When the reinsurance market is challenging, competitive and underwriting opportunities seem less attractive so you pull back on premiums underwritten, wouldn’t it be nice to still make a decent return on your investments?
Reinsurers across the industry are looking at how to become more efficient, how to extract more value out of their underwriting, how to leverage efficient third-party capital (alongside their own) and how to maximise the return on their investments.
In the low interest rate environment and with macro financial market volatility rearing its head in the last quarter, many reinsurers have suffered investment declines. This at a time when they are often pulling back on the volume of premiums underwritten, in reaction to the decline in prices, meaning they could really do with an investment boost right now.
This is where the Warren Buffett model at Berkshire Hathaway really comes into its own.
Buffett’s model, which has both its fans and detractors, is to invest the premium float generated by his insurance and reinsurance businesses in a variety of strategies and conglomerate style investments. At the same time Buffett’s strategy is to underwrite more when attractive and to pull-back when re/insurance market conditions are not as conducive.
The idea is to generate an underwriting profit as well as attractive risk-adjusted returns on the asset side. Then if one side of the book is less than attractive, the ability to flex allocation of capital can act as a foil to both the insurance or reinsurance and financial market cycle.
When you have generated a cash-pile the size of Berkshire Hathaway’s, the float has grown to $86.2 billion at the 30th September 2015, up from $85.1 billion at the middle of the year, you stand to benefit from good investment returns, when the market is less volatile.
The kind of big bets that Warren Buffett takes on also allow greater profit multiples to be generated, helped by the huge cash-pile that can be put to work.
The recent quarter gave a great example of when this investment-oriented approach can pay off, with Berkshire reporting a big dip in underwriting profit, both due to pulling-back on premiums underwritten as well as suffering losses, but at the same time the investment return continued to deliver.
In Q3 2015 Berkshire reported net earnings from underwriting operations of $414 million, down significantly from $629 million in Q3 2014. However on the investment side the earnings reported from insurance related assets was $840 million in Q3 2015, up from $811 million in Q3 2014.
The improvement in investment earnings is impressive, especially when you consider that almost every other reinsurer, be they investment-oriented or hedge fund backed which suffered the biggest investment declines in Q3, or traditional which were also largely hit by market volatility, reported poor investment performance.
Premiums written across the Berkshire Hathaway insurance and reinsurance businesses rose however, so the decline in net earnings is really a sign of the lower pricing in reinsurance and some insurance lines, as well as losses such as Tianjin, which hit Berkshire in Q3.
But the investment returns continue to deliver, helping Berkshire Hathaway to report impressive quarterly results despite the clear decline in re/insurance profitability and the broad financial market volatility.
The thing is, while some reinsurers say they would like to emulate Buffett’s model, few do. Buffett’s ability to invest float into companies, whole industries and much more broadly, provide his investment returns with the boost that keeps his shareholders happy.
Also the fact the float is so large, continues to grow quarter by quarter and with much of it being longer-duration, more permanent capital, gives Buffett the ability to invest differently to the likes of the hedge fund reinsurers. Right now the strategy seems very effective in the current market environment.
That’s not to say Warren Buffett isn’t aware of the challenges his insurance and reinsurance businesses face, he is clearly cognizant of the issues the market faces and actively leverages his ability to lever between underwriting and investment to counteract this.
“Insurance industry capacity remains high and price competition in most property/casualty reinsurance markets persists. We continue to decline business when we believe prices are inadequate. However, we remain prepared to write more business when more appropriate prices can be attained relative to the risks assumed,” the Berkshire 10Q reports.
The huge investment float of Berkshire gives the business the ability to move with the cycle, adjusting where and how much it underwrites depending on the attractiveness of opportunities, while still generating attractive investment returns to boost earnings.
No other reinsurance business has the ability to do this so reliably. Interestingly, the strategy adopted by Richard Brindle’s new company Fidelis looks to emulate this, flexing capital deployment between underwriting and investment as each of the cycles demand.
Buffett’s model continues to look increasingly compelling, so its no surprise so many hybrid approaches to reinsurance and investment have emerged. But getting to the scale of investment float where it can make really meaningful impacts such as this, enabling companies to better manage the cycle, is no easy task and those emulating the model will find scale matters on the float side, just as much as on the underwriting.
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