This is the third article in this series. You can read the other two parts here: Part 1 and Part 2.
In reading Warren Buffett's letters to shareholders, we found many gems that inform our opinions and beliefs about how to be successful in the insurance industry. We wanted to share these five pieces that we found key:
1. Be great in your niche rather than a generalist
"[A great insurance manager] follows the policy of sticking with business that he understands and wants, without giving consideration to the impact on volume," Buffett wrote.
Developing an area of expertise and choosing target markets the company understands in-depth is essential to the success of a carrier or of an agency. This is particularly relevant today as new risks are emerging quickly. Attempting to cover a risk you don't fully understand is a fool's game.
2. Underwriting discipline is key for long-term success
"We hear a great many insurance managers talk about being willing to reduce volume in order to underwrite profitably, but we find that very few actually do so," Buffett wrote.
While it is common to talk about writing business only with strict underwriting criteria, it is hard to avoid the siren song of growth, especially for publicly traded carriers that have to worry about investors who only care about next quarter. Though it is challenging, a good underwriter must practice discipline in choosing the risks that it insures. Profitable companies will understand that this may mean growing more slowly or less than the year before but will ensure profitability.
3. Never downsize your underwriters during slowdowns
"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)," Buffett wrote.
In his own companies, Buffett professes to never downsize underwriters because of slowdowns in the market Rather, he prefers to keep the extra capacity to be ready to pounce once the market comes around and the business can be written at proper pricing with expected underwriting profitability. If a company wants to commit to profitability, employees must understand that their first priority is profitability. The best way to do this is to make it clear that employees will be rewarded when this profitability is achieved. Assuring employees that they are not in danger of being laid off because of slow growth is an effective signal. In addition, it will be important to manage hiring practices during periods of growth, so that the company is not overstaffed. The company must strive for efficiency during all cycles.
4. Understand the challenges of commoditization and regulation
"Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and the rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition. It is commonplace, in corporate annual reports, to stress the difference the people make. Sometimes this is true and sometimes it isn't. But there is no question that the nature of the insurance business magnifies the effect which individual managers have on company performance," Buffett wrote.
The fact that the industry is so stringently regulated is a challenge for insurers. It is important, therefore, to hire people who are committed to professional development and growth. If the people in your company are going to be the difference, they must believe in the industry and strive every day to do the best work they can. Supporting your employees' development efforts will inspire a strong culture of growth and achievement.
5. Reserve conservatively
"We are making every effort to get our reserving right. If we fail at that, we can't know our true costs. And any insurer that has no idea what its costs are is heading for big trouble. [...] The natural tendency of most casualty-insurance managers is to underreserve, and they must have a particular mindset - which, it may surprise you, has nothing to do with actuarial expertise - if they are to overcome this devastating bias. Additionally, a reinsurer faces far more difficulties in reserving properly than does a primary insurer," Buffett wrote.
Companies must recognize and support the need to have an accurate picture of their costs. To this end, a company should encourage its claims departments to strive for accuracy and report potential losses fairly. If a company does not know what it faces, it cannot set goals that will lead to success. Insurance is an unusual business in that we do not know our cost of goods sold until long after the pricing has been set and the policy has been sold; thus, proper reserving is of do-or-die importance.
Much of Buffett's advice in these five statements centers on the importance of well-educated and knowledgeable employees, which is one of the key things we push for at InsNerds.
