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
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
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.
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.
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:
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.