Warren Buffett’s annual letter to the shareholders of Berkshire Hathaway is always peppered with insights, and this years edition was no different.
Buffett pointed out a number of interesting trends affecting the reinsurance industry today and even made the odd forecast for the future.
One of his forecasts was something he has predicted before, that the returns achieved by reinsurers over the last ten years will not be repeated so easily, but this time he gave some new insight as to exactly why he believes this to be the case.
In the past Buffett has bemoaned new entrants to the market, competition, pricing, all of which do mean the reinsurance market is unlikely to ever return to the same status quo as seen a decade ago.
But this time he pointed out something that really doesn’t get enough attention, that will affect every insurer and reinsurer, particularly those with longer-term assets in their investment portfolios.
Buffett describes the concept of float, the free money he sees coming from premium income and profit that adds to Berkshire Hathaway’s investment income.
This, he writes, is all well and good, a strategy that has reaped dividends for Buffett and Berkshire Hathaway’s shareholders, but he warns that macro-economic effects could reduce re/insurers ability to generate their profits going forwards.
He writes that competition and the desire to always generate this underwriting profit, to add to float, to generate more investment income from free money, means the industry almost dooms itself to an increasingly hard time.
“Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continues its dismal record of earning subnormal returns on tangible net worth as compared to other American businesses,” he explains.
One thing is making this even more certain going forwards, Buffett says, the dramatically lower interest rate environment that the world has been experiencing in recent years.
“The investment portfolios of almost all P/C companies – though not those of Berkshire – are heavily concentrated in bonds. As these high-yielding legacy investments mature and are replaced by bonds yielding a pittance, earnings from float will steadily fall,” Buffett forecast.
This matters right now, at a time when P/C companies are often underwriting at close to break-even. The investment return, no matter how minimal sometimes, really does matter to many of the world’s largest P/C insurers and reinsurers.
Any decline in yield generated from float could exacerbate the effects of lower underwriting returns generated during the softened reinsurance market, leaving little room for error on any side of the balance sheet.
For this reason Buffett says, “It’s a good bet that industry results over the next ten years will fall short of those recorded in the past decade, particularly in the case of companies that specialize in reinsurance.”
The reinsurance sector would do well to heed this warning from the Sage of Omaha, as Buffett is rarely proved wrong.
Some re/insurers have clearly seen this coming and are preparing, with a number of companies changing quite significant chunks of their investment portfolios in recent years.
But there are many that haven’t taken any steps and if Buffett is right and the generally lower yield environment really comes back to bite them, when many of the currently higher-yielding assets have matured, there will be tough times ahead as he forecasts.
