A strong moat is about being resilient to competition. But antifragility is beyond resilience. Using the example of Berkshire’s insurance operations, we explore the characteristics of an antifragile business.
Wind extinguishes a candle and energizes a fire. Likewise with randomness, uncertainty, chaos: you want to use them, not hide from them. You want to be the fire and wish for the wind. ~ Nassim Nicholas Taleb
If you threaten a lizard, it may sometimes run away leaving its tail behind. As a kid it was the most fascinating thing I ever witnessed while conducting my own zoology experiments. It’s common in many lizard species to shed a part of their tails and this trick is employed by these reptiles to allow them to escape when captured by the tail by a predator. The detached tail writhes and wiggles, creating a deceptive sense of continued struggle, distracting the predator’s attention from the fleeing prey animal. That’s a fascinating self-preservation mechanism that evolution has given to lizards. And what’s more fascinating is that these lizards can grow that tail back in a matter of few weeks. What a robust way to deal with loss! If that sounds cool, then you must also know about Hydra. It is a serpent-like creature from Greek mythology. Hydra grows two new heads every time you cut one off. In Indian mythology, there is a similar character called Raktabija. A demon (asura) who has the magic boon that every drop of blood shed from his body give rise to another Raktabija (literally the blood borne).
[show_to accesslevel=’almanack’] These apocryphal characters tell us something about our limited understanding of fragility and robustness. Just like opposite of ‘decrement’ is not ‘staying the same’, opposite of fragile is not ‘robust’. So Nassim Taleb coined a new word for things which are opposite of fragile. He calls it Antifragile. These are the things that benefit from shocks; they thrive and grow when exposed to volatility, randomness, obstacles, disorder, unexpected events, change, and stressors. Antifragility is beyond resilience or robustness. Being resilient or robust means that you bounce back quickly from disturbances — for example, a bridge that can withstand a 9.0 earthquake. Antifragility describes things that not only bounce back quickly, but come back stronger when they meet adversity. The resilient resists shocks and stays the same; the antifragile gets better. A lizard is robust but a Hydra is antifragile.
If antifragility looks to you like an academic concept with no real world application, then let me take a non-mythological example. When you exercise, the muscle fibres break down. And when you follow up your workout with good rest, those muscle fibres not just grow back but become stronger. That’s antifragility of human body. My laptop isn’t growing stronger as I am hammering my fingers on the keyboard. Laptop is, thus, fragile or at best robust, if it lasts forever.
What implication does this idea have for an investor? The most obvious question to ask would be – are there any antifragile businesses? If yes and if they are available at reasonable price, you’ve got a jackpot. But instead of answering that question, let’s explore a more useful question. What does an antifragile business look like? If we can understand the characteristics of an antifragile business it will give us very important clues for finding such companies.
Warren Buffett owns world’s biggest antifragile business i.e. Berkshire Hathaway (BRK). To decode the antifragility of Berkshire, we would need to look at its core operations i.e. insurance.
Buffett first tasted the blood in insurance when he acquired National Indemnity, a property-causality (P/C) insurance company, for $8.6 million in 1967. The financial characteristics that attracted Buffett to insurance industry was something called float. The nature of most insurance businesses is such that the premiums are collected up front and the claims are paid much later. This collect-now, pay-later model leaves P/C companies holding large sums – called float – that will eventually go to others. Though the individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. As the business grows so does the float. Today that same company that Buffett acquired four decades back is world’s largest P/C company. Over the same period BRK acquired many other insurance operations which has grown BRK’s float from a modest $40 million in 1970 to a staggering sum of $88 billion in 2015.
Now don’t get too excited by BRK’s insurance numbers because it’s an industry plagued with intense competition. This competition is so severe that the P/C industry as whole operates at significant underwriting loss in most years. Underwriting loss results when the income from insurance premium isn’t sufficient to cover the claims and operating expenses. However, BRK’s insurance operations are exceptional and defy the base rates of insurance industry.
Disciplined risk evaluation is the daily focus of all of our insurance managers, writes Buffett, “who know that while float is valuable, its benefits can be drowned by poor underwriting results.”
Why is so hard to run a profitable insurance operation? In his 2014 letter to shareholders Buffett explains –
At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained.
Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance.
Buffett’s managers run the insurance operations with extreme underwriting discipline and barring a handful of instances, they have closed each year with underwriting profits. In 2015, apart from the float, BRK’s insurance operation generated close to $2 billion of underwriting profits. Operational efficiency makes BRK’s insurance business very resilient but there’s something else to it which is not present in other profit making insurance companies. BRK’s insurance isn’t just resilient, it’s Antifragile.
To understand that we would need to first understand what expectations does a customer have from an insurer?
Insurance, in very simple words, is the sale of promises. The customer pays money now and the insurer promises to pay money in the future should certain events occur. Which means, both the ability and willingness of the insurer to keep its promise, (especially in the face of economic chaos) when payment time arrives, is very important.
Usually, insurer’s promise is not tested for decades. The 9/11 kind of terrorist attacks don’t happen every year. Katrina and Tsunami don’t come every year. But the absence of these black swan events lulls most insurers into complacency. They forget that every uneventful year increases the chances of a super catastrophe in the following year. In a race for higher revenue, most insurance companies forget the underwriting discipline and start writing policies which expose them to accumulated risk.
This is precisely when Buffett takes a step back because an uneventful environment not only creates a temptation to assume unwarranted risk but also makes the business unprofitable in short term too. Buffett writes –
Up to now, climate change has not produced more frequent nor costlier hurricanes nor other weather- related events covered by insurance. As a consequence, U.S. super-cat rates have fallen steadily in recent years, which is why we have backed away from that business. If super-cats become costlier and more frequent, the likely — though far from certain — effect on Berkshire’s insurance business would be to make it larger and more profitable.
BRK’s antifragility makes it withdraw from low-insurance-premium environment.
Once in a while, when disaster strikes, most insurers find themselves unable to keep their promises which in turn loses the trust of the customers.
Berkshire coffers are always overflowing with gargantuan amount of cash. Buffett maintains at least $20 billion in cash-equivalents that earn short-term rates. More often, BRK’s short-term investments are in the $40 billion to $60 billion range. That not only creates a huge cushion to absorb any insurance losses arising out of massive catastrophe (hurricane, earthquake, flood, terrorist attack) but gives a peace of mind to customers about Berkshire’s ability to cover all its insurance claims in the event of any mega-catastrophe. In his 2015 letter to shareholder, Buffett wrote –
…if the insurance industry should experience a $250 billion loss from some mega-catastrophe – a loss triple anything it has ever experience – Berkshire as a whole would likely record a significant profit for the year because of its many streams of earnings. We would also remain awash in cash and be looking for large opportunities to write business in an insurance market that might well be in disarray. Meanwhile, other major insurers and reinsurers would be swimming in red ink, if not facing insolvency.
So when it comes to unquestionable promise that claim payments will be made, Berkshire has been the party — the only party — to call.
Right when the whole insurance industry is in the middle of huge shock, BRK’s hydra starts growing new heads. Berkshire doesn’t just benefit from increased business, it also gets to charge higher premium for the same policies. Customers are willing to pay more for the same risk because of recency bias.
Most people are afraid of flying right after they hear about a plane crash. However, a rational thinker would know that the risk of another terrorist attack actually reduces immediately after it happens because of increased security everywhere. Similarly, every plane crash exposes the problems that caused it and makes it less likely that the same problem will result in another disaster. In spite of that people are willing to pay more for a travel insurance or terrorist attack or natural calamity just because they have seen one happening recently.
So recency bias is another disorder which plays in favour of BRK.
Berkshire wasn’t always antifragile. But over the past decades, it has grown in a manner which distinguishes it from any other insurance company including BRK’s own former self. Buffett wrote in his 2015 letter –
We are for the first time including insurance underwriting income in business earnings. We didn’t do that initially …because our insurance results were then heavily influenced by catastrophe coverages. If the wind didn’t blow and the earth didn’t shake, we made large profits. But a mega-catastrophe would produce red ink….Today our insurance results are likely to be more stable than was the case a decade ago because we have deemphasised catastrophe coverages and greatly expanded our bread-and-butter lines of business.
Here’s an excerpt from Buffett’s note that he wrote in 2014 on his 50th anniversary as BRK chairman. It nicely summarises why BRK insurance operations is an antifragile business.
I believe the chance of any event causing Berkshire to experience financial problems is essentially zero. We will always be prepared for the thousand-year flood; in fact, if it occurs we will be selling life jackets to the unprepared. Berkshire played an important role as a “first responder” during the 2008-2009 meltdown, and we have since more than doubled the strength of our balance sheet and our earnings potential.
Financial staying power requires a company to maintain three strengths under all circumstances: (1) a large and reliable stream of earnings; (2) massive liquid assets and (3) no significant near-term cash requirements. Ignoring that last necessity is what usually leads companies to experience unexpected problems: Too often, CEOs of profitable companies feel they will always be able to refund maturing obligations, however large these are. In 2008-2009, many managements learned how perilous that mindset can be.
Here’s how we will always stand on the three essentials. First, our earnings stream is huge and comes from a vast array of businesses. Our shareholders now own many large companies that have durable competitive advantages, and we will acquire more of those in the future. Our diversification assures Berkshire’s continued profitability, even if a catastrophe causes insurance losses that far exceed any previously experienced.
Next up is cash. At a healthy business, cash is sometimes thought of as something to be minimized — as an unproductive asset that acts as a drag on such markers as return on equity. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.
American business provided a case study of that in 2008. In September of that year, many long-prosperous companies suddenly wondered whether their checks would bounce in the days ahead. Overnight, their financial oxygen disappeared.
At Berkshire, our breathing went uninterrupted. Indeed, in a three-week period spanning late September and early October, we supplied $ 15.6 billion of fresh money to American businesses.
We could do that because we always maintain at least $ 20 billion — and usually far more — in cash equivalents. And by that we mean U.S. Treasury bills, not other substitutes for cash that are claimed to deliver liquidity and actually do so, except when it is truly needed.
Finally — getting to our third point — we will never engage in operating or investment practices that can result in sudden demands for large sums. That means we will not expose Berkshire to short-term debt maturities of size nor enter into derivative contracts or other business arrangements that could require large collateral calls.
As we have seen availability of huge cash was primary reason for BRK’s antifragility. So the first lesson that I draw from this discussion is that cash makes a business antifragile and as a corollary to this, debt introduces fragilily.
Recall the fundamental notion behind antifragility: the antifragile benefits from volatility and disorder, the fragile is harmed. Well, ‘time’ is the same as disorder. “Time has sharp teeth that destroy everything,” declaimed the sixth-century poet Simonides. But if something survives the ravages of time, it probably has some antifragility into it. A business which has survived few market cycles (10 years) has better odds of being antifragile than the one which has been around only for past few years.
“What survives must be good at saving some (mostly hidden) purpose that time can see but our eyes and logical faculties can’t capture.” writes Nassim Taleb in his book Antifragile.
Berkshire’s great managers, premier financial strength and a variety of business models protected by wide moats amount to something unique in the insurance world, writes Buffett, “This assemblage of strengths is a huge asset for Berkshire shareholders that will only get more valuable with time.”
So if you, or for that matter any business, can make time an ally, it will serve well. Think on the scale of months and years and decades (not hours, days, weeks). So the second important lesson here is that being a Hydra is all about the long term.
Remember what Buffett once said –
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Time is the friend of the wonderful company, the enemy of the mediocre
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