses, an underwriting profit is registered and adds to the investment income that the float produces.
However, he noted that all insurers invariably wish to achieve a similar happy result, and hence there has been intense competition, “so vigorous indeed that it frequently causes the P&C industry as a whole to operate at a significant underwriting loss”.
He shared that in his company’s operations, while all the insurance managers understand the value of underwriting risks for premium (which will help to build their funds for investment), they also know that its benefits can be drowned by poor underwriting results. “That message is given at least lip service by all insurers; at Berkshire, it is a religion,” he said.