Buffett Savors Berkshire's Strategy.

Insurance is a tough business, but with some good old-fashioned horse sense and a passion for the fundamentals, it is survivable.

That is what legendary investor Warren Buffett had to say to his investors in his annual letter to shareholders, included in Berkshire Hathaway Inc.'s 2000 annual report. Buffett's annual letter, known for its understated humor and nuggets of financial wisdom, did not disappoint.

Speaking of thc eight acquisitions Berkshire Hathaway negotiated in 2000, Buffett wrote, partly tongue-in-cheek, "I will tell you now that we have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement."

Buffett had plenty to say about the high-tech boom and subsequent bust that took place over the past year as well. Often the target of abuse from Wall Street dot.com gurus for his refusal to dive into the technology investment craze, Buffett had the last laugh in his usual understated way. Commenting on auto insurer Geico's Internet selling efforts, together with the success of Texas brickmaker Acme--a 2000 Berkshire Hathaway acquisition--Buffett wrote: "I can't resist pointing out that Berkshire--whose top management has long been mired in the 19th century--is now one of the very few authentic 'clicks-and-bricks' businesses around. We went into 2000 with Geico doing significant business on the Internet, and then we added Acme. You can bet this move by Berkshire is making them sweat in Silicon Valley."

Buffett goes on in his letter to give a sharp analysis of the dot.com craze and its downfall, summing up his own strategic view of that Wall Street drama with an image from Aesop's fables: a bird in the hand is worth two in the bush.

But if bricks, paint, carpeting and other such dull businesses are Buffett's safety net, insurance is his passion. And his letter is an education in that business.

Buffett outlined his method for evaluating an insurance company. For Buffett, the key is what he calls the "float," or the money an insurer has after taking in premium and before paying out a claim. Buffett writes that, because an insurer usually doesn't take in enough in premiums to cover the costs of claims and expenses, what it does with the float has a lot to do with its success or failure. Given Buffett's legendary savvy as an investor, one can see why he would relish the insurance business.

Berkshire Hathaway's 2000 results illustrate the importance of this principle. The insurance group was an underwriting money-loser: reinsurance underwriting losses were $1.4 billion, and Geico lost $224 million. Partially offsetting this was an underwriting profit of $38 million in the company's other insurance businesses. The insurance group did generate net investment income of $2.7 billion, however, giving it net operating income of a shade over $1 billion (about the same as 1999).

The float paid off.

Add in Berkshire Hathaway's other businesses--most of which generated positive cash flow--and the result is operating earnings of $1.7 billion, plus capital gains from investments of $3.9 billion. Total earnings: $5.6 billion. This compares nicely with total 1999 earnings of $2.45 billion.

Where are those Wall Street guys who shrilled so loudly a year ago that the Sage of Omaha lost his touch?

Buffett pointed out that much of Berkshire's reinsurance losses come from "a few insurers that are currently experiencing large losses" and had "offloaded a significant portion of these on us in a manner that penalizes our current earnings but gives us float we can use for many years to come."

After a first-year loss on a new reinsurance policy, Buffett gains from those premiums in future years. "When these policies are properly priced, we welcome the pain-today, gain-tomorrow effects they have," he wrote.

Taking a closer look at Geico, Buffett acknowledged his own error in assuming a year ago that more advertising dollars would keep the auto insurer growing at a brisk rate. "I was wrong," he wrote. "The extra money we spent did not produce a commensurate increase in inquiries. Additionally, the percentage of inquiries that we converted into sales fell for the first time in many years."

In an accompanying chart, Buffett shows that Geico acquired 1.47 million new voluntary auto policies in 2000, compared with 1.65 million a year earlier. Geico's voluntary--as opposed to assigned risk--policies in force grew by 8.5% in 2000, a much slower rate than 1999's 21.6% growth.

Buffett identified four factors for this slowdown: oversaturation in advertising, the "low-hanging fruit" in direct-marketing has been picked, stricter underwriting and competitive pressure.

Buffett then gets more specific about that last factor: in two words, State Farm. The giant mutual insurer, the largest auto underwriter in the United States with 19% of the total market, "has been slow to raise prices," Buffett laments. With its huge reserves and long-term outlook, State Farm is a giant planet affecting the orbits of its smaller competitors, but Buffett believes it will have to give in and raise rates eventually.

                             Geico's Growth
                         Geico's in-force auto
                        policies have more than
                          doubled since 1993.
        New Auto      Auto Policies
Years   Policies [*]    In-Force [*]
1993     346,882        2,011,055
1994     384,217        2,147,549
1995     443,539        2,310,037
1996     592,300        2,543,699
1997     868,430        2,949,439
1998   1,249,875        3,562,644
1999   1,648,095        4,328,900
2000   1,472,853        4,696,842
(*.)Assigned risks excluded.
Source: Company report