History of Berkshire Hathaway, Part 2
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From textiles to insurance
After Warren Buffett took control of Berkshire Hathaway, the company operated in dual roles. First, it maintained its core business of textiles; secondly, Buffett gradually began to use it as an investment vehicle.
As far as textiles were concerned, Buffett realised the difficulties and future problems for textile mills but for various reasons persevered, apparently for altruistic and non-altruistic reasons. He recognised that closure of the plants would cause job losses and community disfunction but also thought that he could operate the business profitably. He said that he would not shut down a business with lower than average profits just to add a small portion to business returns.
However as time passed, Buffett realised that the business was in trouble from increasing foreign competition and high structural costs. The end was near. In 1985, the company discontinued its historic role in the textile business. Even Warren Buffett could not turn around a company whose business operations had become structurally unprofitable.
In about 1967, Buffett turned the companys eyes towards the insurance business, negotiating the purchase of two Nebraska companies, National Indemnity and National Fire and Marine Insurance. Now the insurance business is risky, subject to strong competitive forces, and strongly reliant on astute management. Why would an investor like Buffett exchange one type of commodity business (textiles) for another?
The reason is that insurance companies charge premiums against a risk that may or may not eventuate, generating large amounts of cash that lie about looking for something to do. This allows the insurance company to invest spare monies to gain further profits over and above that generated by the insurance business itself. However, the investments need to be in liquid assets that can be realised when and if necessary to pay claims. The prime market for liquid investment is stocks and bonds.
There is also another factor, as Buffett knew. If an insurance company is financially strong, customers and agents of that insurance company will have confidence in its ability to pay claims, allowing the company to remain vibrant and viable even when insurance margins are falling through increased competition or larger than usual claim years.
Buffett also maintained a policy in the companies that concentrated on premium safety rather than in volume of business. If the premiums had a sound basis, the companies would do as much business at those prices as it could. If the prices were not rational, the company would not write the business and it was irrelevant if volumes dropped off. If customers chose to buy elsewhere that was up to them.
If you think about it, this is just a variation of Buffetts concept of, if necessary, waiting forever to buy a share at the right price.
This first investment in insurance was the start of Berkshire Hathaways rise to the investment legend it has become today. In a few years, Berkshire Hathaway would acquire GEICO General Insurance Company, which would add to Buffetts profits through both insurance premiums and the huge cash flow that would allow further stock investments.