Warren Buffett cautions against underwriting at any cost

Warren Buffett doled out some more of his sage advice in the annual Berkshire Hathaway letter to shareholders this year, offering something for the reinsurance industry to ponder at this competitive time.

Be willing to walk away.

This is a subject that comes up a lot, of course, with the softened state of reinsurance causing concerns over discipline, over how much diversification can allow rates to be discounted, and over motivations of capacity.

Buffett lays his concerns out succinctly, as is typical of his letter.

He explains; “At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk way if the appropriate premium can’t be obtained.”

Obtaining appropriate premium is something every reinsurer and ILS fund manager would profess to be doing when asked, but in the currently competitive and softened marketplace it’s got to be tempting not to.

“But diversification allows me to write European windstorm exposed programs at a rate-on-line barely (if at all) above expected loss,” the very large and globally diversified reinsurance capacity providers would cry.

Well, yes, it does and under that diversified business model it may be deemed an appropriate premium while the going is good, although not always risk commensurate we would venture.

What would happen if reinsurers walked away from the peril regions where pricing is near, at, and sometimes even below, expected loss when the next major event strikes?

Buffett explains how he sees the market; “Many insurers pass the first three tests and flunk the forth. They simply can’t turn their back on business that is being eagerly written by their competitors.”

Here’s where problems could crop up.

With major global players able to wield scale and diversity to deploy capacity driving down pricing, seen widely in some diversifying peril regions, smaller reinsurance firms may be tempted to follow the herd, which could be fatal for them.

“That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but none more so than insurance,” Buffett warned.

Underwriting at expected loss, or below it, isn’t really doing even bigger reinsurers any favors, as when they do face major losses in those regions, which will happen, they will find getting their “pay back” not as easy as before.

This is due to market conditions, with all that capital on the sidelines and the ILS sector ready to find new diversifiers as soon as the rates meet their minimum return guidelines.

But it is also because the cedents in those markets are getting so used to the very low pricing that stomaching any increases is going to be testing, when many companies will have built their business models around the availability of cheaper reinsurance capacity.

There’s a risk that if major losses are suffered and reinsurers want paying back, but a region can’t stomach the price rises during a capacity crunch, that local re/insurers find protection becomes scarce.

That’s not building markets for the future, it’s more like setting markets up to fail.

Risk commensurate reinsurance pricing may benefit the ceding companies just as much as reinsurers, offering a more sustainable view of their future reinsurance costs.

And while the capital markets or ILS funds could replace some capacity, in the diversifying regions they may not even want to as pricing can be very thin and they do have investor returns to consider.

Buffett’s warning is a sage one, and good advice for cultivating healthy markets.

Walking away because the price is too low is better than walking away years later because you took heavy losses and hadn’t been charging enough, as in the reinsurance and insurance market of the future consistency in pricing may increasingly be key.