Warren Buffett's brainchild has a simple but unreplicable competitive advantage in the insurance industry

One of my heroes in the investment industry is Warren Buffett. His brainchild, Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B), is one of the 50-plus companies in my family's investment portfolio.

We've owned Berkshire shares since August 2011, and I shared my investment thesis on the company recently in The Good Investors.

In my Berkshire thesis, I discussed the fantastic track record of profitability that the company's insurance subsidiaries have produced over the years.

I shared that the track record is the result of Buffett's unique mindset in managing the insurance subsidiaries:

"Next, Buffett also does not push for short-term gains at the expense of Berkshire's long-term business health. A great example can be seen in Berkshire's excellent track record in the insurance industry: Its property and casualty (P/C) insurance business has recorded an underwriting profit for 15 of the past 16 years through to 2018. In contrast, the P/C industry as a whole often operates at a significant underwriting loss; in the decade ended 2018, the industry suffered an underwriting loss in five separate years."

A missing piece

Years ago, I read a document from Buffett suggesting that Berkshire does not pay its insurance employees based on the policy-premiums they bring in.

That's because Buffett does not want to incentivise his insurance employees to chase unprofitable insurance deals when premiums across the industry do not make sense.

I wanted to include Buffet's unique remuneration structure for his insurance employees in my Berkshire investment thesis.

I thought it was a beautiful illustration of a simple but unreplicable competitive advantage that Berkshire has in the insurance industry.

But when I was writing the thesis, I forgot where I came across the information and I could not find it after a long search. So I decided to leave it out.

Found again

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As luck would have it, I finally found it again. All thanks goes to my friends Loh Wei and Stanley Lim! Stanley runs the excellent investment education website, Value Invest Asia.

He recently interviewed Loh Wei, who talked about Berkshire and Buffett's unique mindset for remunerating his insurance employees.

After watching the interview, I asked Loh Wei where he found the information and was guided toward the source that I came across years ago: Buffett's 2004 Berkshire shareholders' letter.

Wisdom from the Oracle of Omaha

Here's what Buffett wrote (emphases are mine):

"What we've had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasised, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO [National Indemnity Company] had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers - but they left us.

"Most American businesses harbour an "institutional imperative" that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s).

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"Finally, there is a fear factor at work, in that a shrinking business usually leads to layoffs. To avoid pink slips, employees will rationalize inadequate pricing, telling themselves that poorly-priced business must be tolerated in order to keep the organisation intact and the distribution system happy. If this course isn't followed, these employees will argue, the company will not participate in the recovery that they invariably feel is just around the corner.

"To combat employees' natural tendency to save their own skins, we have always promised NICO's workforce that no one will be fired because of declining volume, however severe the contraction. (This is not Donald Trump's sort of place.) NICO is not labour-intensive, and, as the table suggests, can live with excess overhead. It can't live, however, with underpriced business and the breakdown in underwriting discipline that accompanies it. An insurance organisation that doesn't care deeply about underwriting at a profit this year is unlikely to care next year either.

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"Naturally, a business that follows a no-layoff policy must be especially careful to avoid overstaffing when times are good. Thirty years ago Tom Murphy, then CEO of Cap Cities, drove this point home to me with a hypothetical tale about an employee who asked his boss for permission to hire an assistant. The employee assumed that adding $20,000 to the annual payroll would be inconsequential. But his boss told him the proposal should be evaluated as a $3 million decision, given that an additional person would probably cost at least that amount over his lifetime, factoring in raises, benefits and other expenses (more people, more toilet paper). And unless the company fell on very hard times, the employee added would be unlikely to be dismissed, however marginal his contribution to the business.

"It takes real fortitude - embedded deep within a company's culture - to operate as NICO does. Anyone examining the table can scan the years from 1986 to 1999 quickly. But living day after day with dwindling volume - while competitors are boasting of growth and reaping Wall Street's applause - is an experience few managers can tolerate. NICO, however, has had four CEOs since its formation in 1940 and none have bent. (It should be noted that only one of the four graduated from college. Our experience tells us that extraordinary business ability is largely innate.)

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"The current managerial star - make that superstar - at NICO is Don Wurster (yes, he's "the graduate"), who has been running things since 1989. His slugging percentage is right up there with Barry Bonds' because, like Barry, Don will accept a walk rather than swing at a bad pitch. Don has now amassed $950 million of float at NICO that over time is almost certain to be proved the negative-cost kind. Because insurance prices are falling, Don's volume will soon decline very significantly and, as it does, Charlie and I will applaud him ever more loudly."

In the quotes above, Buffett referenced a table of financials for NICO. The table is shown below.

Note the red box, which highlights the massive decline in NICO's revenue (written premium) from 1986 to 1999.

Can you do it?

"What we've had going for us is a managerial mindset that most insurers find impossible to replicate."

This is the simple but unreplicable competitive advantage that Buffett and Berkshire has in the insurance industry.

It is simple.

You just have to be willing to tolerate a huge decline in business volume - potentially for a long time - if the pricing for business does not make sense.

But it is unreplicable because it goes directly against our natural human tendency to be greedy for more.

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If we spot similar simple but unreplicable competitive advantages in companies, it could lead us to fantastic long-term investment opportunities.

Jeff Bezos, the founder and CEO of Amazon.com (NASDAQ: AMZN), shared the following in his 2003 Amazon shareholders' letter (emphasis is mine):

"Another example is our Instant Order Update feature, which reminds you that you've already bought a particular item. Customers lead busy lives and cannot always remember if they've already purchased a particular item, say a DVD or CD they bought a year earlier.

"When we launched Instant Order Update, we were able to measure with statistical significance that the feature slightly reduced sales. Good for customers? Definitely. Good for shareowners? Yes, in the long run."

Bezos was able to cut through short-term greediness and focus on long-term value. I also shared Bezos's quote above in my recent investment thesis for Amazon.

My family's investment portfolio has owned Amazon shares for a few years.

Here's a chart showing much a $10,000 investment in Amazon shares would have grown to since the company's 1997 listing:

Competitive advantages need not be complex. They can be simple. And sometimes the really simple ones end up being the hardest, or impossible, to copy.

And that's a beautiful thing for long-term investors.

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.