I have often said that insurance companies have an economic incentive to hold claim money as long as possible, play this "float," and profit from it. Skeptics and attorneys who represent insurance companies always ask for me to provide proof of this allegation. While there are numerous examples, the quote from Warren Buffett in his 2009 annual letter proves the point:
"As predicted in last year’s report, the exceptional underwriting profits that our insurance businesses realized in 2007 were not repeated in 2008. Nevertheless, the insurance group delivered an underwriting gain for the sixth consecutive year. This means that our $58.5 billion of insurance “float” – money that doesn’t belong to us but that we hold and invest for our own benefit – cost us less than zero. In fact, we were paid $2.8 billion to hold our float during 2008. Charlie and I find this enjoyable.
Over time, most insurers experience a substantial underwriting loss, which makes their economics far different from ours. Of course, we too will experience underwriting losses in some years. But we have the best group of managers in the insurance business, and in most cases they oversee entrenched and valuable franchises. Considering these strengths, I believe that we will earn an underwriting profit over the years and that our float will therefore cost us nothing. Our insurance operation, the core business of Berkshire, is an economic powerhouse."
In the insurance business, it is economically efficient to cheat or underpay claims—-if the insurer does not get caught or never has to pay for such sin. Honest insurers that provide first class treatment, rather than merely talk of first class treatment, are at an economic disadvantage. Most people buy insurance based on price, not recognizing that the low cost insurer may offer an inferior product in the small type or in the actual claims performance.
Fair claims practice lawsuits are important because they represent the few public presentations of how bad the insurance industry is at claims performance. Unfortunately, because there are so few of these suits and the "market conduct studies" run by the departments of insurance are significantly flawed, there is little chance that insurance cultures of paying too little or paying far too late will be stopped. The result is that companies that engage in such behavior have an economic advantage over honest insurers because they can maintain profit margins at lower rates. Being able to charge less is key to economic success in the insurance business. This point was also made by Buffet:
"GEICO grows because it saves money for motorists. No one likes to buy auto insurance. But virtually everyone likes to drive. So, sensibly, drivers look for the lowest-cost insurance consistent with first-class service. Efficiency is the key to low cost, and efficiency is Tony’s specialty. Five years ago the number of policies per employee was 299. In 2008, the number was 439, a huge increase in productivity."
I am not saying that GEICO is engaging in bad behavior. I have far too few cases against this company to make that judgment. But, it is very easy to claim that a company gives first class service rather than actually give it. How do executives and claims management even track it? Virtually every tracking mechanism of claims service is designed to drive down claims payments. Allstate is the champion of that type of claims management in the automobile claims business—the Florida Office of Insurance Regulation made Allstate put part of that proof on the internet last year.
I strongly suggest that you read Buffett’s letter. It has much wisdom and discussion of where our economy has been and may be heading. I optimistically agree with this observation:
“Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.
Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 211/2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.
Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead."
