As I read the summary of the performance of the various non-insurance operations like Borsheim, Nebraska Furniture Mart, See’s Candy, Fechheimer, Scott Fetzer and Buffalo News for the umpteen time, I was given the reason by Buffett why these companies continue to do well.
Whatever the reason for their performance, when you invest in a stock, at the end of the day you are looking at the quality of the business. If the company has a good business model and stand above your competitors, then your stock will do well.
Measuring Insurance Performance
The combined ratio represents total insurance costs (losses incurred plus expenses) compared to revenue from premiums: A ratio below 100 indicates an underwriting profit, and one above 100 indicates a loss.
Typical property-casualty insurers can have a ratio of 107-111% and still be profitable because of investment returns from the insurance funds (float).
Exceptions include insurance covering losses to crops (which produce no float at all) and malpractice insurance which has a higher tolerance due to delayed payment caused by lengthy litigation.
Most analysts and managers look to the combined ratio when measuring an insurance business; however Buffett has another method.
He looks at the underwriting loss to float developed ratio (over an extended period of time) and then treats that as the “cost of funds developed from insurance.”
If this cost (including the tax penalty) is higher than that applying to alternative sources of funds, then it’s a poor business. If the cost is lower, it is a good business – and if the cost is significantly lower, the insurance business qualifies as a very valuable asset.
To put it simply, insurance is a place where you can generate funds for investment. If the cost of these funds (after deducting all expenses) are lower than what you pay outside, then you have a good business!