Rented suits

In his 2008 letter to shareholders, Warren Buffett has a charming little story about the problems of IBNR and the known unknowns (ahem):

We also include a large reserve for losses that occurred before year-end but that we have yet to hear about. Sometimes, the insured itself does not know that a loss has occurred. (Think of an embezzlement that remains undiscovered for years.) We sometimes hear about losses from policies that covered our insured many decades ago.

A story I told you some years back illustrates our problem in accurately estimating our loss liability: A fellow was on an important business trip in Europe when his sister called to tell him that their dad had died. Her brother explained that he couldn’t get back but said to spare nothing on the funeral, whose cost he would cover. When he returned, his sister told him that the service had been beautiful and presented him with bills totaling $8,000. He paid up but a month later received a bill from the mortuary for $10. He paid that, too – and still another $10 charge he received a month later. When a third $10 invoice was sent to him the following month, the perplexed man called his sister to ask what was going on. “Oh,” she replied, “I forgot to tell you. We buried Dad in a rented suit.”

It’s a good story, and I’m reasonably certain that more suits will turn up for Berkshire. Possibly a lot more. In fact…oh better not.

Mr Buffett also goes on to make some scathing (well, insofar as he ever gets that scathing about anything) comments about financial salesmen and their proclamations about the future value of pension investments in particular. Basically, to continue the last century’s performance, the DOW would have to rise to 24m by 2100. Which, as he says, appears a trifle unlikely. See page 19 of the letter in particular.

Finally, returning to the insurance world, Buffett asks us all to note that in 2007:

…our insurance business – the cornerstone of Berkshire – had an excellent year. Part of the reason is that we have the best collection of insurance managers in the business – more about them later. But we also were very lucky in 2007, the second year in a row free of major insured catastrophes.

That party is over. It’s a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. Prices are down, and exposures inexorably rise. Even if the U.S. has its third consecutive catastrophe-light year, industry profit margins will probably shrink by four percentage points or so. If the winds roar or the earth trembles, results could be far worse. So be prepared for lower insurance earnings during the next few years. [my emphasis]

Sorry, there should be more commentary here, but I just can’t really top what Buffett says.