Risk is a seemingly simple word that confounds most organizations when it comes to achieving strategic outcomes. We prefer the word uncertainty. How did insurance come to dominate thinking about uncertainty and what can business leaders learn from Warren Buffett – the Oracle of Omaha?
If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it.
- Warren Buffett, 2016 Berkshire Hathaway Shareholder Letter
Many business leaders equate addressing uncertainty with buying insurance as a means to protect against the potential for negative risk - the probability and severity of a bad thing happening. This overly narrow “risk = insurance” mindset can be traced back to the 1600s when shipowners and financiers met in London coffeehouses. These coffeehouse meetings culminated in the first commercial insurance agreements: shipowners agreed to pay a small loss (the premium) to a group of financiers (today Lloyd’s of London) who agreed to provide access to a pre-funded line of credit (insurance) in the event of a large loss (e.g., an “unsinkable” ship like the Titanic is lost at sea). By the 1940s, commercial insurance products advanced to the point that companies could buy them for many types of negative risk (e.g., work-related injuries suffered by employees). In the 1950s, the inherent complexity of buying and administering various types of commercial insurance products necessitated the creation of a full-time position entitled “insurance manager.” The 1960s brought the first courses leading to certification of insurance-related expertise and admission to the American Society of Insurance Management which today is known as RIMS (historically known as the Risk & Insurance Management Society).
Efforts over the last few decades to broaden the corporate risk management function beyond insurance have been mixed at best. Some of this is a function of the insurance industry driving the development of the corporate risk management function as opposed to critical thinking. A siloed approach has also caused the handling of insurance, like many business functions, to become fragmented and disjointed. The conservation of physical assets and the control of insurance purchasing is often the province of the treasurer or the chief financial officer. Meanwhile, corporate law departments tend to focus on managing losses and submitting insurance claims, sometimes in disagreement with the corporate risk manager who frets about trying to explain the rising costs of premiums to senior executives uninterested in anything other than near-term costs. The last 30 years have also produced costly legal battles between corporate policyholders and commercial insurers over mass tort (asbestos for example) and environmental losses, leading to ongoing changes in policy forms. Looking back at this history caused one industry commentator to make the following observation:
The truth, as risk managers know, is that as soon as the insurance industry is faced with major risks – latent diseases, product liability, AIDS, among others – it runs for cover and leaves industry to its own devices. Basically, society cannot expect too much help from insurers in sorting out its risk problems because insurers are interested not in risk reduction . . . but in risk predictability.
Chris Best, London Perspective, Risk Management (Feb. 1989).
Few, if any, people have profited more from risk predictability and insurance than Warren Buffett – the so-called Oracle of Omaha. As stated, insurance is a form of financial credit. Customers exchange their hard-earned cash (premium) for a promise that an insurance company will pay a future claim in an amount greater than the tendered cash, provided certain pre-negotiated conditions are met. The policyholder’s money “floats” in the insurer’s financial accounts until a claim is paid which allows the insurer to invest the float to make money – similar to the way a bank makes money by loaning your deposit to other people or companies for a fee. Making money off the insurance float is so lucrative that many insurers (but not Buffett-owned insurers) operate at an underwriting loss (total premiums are insufficient to pay losses and related claim expenses).
The insurance float became the backbone of Buffett’s financial empire in 1967 when he paid $8.6 million to buy his first insurance company, National Indemnity – a specialist in commercial auto and general liability insurance that was founded in 1940. At the time, Buffett was attracted to National Indemnity’s float of $20 million which he saw as a permanent base of capital that was superior to raising money from private equity, investment firms and hedge funds. Buffett continued to buy other insurance companies such as GEICO (1996) and General Reinsurance (1998). Unlike the rest of the insurance industry, however, Buffett’s insurers typically register an underwriting profit (premiums exceed total cost of expenses and losses) that adds to the investment income produced by the float. According to Buffett’s 2018 annual report, the total float of Berkshire’s insurance operations has multiplied nearly 6,000 times since 1967, reaching $114 billion at latest count.
What is Buffett’s secret? The answer is mindset. Both at the personal and corporate level, society has come to view insurance as a must-have commodity and Berkshire companies are extremely disciplined about who and what they insure. Berkshire-related insurers excel at risk identification, risk evaluation, and insuring only predictable negative risk that will allow them to make a profit. In contrast, many insureds, at the end of the day, don’t care from whom they buy; often they don’t truly understand the standard form insurance contracts they are purchasing; and they tend to shop year-to-year based on price and brand-name as if insurance were like buying razor blades (Gillette) or soda (Coke).
Why should you care? In the first instance, you should, much like Warren Buffett, truly manage risk through unending investment in your people and processes – not by comparing your annual premium costs to the value of your assets, revenue and equity. Second, pride, if, nothing else, should cause you to not want to let your insurers enjoy free use of your money – or worse – get paid for holding your hard-earned money. Our next few columns will focus on learning more about probability and uncertainty – the same tools used by the Oracle of Omaha to become one of the wealthiest people in the world.
- Warren Buffett, 2016 Berkshire Hathaway Shareholder Letter
Many business leaders equate addressing uncertainty with buying insurance as a means to protect against the potential for negative risk - the probability and severity of a bad thing happening. This overly narrow “risk = insurance” mindset can be traced back to the 1600s when shipowners and financiers met in London coffeehouses. These coffeehouse meetings culminated in the first commercial insurance agreements: shipowners agreed to pay a small loss (the premium) to a group of financiers (today Lloyd’s of London) who agreed to provide access to a pre-funded line of credit (insurance) in the event of a large loss (e.g., an “unsinkable” ship like the Titanic is lost at sea). By the 1940s, commercial insurance products advanced to the point that companies could buy them for many types of negative risk (e.g., work-related injuries suffered by employees). In the 1950s, the inherent complexity of buying and administering various types of commercial insurance products necessitated the creation of a full-time position entitled “insurance manager.” The 1960s brought the first courses leading to certification of insurance-related expertise and admission to the American Society of Insurance Management which today is known as RIMS (historically known as the Risk & Insurance Management Society).
Efforts over the last few decades to broaden the corporate risk management function beyond insurance have been mixed at best. Some of this is a function of the insurance industry driving the development of the corporate risk management function as opposed to critical thinking. A siloed approach has also caused the handling of insurance, like many business functions, to become fragmented and disjointed. The conservation of physical assets and the control of insurance purchasing is often the province of the treasurer or the chief financial officer. Meanwhile, corporate law departments tend to focus on managing losses and submitting insurance claims, sometimes in disagreement with the corporate risk manager who frets about trying to explain the rising costs of premiums to senior executives uninterested in anything other than near-term costs. The last 30 years have also produced costly legal battles between corporate policyholders and commercial insurers over mass tort (asbestos for example) and environmental losses, leading to ongoing changes in policy forms. Looking back at this history caused one industry commentator to make the following observation:
The truth, as risk managers know, is that as soon as the insurance industry is faced with major risks – latent diseases, product liability, AIDS, among others – it runs for cover and leaves industry to its own devices. Basically, society cannot expect too much help from insurers in sorting out its risk problems because insurers are interested not in risk reduction . . . but in risk predictability.
Chris Best, London Perspective, Risk Management (Feb. 1989).
Few, if any, people have profited more from risk predictability and insurance than Warren Buffett – the so-called Oracle of Omaha. As stated, insurance is a form of financial credit. Customers exchange their hard-earned cash (premium) for a promise that an insurance company will pay a future claim in an amount greater than the tendered cash, provided certain pre-negotiated conditions are met. The policyholder’s money “floats” in the insurer’s financial accounts until a claim is paid which allows the insurer to invest the float to make money – similar to the way a bank makes money by loaning your deposit to other people or companies for a fee. Making money off the insurance float is so lucrative that many insurers (but not Buffett-owned insurers) operate at an underwriting loss (total premiums are insufficient to pay losses and related claim expenses).
The insurance float became the backbone of Buffett’s financial empire in 1967 when he paid $8.6 million to buy his first insurance company, National Indemnity – a specialist in commercial auto and general liability insurance that was founded in 1940. At the time, Buffett was attracted to National Indemnity’s float of $20 million which he saw as a permanent base of capital that was superior to raising money from private equity, investment firms and hedge funds. Buffett continued to buy other insurance companies such as GEICO (1996) and General Reinsurance (1998). Unlike the rest of the insurance industry, however, Buffett’s insurers typically register an underwriting profit (premiums exceed total cost of expenses and losses) that adds to the investment income produced by the float. According to Buffett’s 2018 annual report, the total float of Berkshire’s insurance operations has multiplied nearly 6,000 times since 1967, reaching $114 billion at latest count.
What is Buffett’s secret? The answer is mindset. Both at the personal and corporate level, society has come to view insurance as a must-have commodity and Berkshire companies are extremely disciplined about who and what they insure. Berkshire-related insurers excel at risk identification, risk evaluation, and insuring only predictable negative risk that will allow them to make a profit. In contrast, many insureds, at the end of the day, don’t care from whom they buy; often they don’t truly understand the standard form insurance contracts they are purchasing; and they tend to shop year-to-year based on price and brand-name as if insurance were like buying razor blades (Gillette) or soda (Coke).
Why should you care? In the first instance, you should, much like Warren Buffett, truly manage risk through unending investment in your people and processes – not by comparing your annual premium costs to the value of your assets, revenue and equity. Second, pride, if, nothing else, should cause you to not want to let your insurers enjoy free use of your money – or worse – get paid for holding your hard-earned money. Our next few columns will focus on learning more about probability and uncertainty – the same tools used by the Oracle of Omaha to become one of the wealthiest people in the world.
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