The four commandments of reinsurance, according to Warren Buffett

There are four commandments that any company operating in the insurance and reinsurance industry should follow, according to Berkshire Hathaway’s Sage of Omaha Warren Buffett, and interestingly they reflect the discipline of the ILS market.

Writing in his annual letter Warren Buffett explained that these four commandments are disciplines that any insurance or reinsurance operation must follow at a minimum. They reflect underwriting expertise, prudent reserving, risk appropriate pricing and having the discipline to walk away if necessary.

The insurance-linked securities (ILS) and collateralised reinsurance markets display these traits, in the main, as do many of the world’s top reinsurers. The four commandments of re/insurance are a reminder that operating in the risk space needs to be a disciplined affair or companies will not enjoy the longevity that Warren Buffett’s companies, such as Berkshire Hathaway Re and General Re, have.

The first commandment is that insurers and reinsurers need to ensure that they “understand all exposures that might cause a policy to incur losses,” according to Buffett.

The second commandment reads that re/insurers must “conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does.”

The third commandment states that in re/insurers should seek to “set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered.”

Finally, the fourth commandment of reinsurance is to display discipline and restraint, and “be willing to walk away if the appropriate premium can’t be obtained.”

All good advice from Warren Buffett and lessons that the ILS funds, investors and collateralised reinsurance market has been learning and following and here’s why we believe that to be the case.

On the first commandment, understanding exposures, increasingly ILS fund managers are growing their teams, adding new expertise and strength in-depth as they grow to ensure they have risk modellers and underwriters who can truly interpret and assess the risks they underwrite.

In fact some ILS and collateralised players are attracting serious heavyweights from the traditional reinsurance market as they grow, a good sign that they are taking their risk analysis very seriously indeed.

On the second commandment, conservatively and prudently assessing events and if necessary reserving appropriately, is something ILS players are displaying in their setting of side-pockets for any loss events.

We’ve seen this practice adhered to diligently, with side-pockets often established at a size larger than generally required, resulting in subsequent releases back to investors once the extent of a catastrophe loss is known.

This practice resonates well with ILS end investors, allowing them to prepare for the worst case on losses and then benefit from any subsequent addition to net asset value as side-pockets are worked out and closed down post-event.

The third commandment, on risk appropriate pricing, has clearly been evident in the ILS, catastrophe bond and collateralised reinsurance markets, with many cases cited where ILS investors have walked away from deals, or demanded higher cat bond coupons, or not writing any of a program if they cannot match the traditional market pricing.

With the average ILS fund not having as much diversification to benefit from in their pricing habits as a traditional reinsurer, there are cases occurring where the risk is of the type an ILS manager would like to write, but the pricing is too low so they refrain from it.

And that is the fourth commandment, walking away if the price doesn’t meet your return requirements. ILS managers cannot write risks at the very low levels seen in the market sometimes, as they have minimum returns to deliver to investors.

That instills, perhaps, an added layer of discipline in the ILS business model. The need to generate a certain return on capital, combined with the lower level of diversification typically available to help to discount on underwriting, combines to compel ILS players to walk away in many cases these days, while this reinsurance market is so softened.

It’s always worth listening to the sage words of Warren Buffett. His Berkshire Hathaway businesses are among the most profitable and sustainable looking in the re/insurance market and the lessons he and his underwriting chiefs have learned over the years make for worthwhile advice for the ILS market as it matures and grows.