Study: Insurance Companies during Inflationary Periods
Case Study 1: Home & Automobile Insurance Company
In September 1971, Berkshire acquired Home & Automobile Insurance Company which specialized in writing auto insurance in Chicago and nearby suburbs. The company was founded by Victor Raab soon after he returned from serving in the U.S. Army in World War 2. At the time of acquisition, the company was writing $7.5m in premiums ($56m in 2023 dollars).
Although the purchase price is not known, Buffett was willing to pay a $364,000 premium over the net assets of the business.
Berkshire added capital to Home & Automobile Insurance Company, allowing it to establish branch operations. The insurer was known for its highly concentrated, direct marketing and claims approach, and Buffett hoped to extend this strategy to other densely populated areas.
After a successful 1972, Berkshire made plans to expand into Florida and Los Angeles, with further expansion planned within a few more years.
However, inflation suddenly increased from 6.3% in 1973 to 11.3% in 1974, representing the highest rate of inflation since 1947. After years of profitability in the insurance industry, unintelligent competition with consequent inadequate rates and rising prices resulted in a 111% combined ratio (-11% margin) for all of Berkshire’s insurance operations.
Buffett estimated that costs of auto repair and medical payments were rising at the rate of 1% per month on average due to inflation, while insurance premiums rose by only 2% for all of 1974!
This caused the venture into Florida to be disastrous with underwriting losses at over $2m. Berkshire withdrew from Florida in mid-1974 but losses continued to develop.
Pricing in Chicago were also inadequate, Berkshire had to increase prices at the cost of a significant drop in volumes.
Underwriting losses deplete capital, so it was imperative to limit losses in order to preserve capital that would fund significant growth in the future when conditions become better.
In addition to the direct effect of rising prices, a portion of the 1974 letter is on the problem of social inflation, which arises when lawsuits expand coverage beyond limits management contemplated when pricing were set. The insurance group as a whole posted a terrible combined ratio of 118% in 1975. Scarred by several years of unsatisfactory results, Buffett forecasted a substantial gain in premiums during 1976 due to higher pricing rather than number of policies written.
Home & Automobile Insurance Company experienced a strong recovery in 1976. In order to respond more closely to inflationary trends, they shifted to a 6 month policy billing cycle. The combined ratio for the auto insurance business was not specified, but the overall insurance group actually had underwriting profits in 1976 with 98.7% combined ratio.
Insurance is cyclical, and the pattern described above is not abnormal. Periods of high underwriting profitability create incentives to write more policies, and this can sow the seeds of losses in the future. During the early 1970s, pricing were most likely set with the expectation that the status quo of low to mid-single-digit inflation would persist. But when inflation hit 11.1% in 1974 and remained high at 9.1% in 1975, premiums could not cover rising repair and medical costs, not to mention the pressure of social inflation, and underwriting losses ensued.
Case Study 2: GEICO
Buffett’s 1977 letter to shareholders disclosed Berkshire’s investment in convertible preferred and common stock of GEICO, an auto insurer that Buffett had been familiar with for more than 25 years. He outlined the basic business model of GEICO in an article “The Security I Like Best” published on 6 Dec 1951. At the time, the auto insurance industry was recovering from losses due to postwar inflation.
It’s remarkable how many of GEICO’s advantages cited by Buffett in an article written nearly 73 years ago still hold true today. However, one difference between 1951 and the 1970s is that GEICO remained highly profitable. During the first half of 1951, GEICO’s combined ratio was 91%. Nearly all other insurers had underwriting losses. The article went on to note Benjamin Graham’s role as Chairman of the Board due to his large ownership interest and noted that the stock traded at 8x earnings (1950).
Unfortunately, GEICO’s results during the 1970s Great Inflation were far worse than its results of the 1950s. GEICO reported an underwriting loss of $140m in 1975 compared to a profit of $26m in 1974. Pricing was inadequate and failed to catch up with double-digit inflation.
By the end of 1975, GEICO’s ratio of premiums-in-force to capital was roughly 9 to 1, far above the 3 to 1 ratio that regulators typically mandated. GEICO was facing insolvency.
Jack Bryne was recruited as CEO to change GEICO. He promptly withdrew from states that were unprofitable, cut costs by laying off workers, and managed to convince other insurers to reinsure the claims on GEICO’s books. His reasoning was that if GEICO went bankrupt, these unprofitable businesses would be absorbed by the other industry players anyway. Buffett had a meeting with Jack in 1976 and was convinced that he was the right CEO to save GEICO. He immediately bought 500,000 shares of GEICO the next day at $2.12 and $2.25 per share (after a 90% drop from it’s high).
At the end of 1977, Berkshire owned $33m of GEICO convertible preferred stock and $10.5m of common stock for a total of $43.5m invested in the company with a cost basis of $23.5m. The investment in GEICO accounted for 24% of Berkshire’s equity portfolio.
18 years later in his 1995 letter to shareholders, Buffett took a trip down memory lane recounting his involvement in GEICO dating back to 1951, even going so far as to call GEICO “his first business love”. A portion of the letter is worth reading at some length:
In the early 1970’s, after Davy retired, the executives running GEICO made some serious errors in estimating their claims costs, a mistake that led the company to underprice its policies – and that almost caused it to go bankrupt. The company was saved only because Jack Byrne came in as CEO in 1976 and took drastic remedial measures.
Because I believed both in Jack and in GEICO’s fundamental competitive strength, Berkshire purchased a large interest in the company during the second half of 1976, and also made smaller purchases later. By yearend 1980, we had put $45.7 million into GEICO and owned 33.3% of its shares. During the next 15 years, we did not make further purchases. Our interest in the company, nonetheless, grew to about 50% because it was a big repurchaser of its own shares.
Then, in 1995, we agreed to pay $2.3 billion for the half of the company we didn’t own. That is a steep price. But it gives us full ownership of a growing enterprise whose business remains exceptional for precisely the same reasons that prevailed in 1951. In addition, GEICO has two extraordinary managers: Tony Nicely, who runs the insurance side of the operation, and Lou Simpson, who runs investments.
Warren Buffett, 1995 shareholder letter
We again see the tendency of insurance executives to make rosy assumptions when it comes to claims costs which leads to inadequate pricing. Usually, this is driven by a desire to maintain market share at almost any cost. In the 1970s, GEICO’s overly aggressive assumptions for claims costs combined with unexpected inflation that took the entire industry by surprise resulted in near bankruptcy.
Recent Pandemic & Inflation
By 2020, Warren Buffett had followed GEICO for 7 decades and had directly participated in the insurance industry for 53 years. He observed GEICO’s problems with inflation in the early 1950s and again in the mid-1970s. Through countless communications to shareholders, and no doubt internally to Berkshire’s managers, Buffett had stressed the importance of adequate policy pricing and the virtue of being willing to give up market share in exchange for avoiding losses when competitive pricing is clearly inadequate.
With respect to the recent pandemic, the insurance industry initially benefited greatly from the fact that distance driven plummeted during the lockdowns of 2020. This windfall was offset by rebate programs intended to compensate policyholders who were driving less. Unexpectedly high inflation soon took its toll as medical and repair costs rose faster than premiums were rising. Underwriting losses soon followed.
At the 2023 annual meeting, Vice Chairman Ajit Jain indicated that GEICO was expected to post a combined ratio of just under 100% for the full year and that he anticipated a combined ratio of 96% within two years. Of course, management has made certain assumptions regarding the trajectory of inflation from this point forward and time will tell whether rates are now truly adequate.
Conclusion
Along with many other pernicious effects on the economy, unanticipated inflation wrecks havoc in the insurance industry. Rates are set before costs are known and all cost estimates depend on future inflation. It is understandable why insurance executives ran into problems in the mid-1970s since few expected peacetime inflation to reach double-digits. In response, executives had to decide between raising rates and potentially sacrificing market share or accepting underwriting losses.
In the case of GEICO, the results were nearly catastrophic but opened the opportunity for Berkshire to make a large investment in the business. Eventually, the other half of the business was acquired in 1995.
Despite living through multiple insurance industry cycles and many bouts of inflation over a long career, Berkshire could not avoid the effects of rapid inflation in the post-pandemic period. Although Buffett does not personally manage GEICO, he has long instructed insurance managers to reject inadequate pricing even at the expense of giving up market share. Despite that GEICO still recorded small underwriting losses in 2022.
Such periods of adversity are part of the insurance business. What is important is to stay in the game in the long run, preserving capital for when the cycle turns and rates are again attractive.