Berkshire Annual Letter 2001 (Part 3)
Warren Buffett recommended reading Jack Welch’s book, Jack, Straight from the Gut.
In the words of Warren Buffett, Jack Welch is smart, energetic, hands-on, and expects much of both himself and his organisation.
In investing (just like insurance), you can produce outstanding long term results primarily by avoiding dumb decisions, rather than by making brilliant ones.
Loss Reserves and Development
Loss reserves at an insurer is a liability that states the amount an insurer will have to pay for all losses that have occurred prior to the reporting date but have not yet been paid.
This reserve is difficult to estimate and is often understated.
Some insurance companies make a silly mistake of discounting loss reserves in their accounts. They argue that their present value is less thatn the stated liability. This is not acceptable as the loss reserves is an estimate (often underestimated) in the first place.
One term that is commonly used in insurance reporting is “loss development”.
When it becomes clear that loss reserves are understated, a loss development charge is then added to current earnings to “make-up” for the losses.
Sometimes, “loss development” is also referred to as “reserve strengthening”. In both cases, the terms used are very misleading.
The former term suggest that something has developed in the current year to cause the loss, while the latter term implies that reserves have been strengthened.
The truth is that an error in estimating previous loss reserves has occurred, and they are now being accounted for in the books.
In effect, insurance accounting is a self-graded exam, in that the insurer gives some figures to its auditing firm and generally doesn’t get an argument. What the auditor gets, however, is a letter from management that is designed to take his firm off the hook if the numbers later look silly.