A letter a day!

A letter a day!

Letter #28 1974

Key learnings:

1.As already guided in the earlier letters, the performance of the insurance business has declined and is expected to decline even in the next year. Buffett’s course of action during this bad performance is to build financial strength and liquidity so that when the insurance rates are in favor they can aggressively pursue opportunities for growth in this area.

2.Textile operations: The textile business of BH is “curtain goods”. In periods of uncertainty, these goods tend to get a lower level of importance. As there is lesser demand, Buffett has chosen to operate on 1/3 of the capacity to reduce inventory.

“Our products are largely in the curtain goods area. During a period of consumer uncertainty, curtains may well be high on the list of deferrable purchases. Very low levels of housing starts also serve to dampen demand. In addition, retailers have been pressing to cut inventories generally, and we probably are feeling some effect from these efforts. These negative trends should reverse in due course, and we are attempting to minimize losses until that time comes.”

3.Insurance underwriting: This business has been experiencing losses due to 2 major factors: 1) competition and 2) inflation. The premium rates have remained unchanged to sustain in the competitive environment while the cost of repairing etc which is
covered by insurance has been increased due to inflation. This is very well explained in the letter, sharing its excerpt here:

“The costs of the product we deliver (auto repair, medical payments, compensation benefits, etc.) are increasing at a rate we estimate to be in the area of 1% per month. Of course, this increase doesn’t proceed in an even flow but, inexorably, inflation grinds very heavily at the repair services—to humans and to property—that we provide. However, rates virtually have been unchanged in the property and casualty field for the last few years. With costs moving forward rapidly and prices remaining unchanged, it was not hard to predict what would happen to profit margins.
Best’s, the authoritative voice of the insurance industry, estimates that in 1974 all auto
insurance premiums in the United States increased only about 2%. Such a growth in the pool of dollars available to pay insured losses and expenses was woefully inadequate. Obviously, medical costs applicable to people injured during the year, jury awards for pain and suffering, and body shop charges for repairing damaged cars increased at a dramatically greater rate during the year. Since premiums represent the sales dollar and the latter items represent the cost of goods sold, profit margins turned sharply negative.”

4 When a new player enters a concentrated industry, it is extremely difficult to survive. Buffett in his last letter decided to expand the insurance business in Florida. However, due to the concentration in the industry players, they suffered huge losses and decided
to shut down the business.

“We can’t blame external insurance industry conditions for this mistake. In retrospect, it is apparent that our management simply did not have the underwriting information and the pricing knowledge necessary to be operating in the area. In Cook County, where Home and Auto’s volume traditionally has been concentrated, evidence also became quite clear during 1974 that rates were inadequate. Therefore, rates were increased during the middle of the year but competition did not follow; consequently, our volume has dropped significantly in this area as competitors take business from us at prices that we regard as totally unrealistic.”