It's on page 9 where Buffett explains the four essential qualities of good insurance businesses. Here is a summarized list of these disciplines.
Insurance companies should:
- Understand the events that would lead to losses
- Conservatively calculate the risk of loss and probable financial losses that could result
- Price policies so that revenue covers losses and operating expenses
- Have a willingness to walk away from underpriced policies
These traits are remarkably simplistic. From discipline one through four, Buffett essentially walks through the logical steps insurance companies need to take to generate underwriting profits -- that is, to make their premium revenue exceed their total costs.
Despite how obvious these disciplines may seem, most insurers fail to live up to the standard. The first quarter of 2013 was the first time since 2009 that the property and casualty insurance industry produced underwriting profits -- meaning premium revenue exceeded losses and expenses. But it was mostly luck as losses were unusually low last year.
Making it up later
Most property and casualty insurers hope to make money on their investments, not their underwriting. Because there is a lag between the time premiums are received and claims are paid, insurance companies can invest their "float" to generate a return.
AIG (NYSE:AIG) is an example of a company that, for the most part, doesn't earn money on its underwriting. Premium revenue in its P&C division merely matches losses and expenses from year to year. However, because it earns just over 4% on its float, writing insurance is profitable.
It's a perfectly reasonable way to do business. But it doesn't have to be this way.
Berkshire Hathaway has generated underwriting profits for the past 11 years in a row. Likewise, property and casualty company Chubb (NYSE:CB) has generated underwriting profits through much of its recent history.
Not only do Berkshire and Chubb get the benefit of the float, they get paid to invest the float. As Buffett stated in his letter to shareholders, floats are very beneficial.
"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money -- and, better yet, get paid for holding it."
Investing in great insurance companies
Any insurance company can make a profit investing their float. Few, however, can create earnings from underwriting. If there is one quality that divides "great" and "good" insurers, it's the existence of underwriting profits -- excess profits very few insurance companies can achieve.
All insurance companies could, theoretically, generate underwriting profits. Most, however, don't listen to Buffett's four disciplines, and thus become merely "good", not "great," insurers.