The Warren Buffett national indemnity investment allowed Buffett to gain an important foothold in the insurance industry. Buffett used cash generated by his textile operations to fund entry into the insurance business by purchasing National Indemnity Company in 1967.
Insurance companies are attractive because of their float, or cash with a near-zero cost of capital, that comes from the insurance premiums insurance companies collect every month.
There were also tax benefits to doing so, for corporate income tax rates are typically lower than personal income tax rates. Thus, using insurance companies as investment vehicles lowers the tax Buffett has to pay on capital gains.
Nonetheless, Buffett had to weigh the pros and cons of this investment carefully. He observed that National Indemnity Company did not appear to have any attributes that would help it overcome the industry’s chronic troubles – it was not particularly well-known, had no informational advantage over its competitors and was not a particularly low-cost operator.
However, the one crucial factor that differentiated National Indemnity Company and that Buffett very much liked was its managerial mindset – the company had a unique managerial mindset that most of its competitors would find impossible to replicate. It was not afraid of shrinking volume – its policies were consistently priced to make a profit rather than to match that of its most optimistic competitor. In other words, National Indemnity Company had a strict underwriting discipline that was not easily swayed by market competition.
In the industry, the urge to underwrite aggressively is difficult to overcome, as the consequences of poorly underwritten policies may not become apparent for some time. In fact, reported earnings will be overstated in the short-term, and many years may pass before the true costs of aggressive underwriting are revealed.
National Indemnity Company overcame this urge by promising its workforce that no one will be fired because of declining volume, however severe the contraction. This company policy also implies that it has to be especially careful to avoid overstaffing when times are good. The human resource department has to evaluate each hire very carefully, for each hire may stick around for a lifetime despite making only marginal contributions.
The Warren Buffett National Indemnity investment was arguably an important strategic move for Warren Buffett.