Severity Claims

I had a socialist professor for some business class or another as an undergraduate. Like most of my undergraduate courses, it was a fairly expensive waste of money, especially given that he was a socialist, but he said one thing of value that has stuck with me because he was 100% correct: Bankers will always need bailouts

The Federal Government will always be bailing out banks because bankers cannot accept that banking is boring and generates a relatively low ROI in a safe environment. Bankers will create a risky environment to juice their ROI and to make people think they are geniuses by turning a low-return business into a high-return business. Because banking is so fundamental to the economy, the government will not have any choice but to bail them out.

He said this just after the S&L crisis in the 1980’s, and he’s been proven correct ever since. I think the solution is to bail out the bank’s customers and put the executives in jail.

Insurance is supposed to be boring, too. People trust boring when they put a ton of their money in a bank or buy insurance. Try selling a policy while wearing flashy clothes, like a classic used-car salesman.

To make insurance exciting, executives take extraordinary risks. How is this most easily achieved? With leverage, just as in banking. The industry today is highly leveraged. Adjusted for Berkshire Hathaway’s surplus, which at the end of 2024 accounted for almost 28% OF ALL SURPLUS in the entire industry, the surplus to net premiums written was less than 0.9. Even with Berkshire Hathaway’s surplus included, it was only 1.2.

Severity claims, catastrophes, etc., hurt much more when skating on the edge. There is nothing complex about this, just like there really isn’t anything complex about insurance in general, other than reading mind-numbing forms. Instead, execution is hard.

One carrier in particular is loudly complaining about large plaintiff-driven awards. That carrier used to have a huge balance sheet. In other words, they had a lot of surplus. Some consultants might advise they had “excess” surplus. Excess surplus is expensive. The return on investment on excess surplus is, by conventional measures, miserably low. This is the same as banks carrying extra reserves, and it is why banks do not like this reform post credit crisis. The expense of running a financial institution with “extra” reserves/surplus is materially higher, so its ROI to shareholders is lower, all else being equal.

But what happens when an insurance company, like this one, eliminates all that “extra” surplus? This particular company cut the extra surplus, including forgoing most reinsurance, as far as likely possible without injuring its A.M. Best rating. From a solvency perspective, it's fine. But from an operating perspective, it has very little room for mistakes or for severity claims.

Another perspective is that if a carrier is run with the minimum surplus, it can return more profits to shareholders. If they must stockpile surplus, their balance sheet grows safer at the expense of the shareholders.

One reason so many articles focus on severity claims, third-party litigation, catastrophes, and so forth is that carriers simply don’t have the cushion for these claims they once had. In other words, the problem is not the claim but the carriers’ balance sheets. As of 12-31-25, it is a fact that their balance sheets are weaker than they were 10 years ago. That is an undeniable truth.

Most businesses don’t go bankrupt because their liabilities exceed their assets, per se. They go bankrupt because they lack adequate working capital. They cannot pay their immediate bills. This is why working capital is a critical balance sheet measure. Extra surplus provides the same kind of cushion.

Berkshire Hathaway has so much surplus it can handle just about any foreseeable series of shock losses. They have a gigantic safety margin. This makes for a boring company because there is no drama. There is no worry about being able to pay the next nuclear verdict. But when a carrier loses its rating or must sell off parts of its business after paying a nuclear verdict, drama is everywhere.

Sometimes carriers have a minimal operating surplus due to bad luck, but mostly it is due to poor management. The most recent cause was bad investment decisions prior to the increase in interest rates. However, I am seeing more carriers choose to minimize their surplus so they can be more exciting for shareholders. Those with excellent operating ratios and strong financial acumen can probably make this work.

But the others who mimic this strategy, likely after hiring expensive consultants who are good in theory but insufficiently appreciative of execution, will fail. This low surplus/higher leverage strategy requires far better operating ratios than 80% of carriers have any hope of achieving.

As with any leverage strategy, the key is higher than normal operating profits. In insurance, the maximum operating ratio is 95% for a carrier to remain healthy. While a higher operating ratio does not mean immediate death, the analogy is more like a heavy smoker slowly dying, but the “cigarettes can’t be all that bad because I haven’t died yet” thought process.

An operating ratio better than 95% is critical because some portion of profits must be returned to surplus, especially if a carrier is already running high leverage. Otherwise, they cannot grow, and to support stock prices, the sweet spot is a triangulation of growth, profit, and risk. A good combination currently is 8% growth, a 55%-60% loss ratio, and a very low risk rate. The industry average growth rate over the last 10 years is 6.5%, with an unweighted 62.4% loss ratio and a risk rate approximately 25% too high.

A carrier with marginal to poor execution can live a long death march, but not if they have high leverage. They are like trust fund kids. If they have a large surplus to slowly waste away, carriers with poor execution can last a long time. But that same model fails quickly without the trust fund.

Very few carriers consistently achieve operating ratios of 90% or better. Even fewer grow at 8% consistently, especially at 90% operating ratios. These are the kinds of numbers required, mandatory in fact, for the exciting and drama-filled high-leverage strategy to succeed.

The next time you hear a carrier complaining about nuclear verdicts and high-impact storms, look up their leverage ratios. If they are like Berkshire Hathaway, these are not material issues. If they are highly leveraged, they might have a true concern. The best way to alleviate the stress is to carry a stronger balance sheet. It’s a boring strategy, but no one needs high-priced consultants if they possess a stockpile of surplus.

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