So here goes (and for the most part I genuinely do not know the answer).
Insurance companies sell promises to make good real goods and services some time in the future for cash now. For example they promise to pay someone's medical expenses or a nursing home bill say 10 years after a premium has been collected.
They mostly hold the cash receipts in cash and bonds. Berkshire also use some real assets (eg railways) and many banking stocks.
Because insurance companies are short real goods and services and long cash and other nominal assets they negatively affected by inflation. Long tail insurance companies are obviously worse hit with inflation than short tail companies.
Can you run through the major Berkshire insurance businesses (GEICO, Gen Re, Ajit Jain's business and others) and tell us what damage inflation will do and why?
Answers are gratefully accepted - especially from Uncles Charlie and Warren (who I somehow doubt read this blog).
John
PS. I should disclose because people are doubting it - that Bronte Capital is LONG Berkshire stock.
J
27 comments:
So long as the rate of return on all investments outpaces the rate inflation, this isn't an issue.
Buffett is truly a master at avoiding and limiting long-term exposure to inflation risk. He has written about the subject extensively, both in his letters and via published articles.
Here's a 100-page-long compilation of some of Buffett's writings on the subject (gotta love Google): http://www.chanticleeradvisors.com/files/107293/Buffett%20inflation%20file.pdf
Buffett bought a long term care reinsurance business at Gen Re.
Its a bad business - he admitted this at the AGM. He said he wished he had less of it.
It is going to pay nursing home bills for people with Alzheimer's disease for decades.
Obviously there is some (considerable) inflation risk there.
Buffett's business are good - but they are NOT IMMUNE.
I would like a real assesment of where the risks lay. I did not get one.
J
Calle, I believe that just outpacing inflation may not be sufficient to do okay. If you have really poor underwriting and price you risk way too low, your investments would have to also cover for shortfalls in your (too low) premiums.
I would guess a big difference in LTI and something like auto insurance is the ability to reprice your policies as industry and economic conditions change, as long as the regulators say it is okay.
I know little to nothing about the insurance industry so hopefully someone will chime in so we can all learn more!
Gen Re, the life side would largely be fixed or decreasing NAR so inflation helps. P&C risk are generally viewed as short term risks although Mold/Asbestos... etc. claims stretched out. Agree that Long Term care seems very sensitive to inflation. GEICO is short term in nature so it doesn't seem overly sensitive.
No clue what goes on at Ajit's business.
Wouldn't inflation be a bigger issue if he was in long exposure business and invested mostly in bonds rather than equity?
Anon at 2.11 is roughly my first cut of the problem - though I wonder about the life blocks.
There are a few really bad businesses in there (mould, long term care, asbestos, some medical malpractice etc) that look really bad in an inflationary environment.
Those are the ones I can think off the top of my head - but Warren when he wants to answer a question will give you a much more sophisticated answer than that.
Those guys (especially Charlie) are apt to say things you do not expect. They did not at the meeting though.
"So long as the rate of return on all investments outpaces the rate inflation, this isn't an issue." This is the correct way to think about it. I would say they have more interest rate risk than inflation risk. As rates rise in the future, their bond portfolios will be hurt. Insurance companies rarely have much cash (at least for extended periods of time), but instead have about 80-85% in bonds. Although when interest rates rise, they will just hold bonds to maturity (they usually do anyways) so they wouldn't get hit bad. Beyond inflation and interest rate risk, the key to insurance is understand the hard/soft market cycle. Right now the insurance business is in one of the longest soft markets (low prices) it has ever been in. When the market hardens, and it will at some point, premiums will rise drastically. Berkshire will be a huge beneficiary of this.
"So long as the rate of return on all investments outpaces the rate inflation, this isn't an issue." This is the correct way to think about it. I would say they have more interest rate risk than inflation risk. As rates rise in the future, their bond portfolios will be hurt. Insurance companies rarely have much cash (at least for extended periods of time), but instead have about 80-85% in bonds. Although when interest rates rise, they will just hold bonds to maturity (they usually do anyways) so they wouldn't get hit bad. Beyond inflation and interest rate risk, the key to insurance is understand the hard/soft market cycle. Right now the insurance business is in one of the longest soft markets (low prices) it has ever been in. When the market hardens, and it will at some point, premiums will rise drastically. Berkshire will be a huge beneficiary of this.
Long tail risks are matched with long tail assets --- that's why Ajit's National Indemnity holds the asbestos liabilities AND is the parent company of Burlington Northern.
Putting Burlington Northern under National Indemnity also increases National Indemnity's regulatory capital --- thus allowing National Indemnity to take even more retroactive asbestos reinsurance deals.
It is interesting to see the views (mostly incorrect) about the Long Term Care Insurance (LTCI) exposure to inflation. The view ascribed to Warren Buffett about LTCI is a correct description of how he feels (I have actually talked to him one on one about it a few years ago) but is probably misguided, since his experience has been with his reinsurance company reinsuring products with poor underwriting and incorrect actuarial assumptions, particularly with regard to persistency (too many people have continued to pay premiums).
In actuality, inflation is the friend of Long Term Care Insurance and if there was an enemy, it would be deflation.
Long Term Care Insurance is sold in fixed daily benefit amounts (much more like disability insurance than medical insurance). Likewise, policies that are expected to pay out more than they were originally priced to pay, will see their premiums increased for future years (subject to regulatory approval of the increases being justified). Finally, the real risk in long term care insurance (other than deflation) is the investment rates remaining low for an extended period of down (probably a decade or more into the future) since the profits are sensitive to long term interest rates remaining depressed.
Are you by any chance expecting an inflationary environment?
I (in UK) am, in the medium term, because of money printing (effectively) in UK and US. Alas, it's to some extent been supporting asset and commodity prices (and UK house prices) - I should have dived into equities in November 2008, but didn't.
If you expect inflation, why ?
John,
In many cases the dollar value of the goods and services insurance companies promise to deliver has been fixed/capped.
For example LTC insurance typically has a daily $ rate and/or a max cap. Life, commercial, homeowners all tend to have a fixed $ exposure.
So I dont think inflation would necessarily damage them in the ways you mention.
thx
Scott
John,
Not knowing a huge amount about insurance, the only thing I can think of is that at least some of that inflation risk has been offset by Berkshire's investment in real-goods producing companies, ones with strong competitive advantages and the power to increase prices (See's is probably the classic example).
So perhaps as a whole the inflation risk (short real goods/services) is hedged? Nevertheless, always interested in learning more about BRK, so looking forward to some good responses.
Following on from Calle's comment.
Thanks to most central banks focusing on inflation as the #1 should high inflation occur, it will inturn mean that most central banks will set high enough interest rates. Allowing insurers to off set the high inflation with high returns.
However, two significant risks exist for this basic model.
1. Interest rates being less than inflation, re America - look at QBE's recent investment returns for evidence of the impact low interest rates can have.
2. Hyper-inflation. Fairly self expanatory.
At the end of the day, an insurers ability to combat the threat of inflation, is to generate an underwriting profit (something Buffett is a master off) by paying out less in claims than he receives in premium. Inflation will then not be a factor.
Therefore, find insurers and re-insurers that generate underwriting profit, and you remove inflation as a factor.
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I work in the insurance industry and thought I'd offer my 2 cents here.
I don't think most know this, but if you dig into the past records, you'll learn that GEICO was once at the brink of bankruptcy, largely due to inflation. They had a number of problems occurring, but I think the biggest was that their reserves weren't accurate. They're always an estimate, but they were way off, and it's likely due to the inflation that they were experiencing. It killed them so bad that they needed a bail out, except no one had an incentive to save a competitor. In the end, likely because they didn't want regulators to become tougher, 26 insurers banded together and issued a reinsurance contract to GEICO. Remember, their stock price had probably fallen 90% by this time and so bankruptcy/regulatory intervention wasn't too hard to envision. With this giant reinsurance contract (insurance for insurers, or a temporary "sharing" of revenue/expenses in this case), GEICO was given a chance.
A new CEO was brought in and demanded rate increases at every state, but they resisted. In New York, where this is very common, he flew out himself to meet with the regulators and threatened to not renew a single policy unless the rate increases were given. Ultimately, GEICO stopped writing in New York and set the tone for all the other states. As far as I know, they got the rate increases that they demanded after that.
GEICO was turned around and saved with a reinsurance contract, and a capital infusion as well. During this time, Buffett himself bought 33% of the business. He would literally be sitting in the living room of the GEICO founders when he would make a call to the CEO and give his verbal commitment. Through share repurchases, this 33% became 50%, and then he bought the entire business in the 90's.
I think Buffett is very well aware of the risk of inflation, because he himself has lived through it.
What is the exposure
1. Pull up his 10-k: http://sec.gov/Archives/edgar/data/1067983/000119312512079022/d280149d10k.htm
2. Scroll to page 37
3. "The major components of float are unpaid losses, life, annuity and health benefit liabilities, unearned premiums and other liabilities to policyholders less premium and reinsurance receivables, deferred charges assumed under retroactive reinsurance contracts and deferred policy acquisition costs. Float approximated $70 billion at December 31, 2011, $66 billion at December 31, 2010 and $63 billion at December 31, 2009."
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This is a good starting point where you can see that he has $70 billion of unpaid items + unearned premium (& misc other items). Unpaid losses will already have some kind of inflation trend factor built into these. One important distinction between inflation in general and what matters here is that the inflation will be a little different. If you measure the medical rate of inflation, it will be different than CPI as a whole, because of other factors like the regulatory environment, supply/demand within a specific industry, etc.
Buffett likely believes that he at least has a portion of companies with good pricing power and so they will produce cash flows to make up for the increase in inflation from these groups.
The risk we've looked at so far is only on historical insurance premium, and not even at insurance premium they write during the inflationary period. I've been focused on P&C insurance so far and have yet to dig into inflation too much, however if others are interested, this is what I would look at: http://www.casact.org/pubs/Friedland_estimating.pdf
I'm sorry I don't have too much insight here. My knowledge is limited within P&C to begin with, and even then, inflation is a factor I really should be learning more about.
I think that when we invest, we have to be happy with what we have, and if we're betting on business operations to go well, we need to have faith that those in control of the business units will do the right thing. We cannot control every single risk and if I were to personally invest in Berkshire Hathaway, it would be largely because the valuation seems rational and I know that I can trust Buffett to protect my capital.
Insurance is a very interesting field and there's a lot to it, but just like any business endeavor, I think we want to be in a place where we can sleep well at night. While Berkshire is diversified, I would never want to be 100% invested in it alone, or any other investment for that matter.
Why can't the premiums can (roughly) account for the expected inflation in the future?
The question I wanted to ask is this: What is a $70 billion non callable loan at a zero (or negative) interest rate with an indefinite term worth? Secondly, what is that same loan worth in Warren's hands?
There is no way the cost of long tail float will be negative if there is a big burst of unexpected inflation.
But then it may only wind up being a couple of percent positive - and Buffett will be able to invest at higher rates in that environment.
John
Ahh: the bugbear of insurers is unexpected inflation; both superimposed and CPI/Wages sort.
And more particularly unexpected changes in inflation. Australian insurers include inflation in their claims calcualtions so there is a basis risk problem if it is different to the expectation. Of course it's magnified by the duration of the liabilities.
I suspect the effect on pure reinsurance operations are mitigated by the catch up nature of the industry and if everyone loses the same amounts, premiums go up until losses are made and ceders of RI do not change to cheaper insurers. But obviously thats messy for profits in the short and medium term. Other long tail stuff is far more exposed
The best theoretical answer I've found is the IMF 2009 paper http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1394810
which tells you that all asset classes are buggered in the medium term (except for IIBs) and cash is best of a bad lot. Equities and bonds actually go down when inflation goes up producing a double whammy to solvency etc
Overall I suspect that many insurers have a written option against them which is not priced by capital markets.
It's not well known, but Buffett owns a few tons of gold to hedge his inflation risk - he just won't admit it :)
More seriously, as a retiree I am also sensitive to inflation - especially those things that have increased faster than CPI. "Real productive assets", which Buffett likes, can underperform inflation for a substantial part of my remaining life, and hence are not a good hedge. John, if you have some insights on Buffett's issues, perhaps we retirees can also benefit, because we can't buy a few hundred hours of medical care and save them for the future when they will be needed.
Rich
Hi John,
This is the key sentence from your Q which may partly answer your own Q:
"They mostly hold the cash receipts in cash and bonds. Berkshire also use some real assets (eg railways) and many banking stocks".
Most insurance companies mostly do own nominal cash assets, and they are exposed.
The big question mark for Berkshire is what allocation to nominal assets does it have(particularly those with long durations) vs. stocks & real assets.
The answer may be that they are (partly) protected by having a large - and certainly much larger than is industry standard - allocation to real assets, while keeping their nominal assets of short duration, where theoretically interest rates will rise alongside higher inflation.
If inflation is higher than average, many other insurance companies with higher bond allocations will get into bigger trouble than Berkshire, and eventually there should be an increase in premium rates to compesate for lower industry profitability.
Buffett would then benefit from higher premiums, and may also use its short-duration nominal assets, which will have preserved more of their value, to buy cheap(er) bonds and stocks.
Cheers,
LT
I believe that Buffett would say that over the long term inflation won’t be an impediment to the success of his insurance businesses, but an unexpected burst of inflation would have short term negative effects that would be immaterial over the longer term.
On the underwriting side, I would think that Berkshire Hathaway has probably adequately taken inflation into account in pricing its premiums so that they are sufficient to more than cover the costs of potential claims, and that they have made other adjustments for inflation, such as index clauses in reinsurance contracts. Buffett appears to believe that inflation won’t be problematic, as he wrote in his last letter that “it is likely they will continue to show an underwriting profit in most future years”.
On the investment side, again inflation is a negative but I doubt Buffett believes in will be a long term impediment to the business success. Buffett believes that inflation is a detriment for all investments. Berkshire Hathaway’s insurance business’ investments should be less adversely affected than other insurance companies because Buffett has a smaller percentage of assets in bonds than competitors do and has a shorter duration portfolio. The real danger of inflation is to long term bonds, especially in light of their low yield and Buffett avoids those. The investments that hold up best in an inflationary environment is business with pricing power that have lower capital requirements, and Buffett has a good amount of those, although he does own capital intensive businesses as well.
On the demand/production or total float side, Buffett does not see them growing their $70 billion float much, if at all, but implies he doesn’t see it reducing much either. I would think that inflation would impact demand negatively, particularly on more elective insurance but not enough for Buffett to warn of any negative impact to total float.
I suspect that I haven’t really told you anything you didn’t know very well already. Is what you really want to know is how much have they adjusted the premium prices to account for inflation? What other adjustments, if any, have they made in their insurance contracts for inflation? And what amount of inflation, if any, would begin to impact their underwriting profit negatively, all other things being equal? I wouldn’t know the information necessary to answer these questions but I believe that Buffett believes high inflation is coming, believes in will have a negative impact on his insurance business and its investments, and has adjusted for it as much as possible through higher premiums, provisions such as index clauses in reinsurance contracts, and other provisions, and believes that long term it will not be an impediment to the continued success of their insurance businesses.
doesnt the cost of insurance rise over time anyway? though inflation risk can make insuring a goods or service more expensive in the future, dont the higher premiums of tomorrow help hedge these increases?
ex:
i paid 1.00 today for coverage of 100
5 years from now the claim has a value of 105 and my insurance provider increases my premium to 1.05
Given that you specifically mentioned medical and nursing home services, I will attempt a partial answer as it relates to health (and long-term care) insurance (long answer also published on my blog).
Health insurance actually is a short-term business and for good reasons -- past experience indicates that medical inflation runs at around 2.5% faster than GDP growth which is part of the reason insurers are unwilling to insure long-term medical inflation risk. Therefore contracts usually are on a one-year renewable basis with premium adjustments closely following medical inflation. As utilization is high (claims are frequent and largely predictable), poor underwriting will show its ugly consequences rather fast for both the primary insurer and the reinsurer. The insurer either adjusts premium, discontinues the business or runs into financial difficulties before long-term inflation kicks in. Of course, there is a whole slew of problems associated with the short-term perspective of private health insurance from a system financing perspective (e.g., the unwillingness to invest in net positive but long-term investments in health improvements that do not show up almost immediately).
My understanding (although I am not an expert on it) is that this is very different for long-term care insurance and part of the reason why it is such a difficult business (if you take the insurer's perspective) or why there is such market failure to provide private long-term care insurance on a broad basis (if you take the system perspective). David Cutler has an old paper on it describing long-term cost uncertainty (another word for inflation) to be the primary reason why there is so little long-term care insurance and mostly of the dollar-capped type.
Also, two more observations:
*Why is it not possible for insurance companies to reprice policies annually to reflect the inflation in claims costs. Eg to say healthcare costs went up 8% last year so our premiums are going up 8% also. Float then presumably goes up 8% also.
*Buffett has written very insightfully on inflation in the past, including his 1970s article on "how inflation swindles the equity holder", which in my view is one of the best pieced of equity analysis ever written.
I find it implausible that Buffett will not have thoroughly thought about the potential impact of inflation on the profitability of his insurance policies & structured them in a manner which takes account of this risk.
Cheers,
LT
A gem from pp19-20 of the link supplied by Calle (thanks for that!).
"Ironically, many insurance companies have decided that a one-year auto policy is
inappropriate during a time of inflation, and six-month policies have been brought in as
replacements. “How,” say many of the insurance managers, “can we be expected to look
forward twelve months and estimate such imponderables as hospital costs, auto parts
prices, etc.?” But, having decided that one year is too long a period for which to set a fixed price for insurance in an inflationary world, they then have turned around, taken the
proceeds from the sale of that six-month policy, and sold the money at a fixed price for
thirty or forty years."
Again, it's simply not plausible that Buffett has overlooked inflation risk (or how his managers think about inflation risk) in his insurance businesses.
Cheers,
LT
You said - Because insurance companies are short real goods and services and long cash and other nominal assets they negatively affected by inflation. Long tail insurance companies are obviously worse hit with inflation than short tail companies.
While true for most insurance companies, it really isn't true for Berkshire. Bershire has a lot more equity securities than bonds and cash. I would say they are net long real goods and services
Isn't Inflation a benefit to companies that have insured a fixed amount, rather than replacement value? Looking at the life insurance business, they take a premium in todays money and fix the end outcome don't they depend on inflation to some extent to make it profitable,as the money today is worth much more? Taking on promises for recurring bills in the future is where trouble lies and as you say this causes most companies to go bust, I am not sure if its inflation that causes this though or the fact that people living longer tend to spend more of their time than they used to in ill health (I have no statistics to back up this claim, maybe people are living healthier and longer) but again its an issue of mis-pricing the policy, not something thats a result of inflation.
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