2004: Why don't Berkshire insurance companies ever have layoffs?

AUDIENCE MEMBER: How about a dollar? (Laughter)

David Winters, Mountain Lakes, New Jersey. Thank you, Warren and Charlie, for a fabulous weekend and for the discussion about governance in the mutual fund industry in the shareholder letter.

Specifically, have you altered the compensation potential for the insurance underwriters to make sure, as Charlie has described, the incentive-caused bias creates an environment that encourages writing new policies that, when the tide goes out again in the property and casualty business, Berkshire Hathaway minimizes losses, maximizes float, while compensating underwriters for not writing business?

WARREN BUFFETT: Well, thank you, that feeds into an interesting set of slides I’ve got, if I can find them here to tell the projector what to put up, because that’s a very important point you raise.

I mean, we are very big in insurance, and having the wrong incentives in place could be very harmful.

So let’s put up a couple of slides. Let’s put up slide number one, if we would, please.

Slide number one is the situation at Berkshire, and Shirley, I’ll give you one of these, but that’s the situation at Berkshire shortly before we bought National Indemnity.

There’s our balance sheet there. And as you’ll notice, we just had a few million dollars extra. We had about $20 million tied up in the textile business.

And then I heard that Jack Ringwalt wanted to sell his company. Some of you here in the audience know him. He — for 15 minutes every year, Jack would feel like selling his company. He would get mad at something or other.

And so my friend Charlie Heider knew Jack pretty well, and I’d said to Charlie, “Charlie, next time Jack is in heat, have him, you know, get him over here.” (Laughter)

And so Jack, early in 1967, came by 11:30, 11:45 in the morning, and said he’d had it with insurance, and with the insurance regulators and everything, he’d like to sell. So we bought it.

Now, we bought, that was the — made a major — that’s when we really embarked on what has happened subsequently.

As you can see from that slide, the following year the textile business made all of $55,000. So sticking with textiles would not have been a great idea. We spent $8 1/2 million to buy National Indemnity.

Now, on the next slide, slide two, you will see a record like has never been, I don’t think there’s another insurance company in the world that has a record like this. That’s the premium volume of National Indemnity’s traditional business.

And you will see a company that went from 79 million in that first year of premiums — if you go all the way back to the time we bought it — it was 16 million, but by 1980 we were up to 79 million.

And you will see that in what was known as the “hard market” of the mid-’80s, we got up to 366 million.

And then we took it down — not intentionally, but just because the business became less attractive — all the way from 366 million down to 55 million. And now the market became more attractive in the last few years, and it soared up to almost $600 million.

I don’t think there’s a public company in America that would feel they could survive a record of volume going down like that, year after year after year after year.

But that was the culture of National Indemnity. It was the culture started by Jack Ringwalt, and it was the culture all the way through several other managers, Phil Liesche, and Rolly [Roland] Miller, to Don Wurster, who has done a fabulous job. And we don’t worry about premium volume.

But if you’re not going to worry about premium volume, then you have to take a look at slide three. Because if the silent message had gone out to our employees that unless you write a lot of business, you’re going to lose your job, they would have written a lot of business. You could —

National Indemnity can write a billion dollars’ worth of business in any month it wanted to, all it has to do is offer silly prices. If you offer a silly price, brokers will find you in the middle of the ocean at four in the morning. I mean, you cannot afford to do that.

So what we have always told people in our insurance businesses generally, specifically at National Indemnity, is that if they write no business, their job is not in jeopardy.

We cannot afford to have our unspoken message to employees, that you write business, or your job, or the guy sitting next to you’s, you know, may be lost.

So when we bulged up to 366 million, we — employment went up modestly, and when we went all the way down, you’ll see it trickle downward, but that was all by attrition. We never had a layoff during that period. Other people would have, but we didn’t.

And now we’re going back up some, and we’ll go back down again at some time in the future.

Now, if you go to the next slide, you’ll see that that created an expense ratio that went up dramatically, up as high as 41 percent in 1999, as volume shrunk back. And when we were writing a lot of business, our expense ratio was as low as 25.9.

Now, some companies would feel that was intolerable, but what we feel is intolerable is writing bad business. And again, we can take an expense ratio that’s out of line, but we can’t afford to write bad business. For one thing, if you get a culture of writing bad business, it’s almost important to get rid of.

So we would rather suffer of having too much overhead, than we would want to teach our employees that to retain their jobs, they needed to write any damn thing that came along, because that’s a very hard habit to get rid of once you get hooked on it.

Now, move on to slide number five, you will see what the result has been of that policy. And it’s been that we had a few years, bad years, in the early ’80s — that’s what led to that hard market. But even with a high expense ratio, you’ll see that we made money underwriting in virtually every year.

You’ll see the year 2001 at 108.4, but that will, in my view, that will come down. I think that will turn out to be quite a good year. These are the — that year is not fully developed yet.

Now, you’ll see in 1980 — in ’86 — we had this incredible year, when we wrote at 69.3, that’s a 30 percent underwriting margin. And the nice thing about it is, we did it with the most volume we ever had to that point, 366 million.

So we coined money when we wrote huge amounts of business, and we made a little money when we wrote small amounts of business.

So it’s absolutely imperative in our view, and I think we’re almost the only insurance company like this — certainly public — in the world that sends the absolutely unequivocal message to the people that are associated with us, that they will never be laid off because of lack of volume, and therefore, we don’t want them to write one bit of bad business.

And we’ll make mistakes, and we’ll have a high expense ratio when business is slow, but we’ll win the game. And that’s what National Indemnity has done over a period of time.

National Indemnity was a no-name company 30 years ago operating through a general agency system which everybody said was obsolete.

It had no patents, no real estate, no copyrights, no nothing, that distinguished it, essentially, from other insurance — dozens of other insurance companies could do the same thing. But they have a record almost like no one else’s because they had discipline. You know, they really knew what they were about.

And they’ve stayed with that. In fact they’ve intensified it over time. And their record has left, you know, other people in the dust.

It wouldn’t be a record you would point to Wall Street, you know, if you went to Wall Street with that record alone in 1990 or 1995, they’d say, “What’s wrong with you?”

But the answer’s nothing’s wrong with it. And you put your finger on having the incentives in place to write the right kind of business for the shareholders at Berkshire. And we try to think those things through.

I mean, you can’t run a — you can’t run an auto company without having layoffs. You know, you can’t run a steel company that’s this way. But this is the right way to run an insurance company.

And that’s why these cookie-cutter approaches to employment practices, or bonuses, and all that are nonsense. You have to think through the situation that faces you in a given industry with its given competitive conditions, and its own economic characteristics.

Charlie, you want to comment on that?

CHARLIE MUNGER: Well, the main thing is that practically nobody else does it. And yet to me it’s obvious it’s the way to go.

There’s a lot in Berkshire that is like that. It’s just a little different from the way other people do it, partly the luxury of having a controlling shareholder of strong opinions.

That accounts for this. It would be hard for a committee, including a lot of employees, to come up with these decisions.