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WHAT'S GOING ON WITH THE INSURANCE INDUSTRY? AND WHAT CAN YOU DO?

What Warren Buffett Knows About Insurance Company Financials

With all due respect to Enron and others, the insurance industry invented financial statement manipulation. The very nature of insurance accounting makes it not only possible, but very easy to do. Now, after 10 years of underreserving its losses, the industry must pay the piper. This is causing pain to all buyers of the product as prices rocket.

LOSS RESERVES

Insurers "incur" losses, that is, claims that must be paid. A small portion of every claim (on average) is paid out immediately while the bulk of it is paid out over many years. The rest of the incurred loss, the estimate of what will eventually be paid, constitutes the "loss reserve." Although it's a little more scientific than this, putting a number on the loss reserve is anybody's guess. This would not be a problem if it did not get to the very heart of the insurer's accounting system. Loss reserves currently account for 60% of the total liabilities of giant American International Group (AIG), for example

Underreserving losses makes the numbers (net income and surplus) look better than they should be. Underreserving is done either intentionally or accidentally, but suffice it to say that it always goes on - for a period of time - and then, eventually, the books must be scrubbed. It's spring cleaning time in the house of insurance.

Warren Buffett knows something about how this works since his Berkshire Hathaway has a very large position in the insurance industry. In one of his recent (famous) annual reports, he stated:

"...because loss costs must be estimated, insurers have enormous latitude in figuring their underwriting results...Errors of estimation, usually innocent, but sometimes not, can be huge. The consequences of these miscalculations flow directly into earnings... I have been amazed by the numbers that big-name auditors have implicitly blessed...."

" As for Berkshire, Charlie and I attempt to be conservative in presenting its underwriting results to you, because we have found that virtually all surprises in insurance are unpleasant ones."

INSURER FINANCIAL STRENGTH

As Buffett suggests, some manipulate the numbers, and others underestimate innocently. As a price war rages on over a decade, however, all insurers must ultimately play the game so they can compete.

When the music stops (it stopped about a year ago), some insurers will get caught in a financially unstable position and fail. It is already happening. The message for this day is to carefully check the financial strength of any insurer you are considering doing business with. The longer the "tail" on the insurance (whether the claims are short term in nature like property, or long term like liability), the more crucial this is. It is also more important now to contract with "admitted" (licensed in your state) insurers so in the event of failure, you will have access to the state's guaranty fund.

Given the inevitability of losses, you'll be judged not by whether you were the victim of an event, but by how well you planned for it.

(C) 2002 Licata Kelleher Risk and Insurance Advisers, Inc. Permission granted for distribution as is (with full attribution).

Contact us for risk management strategy and implementation.

Licata Kelleher is a risk management and insurance advisory firm. The firm does not sell insurance, but does counsel clients on the effectiveness of insurance, on reducing the cost of insurance and on the risk management process.

The above is intended to be general information, and should not be construed as specific recommendations.

For more information, contact Debora Wu, at DWU@LicataRisk.com

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