Friday, August 22, 2008

Risk aversion – Berkshire style

Chatting with a well known blogger yesterday who made the (common) assertion that all insurance companies eventually go to zero. The world – it is argued – is full of surprises – and if you take even a small chance of blowing up then eventually your number will be up and you will blow up.

Then our protagonist argues all insurance companies take a small chance of blowing up – and eventually there number is up.

This I think is too simplistic. I think some types of insurance have realistic (albeit small chances) of blowing up. Others (rarer) do not.

Take for example household versus auto insurance.

Household insurance is subject to super-catastrophes. Big earthquakes are theoretically possible anywhere (although vanishingly unlikely in some locations). Hurricanes happen as well and the 250 year storm seems to happen fairly regularly.

But auto insurance is not generally subject to super-catastrophes – cars drive away from hurricanes and bounce around in earthquakes. The only catastrophes that regularly affect cars are hailstorms – and the biggest hailstorm claim in insurance history happened in my home town (check this out about 3 inch hailstones).

Has anyone noticed that Berkshire does auto insurance (GEICO) but does next to no household insurance (it writes a few policies in Florida which it tries regularly to cancel – but regulatory rules force it to renew).

If you write household insurance there is the mega-storm that could bankrupt you. Buffett has said that storms substantially bigger than Katrina are possible. Buffett won’t do it even though GEICO could probably – if it chose to be – become the most profitable household insurer in the US.

Also take life insurance

Any student of human history knows that plagues – real devastating plagues which wipe out very large numbers of young healthy people happen irregularly but often enough to be a real risk.

The insurance industry have gotten quite complacent about them – because the only new plague of our lifetime did not affect life insurance companies. HIV is – within the West anyway – primarily a disease of gay men, IV drug users and haemophiliacs. None of these people were regular buyers of life insurance. Had HIV been a disease of middle age men who visit prostitutes because they don’t get it at home it would have selectively targeted the core market for life insurance companies – and every life insurance company in the Western World would have gone bust. In Thailand HIV morphed into such a disease – but surprisingly or not life companies have not been heavily impacted in the West.

Note that if you think plagues are inevitably going to happen then most life insurance companies have a finite life.

Notice that Berkshire does not insure mortality at a primary level and does almost no mortality reinsurance. Swiss Re is the dominant player in that business. Buffett has the capital and the expertise and he does not play.

By contrast annuities are not subject to plagues or shock risk – they can cost you money as life extends due to medicine – but that looks like a continuous process – not a shock process like plagues. Berkshire will write you an annuity online (see http://www.brkdirect.com/)

Again a small risk of blow-up and Buffett will not play.

The Gen Re debacle

The terrorist attacks of 2001 were a true shock to Buffett. General Re was taking a chance of complete wipe-out and had the attack been nuclear there is a fair chance that Gen Re would have folded. Buffett wrote about that in a special letter to shareholders – see this quarterly report which differs from other Berkshire quarterlies as it contains a shareholder letter...

Buffett criticises Gen Re for writing risks that could have been lethal. His company broke the first Buffett rule of risk aversion. [Despite the joke that the rule is don’t lose money – the rule really is don’t blow up. Buffett is quite prepared to lose 5 billion on a single policy.]

Note that almost none of this involves mathematical models. It involves stress tests. And the stress is not a selected 99% probability stress test – it’s a complete implausible debacle stress test.

And when most people do stress tests the process is “well what happens if property prices drop 30%?” and someone says “what if they drop 40%?” and the response is – they can’t go that far.

The Buffett question for a risk manager is “what if they drop 70%?” You might say it can’t happen. One word: Japan.

I know how you live by the Buffett stress test with a diversified portfolio – when I open a fund it will live by that test. (No intolerable concentrations of long only banks or life insurance companies.) But I have no idea how you run a life company by the Buffett stress test. I don’t think you can. That doesn’t mean the businesses shouldn’t exist – but they probably never be considered completely safe. And a portfolio investor should never be totally weighted there even if that is their field of expertise.

John

9 comments:

Anonymous said...

Great post today - very relevant for options traders.

Thanks John!

chris said...

LLoyds of London is an insurance entity that has been around for centuries.

Anonymous said...

One of Buffett's key principles (which Gen Re violated in its policies prior to 9/11) is to always cap risks to a maximum amount. Buffett is OK with losing large amounts (in the billions). What he is not OK with is losing uncapped amounts.

As such, Buffett is always chopping off the tail in his insurance risks. It might be a very small risk but it is absolutely unacceptable to Buffett to assume it.

That is what I have learned from watching him operate.

This is in contrast to insurance and investment banks - their models tell them the risks to the 99%+ level but they implicitly assume that the tail beyond 99% doesn't happen often - when in markets it happens a lot more than the models say it does.

Scott said...

John,

Regarding risks of plagues, I highly recommend "The Coming Plague: Newly Emerging Diseases in a World Out of Balance" by Laurie Garrett. It is lengthy but is well written and documented and I think makes a compelling case that there is indeed significant risk of major mortality in the near future due to the emergence of some hitherto unknown microbe.

Ryan Barnes said...

Stumbled upon your blog on a "third derivative search" day; enjoy your perspective.

One good thing about the long tail is that the stock market doesn't tend to factor it in. Obviously at the end of the day it's case by base, but markets don't price other industries for their sub-1% potentials. I know Buffett grasps this well; he often references such scenarios in his writings and letters. A big reason why he's been so into reinsurance and being the "insurer of last resort" for much of his career.

Good luck with writings, funds. RB

EpiphanyInvesting.com

David Merkel said...

The idea that all insurance companies eventually go to zero is ridiculous. Many of the best performing companies over the long haul have been insurers. Markel, Berkley, Berkshire Hathaway, White Mountains, and many others have been stellar performers. Plus, many great insurance stocks have been bought out. For a current example, look at Philadephia Consolidated.

We may as well say that all Thrifts go to zero, or all Steel companies go to zero. Nothing lasts forever, but saying that every company of a given class goes to zero is a lazy opinion.

John Hempton said...

The idea that there will EVENTUALLY be a plague that takes out all mortality insurers is not odd at all. We came very close with HIV. Had HIV been a disease that targets middle aged men that visit hookers (ie - married, children, don't get enough at home but have life insurance because of the kids) then every life insurance company in the Western world would have gone bust.

A small chance of insolvency with enough time and you go bust.

Buffett's specifically stated rule is do not take those chances.

I suspect Merkel has a small chance of zero. I know AIG does as does Swiss Re and Hannover Re.

If you think the idea is ridiculous invest your money on that basis. Sometime you or your children or their children will be wiped out.

And you can enjoy genteel poverty.

As Buffett says - and string of impressive numbers multipled by one zero is still zero.

J

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Chris's comment does not understand Lloyds. Lloyds is not an insurance entity - its a market place. Plenty of people have gone bust at Lloyds. Its famous for it.

J

PlanMaestro said...

John,

After one year of reading this post by chance stumble upon it again. I had forgotten how good it was.

Thanks

Dora Jason said...

One of Buffett's key principles (which Gen Re violated in its policies prior to 9/11) is to always cap risks to a maximum amount. Buffett is OK with losing large amounts (in the billions). What he is not OK with is losing uncapped amounts.

As such, Buffett is always chopping off the tail in his insurance risks. It might be a very small risk but it is absolutely unacceptable to Buffett to assume it.

That is what I have learned from watching him operate.

This is in contrast to insurance and investment banks - their models tell them the risks to the 99%+ level but they implicitly assume that the tail beyond 99% doesn't happen often - when in markets it happens a lot more than the models say it does.ensure vs insure

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