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What Investors Can Learn From the Insurance Market

Some of the first acquisitions Warren Buffett (Trades, Portfolio) made when he took over the struggling textile company Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) in the late 1960s were insurance companies.

Buffett has previously explained that the reason why he decided to make acquisitions in the insurance sector is that he understood the industry.

One of the young investor's first substantial investments was GEICO, which he put more than 50% of his net wealth into after spending an afternoon with company executive Lorimer Davidson.

With his inside knowledge of the industry, when National Indemnity came up for sale, Buffett acted quickly to take advantage of the opportunity before it disappeared.

A lot in common

The insurance industry and investing have a lot in common. They both rely on the correct calculation of probabilities for success. For example, to be able to price risk in the insurance market correctly, you have to know the likelihood of a specific event occurring.

The same happens with investing. You have to understand the chances of each specific investment scenario playing out and then invest based on the probabilities.

If there is a 50% chance of a company going bankrupt, the risk-reward ratio is not attractive in much the same way and insurer would balk at the idea of offering an earthquake policy in an area that suffers from serious seismic activity every two years.

Buffett spoke at length on this topic at the 2004 Berkshire Hathaway annual meeting of shareholders. One shareholder wanted to know how Berkshire's business divisions went about pricing sup-cat insurance policies. Buffett replied:

"Try to be as realistic as you can on those numbers [the key variables] - err on being conservative - and then when you're through, make sure you have a margin of safety. In pricing earthquake insurance, look at the number of major quakes in past century - there have been 26 - so we'd assume 30 or 32 going forward (not 50 or we'd never write any business). If we calculated the resulting price to be $1 million, then we'd price it at $1.2 million to build in a margin of safety."

It is interesting to see that Benjamin Graham's famous margin of safety principle is just as crucial to Buffett in pricing insurance contracts as it is when evaluating securities.

After stating the above, Buffett handed the microphone over to his right-hand man, Charlie Munger (Trades, Portfolio), who added:

"Using the book Deep Simplicity, you can predict how size is likely to be allocated. A standard power law will tell you how many earthquakes there will be of various sizes - many small ones, but big ones are less likely. So just do the math, apply the power law and calculate estimated damages."

The accurate pricing of contracts relies on an evaluation of the probabilities and estimated damages. Investment analysis is very similar. When assessing whether or not an opportunity is worthwhile, investors need to evaluate each potential scenario and its potential losses and profits and calculate the probabilities of each scenario playing out. Incorporating a margin of safety into all of these numbers is vital.

Insurance might seem like a complex and challenging industry to understand at first, but at its core, it is a game of probabilities. Unfortunately, the vast majority of insurance companies do not price risk correctly, and therefore, it isn't very easy to make money in the sector. Most businesses chase volume over profitability, which pushes down prices across the industry.

Berkshire tries to stay out of this game of chance. If the price is not right, the company pulls back and does not underwrite the risk. Buffett uses precisely the same approach when buying stocks. If he doesn't like the price, he doesn't buy.

Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.