I recently came across an article posted on GuruFocus here, quoting a lot from Buffett’s letter to shareholders on the accounting of insurers. Initially I thought the quotes came from the latest Chairman’s letter, after some googling, I realised the quotes came from Buffett’s 1980 Chairman’s letter here.
I would think that the accounting standards would have changed by quite a bit from 1980 until today, so I don’t know how relevant this note is today. Nonethless, I thought it would be good to read through, jot down some key points just to learn about what happened in the past.
The insurance industry at that time was having problems due to the decline in bond prices. Insurers hold long-term bonds at amortized cost, amounting to 2-3 times equity. This leads to the following problem:
- Insurers do not wish to “touch” the long-term bond portfolio for fear that adjustments will result in needing to realize bond losses which can negatively and significantly impact equity.
- As a result, they do not pursue logical moves such as switching into taxable bonds (from tax-exempt bonds) when underwriting losses are expected, so that they can pick up extra yield while their losses can absorb any tax payments.
If the volume of business declines significantly, insurers have to sell their assets to pay off their liabilities, which will cause unrealized losses to be realized. Insurance companies facing declining bond prices and business had two options:
- Keep pricing according to the exposure involved, i.e. get a dollar of premium for every dollar of expense cost plus expectable loss cost.
- As the business is price-sensitive and the policies are renewable annually, this will result in loss of business to competitors.
- The insurer’s liabilities (unearned premiums and claims payable) gradually decreases with less premiums being paid by customers, which will trigger the sale of assets and realization of losses.
- To avoid realizing large losses, insurers sell stocks carried at market values or recently purchased bonds whose values have not decreased by too much. Essentially, they are selling the good and keeping the bad.
- Hope that bond prices go up or business improves, while using the premiums paid by customers to invest at high interest rates.
Most insurers chose the 2nd option, to maintain their premium volumes despite accepting inadequate premium rates. This forces other insurers to maintain low rates.
The takeaway here is that when insurers made large commitments to long-term bonds, it causes them to lose, for a long time, both their investment options and underwriting options. Their investment options are limited because they are unable to sell their long-term bonds to invest in better assets because their equity would be in trouble when losses are realized. Their underwriting options are limited because they are forced to sell at low insufficient rates in order to maintain premium volumes and not be forced to sell assets. This however means high future underwriting losses which are not adequately covered by the premiums.
This may be one good reason why Buffett uses his float to invest in mainly stocks rather than long-term bonds.