When Warren Buffett warned that Berkshire Hathaway's (NYSE:BRK-A)(NYSE:BRK-B) GEICO unit could have a rough quarter because of its exposure to Hurricanes Harvey and Irma, he wasn't kidding. His estimate that Harvey could lead to 50,000 total losses from flooding may have been right on the money.

Berkshire Hathaway estimated that Harvey and Irma cost GEICO as much as $500 million, due to damaged cars owned by its insureds. GEICO's standing as the best car-insurance company, though, remains intact. 

GEICO's razor-thin margins

Car insurance is a particularly competitive industry. Drivers shop for car insurance based on the price, believing (correctly) that car insurance is nothing more than a commodity. As a result, car insurers operate on razor-thin margins, earning very little, even in periods where there are no large natural disasters.

Photo of money going down a drain

Car insurers earn thin margins in good times, thus large losses can drain the industry of years of profit. Image source: Getty Images.

We can analyze GEICO through the lens of the combined ratio, which is commonly used for property and casualty insurance companies like car insurers. Insurance companies and analysts group an insurer's expenses into two broad categories, which together make up the basis for the combined ratio. These expenses are as follows:

  1. Loss and loss adjustment expenses. These are amounts GEICO will pay out for its clients' insured losses. When a $20,000 car is flooded, resulting in a total loss, the amounts GEICO spends to investigate the claim, and the amounts it will pay out on the loss, are recorded as this type of expense.
  2. Underwriting expenses. This includes expenses incurred for advertising, actuarial reviews, and inspections of property for underwriting purposes. Basically, these expenses can be thought of as the administrative costs of underwriting new business, or renewing existing policies.

Losses from major hurricanes or car accidents flow into loss and loss-adjustment expenses. This quarter, loss and loss-adjustment expenses surged as a percentage of premiums earned, rising to nearly 92% of premiums this quarter.

In the three years leading up to GEICO's most recent report, losses came out to 82% of premiums earned. Berkshire Hathaway notes that Hurricanes Harvey and Irma resulted in a 6.6 percentage-point increase in GEICO's loss ratio this quarter, which bridges most of the 10-point increase in GEICO's loss ratio over its three-year average.

Bar chart of GEICO's losses and underwriting expenses as a percentage of premiums earned

Image source: Author. Data from Berkshire Hathaway's SEC filings.

Where GEICO gets its edge

Buffett speaks highly of GEICO and its ability to hold down expenses relative to the average car insurer. This frugality is evidenced in GEICO's below-average underwriting expense ratio.

To understand what makes GEICO special, you only need to compare it to Progressive (NYSE:PGR), a property and casualty (P&C) insurance company that many view as a comparably frugal operator. In the first nine months of 2017, Progressive spent about 20.4% of premiums earned on underwriting expenses, consistent with its historic average. GEICO spent just 14.4% of premiums earned on underwriting expenses.

That 6 percentage-point differential may be small, but as Buffett explains in his annual letters to Berkshire Hathaway shareholders, most insurance companies would be elated with a 1 percentage point underwriting profit, making GEICO's 6 point head start a huge competitive advantage.

By having lower underwriting expenses as a percentage of premiums, GEICO can price its policies lower than competitors, and eke out a larger profit. This results in a "flywheel" effect, wherein more scale begets lower prices for its customers, which brings more customers and more scale.

Speaking of scale, GEICO's growth has been nothing short of extraordinary, given it's growing off a very large base as the second-largest U.S. auto insurer. In the past year, GEICO reported that voluntary auto policies in force grew by just under 10%, even as its underwriting expense ratio -- which includes advertising costs and other new business expenses -- is declining with each passing year. GEICO is extraordinarily good at what it does, a reality that isn't changed by a one-off loss due to Hurricanes Harvey and Irma.

Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.