The Insurance Leader That Continues To Grow
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Sherry starts boiling at 173 degrees Fahrenheit.
The 2 million gallons of fine fortified wine on the upper floor of the California Wine Association warehouse reached that temperature sometime on April 18, 1906, as San Francisco blackened beneath one of the worst fires in American history.
A little after 5 AM, a major fault line cracked under San Francisco Bay, triggering a 7.8 magnitude earthquake. As buildings toppled downtown, boilers and chimneys exploded, blanketing three-quarters of the city with flame.
As fire engulfed the Wine Association building, its massive 80,000-gallon sherry casks charred and crumbled, releasing a flood of boiling wine. The liquid then burned through the floor and filled up the swimming-pool-sized concrete cellar, where it submerged (and boiled) half a million additional bottles of fine champagne.
The champagne bubbled, very un-festively, for two days and nights.
When the fire had subsided, the California Wine Association – who’d lost 10 million more gallons in other wine warehouses across the city – pumped the ruined product out into the street.
Fortunately, the Wine Association had taken out $5 million in Commercial Union, the best fire insurance money could buy. They weren’t worried.
Until their insurance claim was denied.
When the smoke cleared four days later, 3,000 people were dead and 220,000 – over half of the city’s population – were homeless, leaving the city “nothing… but memories,” as eyewitness Jack London put it. Some 28,000 buildings had burned to the ground.
And, unexpectedly, the city’s fire insurance companies refused to cover any of it.
Many of San Francisco’s insurance companies were fly-by-night, barely solvent concerns. Claims of this magnitude would destroy them. One analyst at the time wrote bluntly, “If the insurance is not paid, the city is ruined. If it is paid, many of the insurance companies will break.”
This, of course, was California, the land of constant tremors. Most of San Francisco’s property and casualty (P&C) insurance companies explicitly wouldn’t insure for earthquakes.
But what about fires caused by earthquakes?
It was a chicken-or-egg question... actually, a “ham and eggs” question...
The most devastating blaze that day, known as the “Ham and Eggs Fire,” started around 9 AM in a breakfast stove on Hayes Street. The blaze burned down the chimney and quickly joined with other fires to create a wall of flame a mile-and-a-half wide, responsible for much of the city’s fire damage.
But it was the earthquake that damaged the chimney in the first place… or so the insurance companies argued. Earthquakes weren’t covered. And that meant they didn’t have to pay a damn thing.
After all, without a regulatory board (there wasn’t one) or industry standards (there weren’t any), who was gonna make them?
The courts, maybe. Following the disaster, a second firestorm rolled through the city as business owners sued insurance companies. The Wine Association’s case was the biggest and most acrimonious lawsuit of all, generating 6,000 pages of trial transcripts.
The city’s real estate board got together and passed a resolution to only speak of the disaster as “the great fire,” not as “the great earthquake.” Fat lot of good it did. Insurance said it was an earthquake, and therefore insurance refused to pay.
It was a stalemate that would drag on for another five years.
Catch Me If You Can-Can
At the turn of the 20th century, America’s wildest frontier was insurance.
Ben Franklin – ever the innovator – brought fire insurance to America in the mid-1700s, and soon other forms of property, marine, and life insurance cropped up along the Eastern seaboard. By the turn of the 20th century, the now-popular industry boasted thousands of insurance brokerages and agencies, with some $20 billion in policies (in 1900 dollars!) in life insurance alone. It was also almost totally unregulated, and rife with posers, fraudsters, and conmen.
Then, in 1905 and 1906, the party ended abruptly with twin disasters: the San Francisco fire (or was it an earthquake?), and James Hazen Hyde’s can-can dancing scandal.
To ring in the New Year in 1905, Hyde, the heir to the billion-dollar Equitable Life Assurance empire, hosted a $50,000 ball (more like $1 million today) that featured “improper and scandalous occurrences, such as the dancing of a can-can on the dining tables.” He charged it all to the corporate account.
Another thing America loves is a good moral panic. The titillating pictures hit the tabloids, reporters asked why Equitable had $1 million to spare for can-can dancers, and before long Congress had organized the Armstrong Committee to investigate waste, fraud, and abuse in the life insurance industry.
Turned out, there was lots to uncover. The largest insurance companies, verging on monopoly, acted as de facto banks. Bribery and mismanagement abounded. Some of the “float” money – the premiums people paid up-front – from Equitable’s most popular life insurance policy doubled as a political slush fund. The list went on.
The Committee released its findings to great public outrage. Newspapers vilified insurance men as “squirming, dishonest, unfaithful, contemptible thieves” and joked that their profession was grounds for divorce. Unable to take the heat, James Hazen Hyde gave up his share in Equitable and fled to Paris with a saucy French actress, Yvonne Garrick, for company.
At the same time, the P&C business was wilting under bad press from the Great Earthquake fiasco in California. At least 59 insurance companies refused to pay out anything at all, earning them the names of “weaselers” or “welchers,” while a number of others (called “six-bits”) grudgingly consented to pay partial damages after protracted litigation.
Eventually, the courts squeezed about $243 million in claims out of various reluctant insurance companies – more than the combined profits of the U.S. fire insurance industry over the prior 43 years. The California Wine Association – after a five-year-long legal battle – finally recouped its losses, after which the entire California wine-growing industry packed up and relocated to the Napa Valley. It’s still there today.
Into the middle of this saloon brawl strode the man with the star on his hat: up-and-coming insurance rater Alfred Magilton Best.
Be Best
Alfred used to be an insurance salesman himself – working for one of many pop-up Lloyd’s of London branches that had migrated to America – but when they raised his salary to a “princely” $25 a week, he knew he wasn’t worth that much. Rightly suspecting some sort of fraud, he quit, right before his employer folded.
After that, he developed a single-minded obsession with rating the insurance industry and sorting out the good eggs from the bad. His tiny analysis firm first began to attract press after he wrote up a series of reports on insurance losses from the 1904 Baltimore fire. When the twin life and fire insurance crises hit America in 1905 and 1906, Best was there with bells on.
Alfred worked closely with Miles Dawson, the Armstrong Committee investigator, to develop a system for life insurance ratings, and drew on that data to build a similar set of criteria for fire insurance companies. Seemingly determined to live up to his initials, AM Best, he split his day into two grueling shifts: from nine to five, and from six to 11. The 1905-1906 period, he later recalled, “will always stand out in my memory as pretty overwhelming.”
In his “Life Book” and his “Fire Book” reports – which would later come to be known as Insurance Guides With Key Ratings – Alfred ranked companies on a scale of 1 to 5, scoring them in areas like solvency, safety, and fairness. A few fared well. Most did not.
In one case, a disgruntled insurance executive, not happy at being accused of fraud, challenged AM to a duel. Alfred cheerfully responded that he’d choose the weapons, which would be “baseball bats at a distance of one pace.” The insurance guy never came back to the office.
In the wake of the San Francisco earthquake – after analyzing countless imploding P&C companies for his “Fire Book” – Alfred Best came up with his most lasting contribution to insurance: the combined ratio.
This equation shows, at a glance, just how solvent a P&C company actually is. It’s the sum of two other important ratios: the expense ratio, which measures operating costs, and the loss ratio, which measures the quality of the underwriting. Together, the sum of these ratios gave Alfred – and gives analysts today – an instant, accurate snapshot of the quality of a P&C business.
Gradually – as Alfred developed concrete metrics for separating good insurance companies from shady ones – sanity crept into the insurance industry. In 1910, the California Supreme Court passed a landmark ruling that said fire caused by an earthquake was still fire. (Gadzooks!) Congress took most of the Armstrong Committee’s suggestions, passed laws regulating the industry, and relied on Best’s Insurance Guides to keep everyone honest.
Over the next decade, the life insurance industry more than doubled in size, and the new field of auto insurance propelled P&C to similar heights. By the 1950s P&C had become one of Warren Buffett’s favorite businesses, and by the 1990s, one of Porter’s.
AM Best and his company – now, the world’s largest credit ratings industry – also prospered. Over the years, he added more annually published credit reports, ratings guides, and directories that, today, remain the gold standard for the insurance business. And the P&C benchmark he developed in 1912 – the combined ratio – is still the single metric that tells us whether a P&C insurer will succeed or fail. It has never been replaced or surpassed.
The company we are adding to our Best Buys this month has the distinction of the very best combined ratio – the best expense ratio and the best loss ratio – in the industry. In the last two years the company’s investment portfolio (cash and invested assets) has grown 69%. Total outstanding shares have decreased, and the dividend has grown 79%.
Its extraordinary quality means that any time it gets beaten down on earnings drama (like happened earlier this month) is a good time to buy.
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