December thirtieth, twenty twenty-four to December thirty-first, twenty twenty-four

I. Foundation 

resistance to change and hence greater dependability for the results shown in the past.

Inflation catch-up in macro data: consumer prices and input costs

Actual wage growth is not as concerning as the headline data suggest.

Historically, union wage growth is usually a lagging indicator of labor market conditions, because union contracts are adjusted less frequently, and therefore reflects the inflation peak over a longer period.The chart at the bottom right shows that over the past three years, wage growth for union workers consistently lagged that of nonunion workers, only beginning to catch up in recent quarters.

Chart: A lag between union and nonunion wages

With labor market tightness indicators continuing to decline or remaining flat, some wage growth reflects delayed catch-up increases and does not indicate renewed labor market overheating.Lagged union wage pressures temporarily push up prices in labor-intensive categories, thereby delaying the return of core PCE inflation to target.

Many stories about price inflation can be explained by similar logic:

The parts of current inflation with the largest increases appear overheated, but are actually the result of lagged catch-up effects rather than renewed labor market heating or accelerating demand. This phenomenon is most evident in housing, health care, auto insurance, and other regulated prices.

In these areas, market prices or input costs rose sharply over the past few years, but their growth has slowed recently, while consumer prices are in a catch-up phase. As the gap between prices and costs narrows, price increases will gradually slow.

Take housing, for example: official shelter inflation measures catch up with higher market prices:

Chart: Official shelter inflation measures lag market-price measures

The chart on the left shows that since the first quarter of 2020, rents for new tenants have risen by 24%, while the official shelter price measure has risen by only 22%.Market prices—that is, rents paid by new tenants—often adjust faster than rents for existing tenants, while official shelter inflation measures include rents for both new tenants and renewals.

The latter typically adjust more slowly, because leases are renewed less frequently, landlords are also reluctant to lose tenants by raising rents too quickly. In addition, regulations limit rent increases in some cases.

It takes time for the data to reflect the gradual adjustment in the rental market and the fading of catch-up price increases.

In health care, consumer prices also catch up with higher input costs.Health care prices typically adjust slowly, mainly because contract terms are long, especially in the hospital sector.

As the chart at the bottom left shows, since the first quarter of 2020, health care service costs have risen by 15%, reflecting increases in supply and labor costs (for example, hospital wages rose by 13% during 2021-2022), while consumer prices rose by only 11%:

Chart: Contract terms in health care cause consumer prices to catch up with input costs later

Similarly, in the auto insurance sector, consumer prices are also catching up with higher input costs.

As the chart at the bottom left shows, since the first quarter of 2020, auto insurance costs have risen by 51%, while consumer prices have risen by 43%:

Chart: Auto insurance also requires price coordination with regulators, creating an inflation catch-up effect

These cost increases affect prices with a long lag because auto insurers must negotiate price adjustments with state regulators based on recent costs and profitability.

As a result, when analyzing macro inflation, the components involving inflation catch-up can be excluded when assessing forward-looking trends and turning points, when the prices of the parts of the inflation basket not clearly affected by lagged catch-up effects slow to the high end of the previous cycle’s range, the disinflation trend can be expected to stabilize,

For now, as prices catch up, catch-up inflation is nearing its end.

Chart: Catch-up inflation ends naturally as prices catch up

Officially measured rents have now fully caught up with market prices, and owners’ equivalent rent has nearly caught up with market rents for new tenants, continuing to converge toward the low growth rates of the past two years. Catch-up in government-regulated categories such as auto insurance also appears to be nearing its end.

Chart: Wage growth has tended to fall below 4%, and catch-up wage growth among union members has ended; they often sign multiyear contracts, and those contracts are now nearing expiration.

Further reading:

GS：Continued Catch-Up Means the Latest Wage and Inflation Readings Are Lagging Indicators

GS：Shelter Inflation: A Longer Lag for OER

GS：Car Insurance: Another Case of Catch-Up Inflation

GS：10 Questions for 2025

2024.12.30

Why does auto insurance contribute much less to PCE than to CPI?

Auto insurance’s contribution to PCE is much smaller than its contribution to CPI There are two main reasons. First, the PCE index captures changes in insurance premiums after deducting “normal losses” paid to consumers, whereas the CPI index captures premiums alone.Therefore, auto insurance accounts for about 3.7% of core CPI, but only 0.6% of core PCE.

Auto insurance contributes much less to PCE than to CPI for two main reasons.

First, the PCE index reflects changes in insurance premiums after deducting “normal losses” paid to consumers, while the CPI index reflects premiums alone. Therefore, Auto insurance accounts for about 3.7% of core CPI, but only 0.6% of core PCE.

Example:Suppose a consumer pays 1000 dollars per year for auto insurance, and the insurer pays the consumer 600 dollars per year:

1) CPI directly counts 1000 dollars as insurance costs.

2) PCE counts only 400 dollars (that is, premiums minus payouts), because the remaining 600 dollars are compensation paid by the insurer under the contract, not the cost of the insurance service.

PCE focuses on the net cost of insurance services by deducting “normal losses,” making it a more precise measure of insurance prices. CPI is more direct, reflecting the full premiums paid by consumers, and thus more intuitive as a measure of consumers’ perceived spending pressure.This difference gives auto insurance different weights and price-change patterns in PCE and CPI.

Second, the PCE index measures auto insurance prices through PPI, while CPI uses insurance premium data directly.

In PPI, prices are reset only when a sampled policy comes up for renewal, whereas CPI reprices half of its sample on a rotating basis every two months. The differences in the measurements from PPI and CPI stem mainly from differences in sample-updating methods and frequency.PPI uses dynamic sample adjustments and renewal-based repricing, resulting in greater lag but better representing actual changes in market revenue; CPI, in contrast, is based on a fixed sample, reflects price trends more promptly, but is less adaptable to changes in market structure.

[Impact of the policy renewal mechanism]

1) PPI reprices a policy only when it is renewed in the sample. This means price changes are reflected only after renewal occurs. If the renewal cycle is long (for example, a year or longer), price adjustments are delayed.

2) By contrast, CPI updates prices by resampling some policies every two months, so price changes are captured more frequently and promptly.

3) Cause of occasional jumps: When a group of policies in the sample comes up for renewal at the same time, the price adjustment is concentrated in PPI, causing a noticeable “jump” in the price curve. By contrast, CPI has a smoother curve with fewer such jumps because prices are updated more frequently.

Therefore, the PPI measure can show occasional jumps when policies renew, and may sometimes lag behind CPI. In addition, PPI uses a “targeted replacement” adjustment, periodically updating the policies in its sample so that they better represent insurers’ revenue, while CPI has priced the same set of policies since 2004. As insurance costs have risen in recent years, consumers may have changed the types of policies and coverage they purchase, which also contributes to the difference between the measurements of CPI and PPI.

Further reading:

GS：Car Insurance: Another Case of Catch-Up Inflation

Market Notes 240729: PCE is more relevant to the Fed’s inflation target and monetary policy path than PCE

2024.12.30

Inflation and the auto insurance industry’s profitability cycle

The increase in auto insurance premiums mainly reflects a delayed catch-up with rising costs, as pandemic-related supply chain disruptions caused used-car prices to surge, which later drove up repair and maintenance costs. Medical and legal expenses have also increased significantly in recent years, reflecting higher medical costs per claim due to more severe accidents and more litigation.

However, these cost increases affect prices with a long lag, partly because auto insurers must negotiate rate increases with state regulators based on recent costs and profitability.

As shown in the chart below, In the fourth quarter of 2023, companies’ losses as a share of revenue remained about 8 percentage points above the 2019 level, in which case premiums will subsequently rise further to catch up with costs:

Chart: In the fourth quarter of 23, auto insurers’ losses as a share of premiums collected remained about 8 percentage points above the 19 level

Costs will rise faster than pricing adjustments on the revenue side, so earnings will decline somewhat in the first half of the inflation cycle, while auto insurers’ earnings will improve to some extent in the second half.

Further reading:

GS：Car Insurance: Another Case of Catch-Up Inflation

2024.12.31

A research report Buffett wrote at age twenty: The investment thesis and framework for the auto insurance industry

The original text comes from Buffett’s article “The Security I Like Best,” published in 1951, The GEICO mentioned in the article marked the beginning of Buffett’s path to insurance cash cows; its chairman at the time was his teacher, Benjamin Graham.At the time, Davis, the financial vice president of GEICO, had intended to brush him off, but ultimately spoke with Buffett for more than four hours.

Full employment, sharply rising profits, and record dividends plainly do not go hand in hand with a sluggish stock market.

For the past 5 years, most industries have enjoyed this prosperity, and a few minor fluctuations have done nothing to blunt this powerful wave.Yet the auto insurance industry did not share in this prosperity.After suffering huge losses in the immediate postwar period, the auto insurance industry finally began to recover in 1949. But in 1950, property-casualty insurers were hit hard again, making it the insurance industry’s second-worst year in 15 years.

The share prices of some property-casualty insurers (especially those with a large auto insurance business) have performed very poorly.Judging by profitability and assets, many of these stocks seem undervalued. The auto insurance industry itself tends to smooth cyclical fluctuations. Most car buyers consider auto insurance a necessity.Insurance policy rates must be adjusted every year to reflect conditions at the time. Rate adjustments lag behind costs, creating a headwind during the inflationary period of 1945-1951, but If the economy enters a deflationary period, this should be an advantage.

Other advantages of the industry include having no inventory, collections, labor, or raw-material problems, and no risk of products becoming obsolete or related equipment being phased out.

GEICO was founded in the mid-30s and provides comprehensive automobile insurance services nationwide to eligible groups,

including:

1) Federal, state, and municipal government employees; 2) active-duty and reserve commissioned officers, as well as noncommissioned officers in the top three pay grades; 3) veterans who were eligible for this benefit during their service; 4) former policyholders; 5) faculty and staff at elementary, secondary, and higher-education institutions; 6) government contractors’ employees working specifically in defense; 7) the company’s shareholders.

The company has no agencies or branches, so policyholders can obtain a standard auto insurance policy at a discounted annual rate of up to 30%. The company handles claims nationwide through approximately 500 agents, with very fast processing.

“Growth companies”generally refers to those excluding the effects of price inflation and lessening business competition, sales have still grown over the past few years companies.

Judging by the performance below, GEICO is unquestionably a bona fide growth company:

Image source: Horizon Global Strategy

Of course, yesterday’s growth does not bring profits to today’s investors. In the case of GEICO, we have reason to believe that there is still substantial room to grow. As of 1950, the company was registered in only 15 of the 50 states nationwide (including the District of Columbia and Hawaii).At the beginning of 1950, the company had fewer than 3000 customers in New York State.

For prospective customers, the 25% discount on a 125-dollar policy in New York should seem more appealing than the 25% discount on 50 dollars of premiums in less-developed regions.As cost competition becomes increasingly important during a recession, GEICO’s attractive rates should enable it to win business from other companies in the same sector more effectively.

As insurance rates rise with inflation, the gap in rates of 25% becomes larger in dollar terms. The company also faces no pressure from agents to accept questionable applications or renew policies for high-risk policyholders. In some states with inadequate rate structures, the company may suspend its marketing.

GEICO’s greatest appeal may lie in its profit margin.In 1949, the ratio of the company’s insurance profit to premium income was 27.5%, while the average profit margin of the 135 casualty insurance companies surveyed by Best’s was only 6.7%. Business conditions deteriorated in 1950, and Best’s calculated average profit margin fell to 3%, while GEICO fell to 18%. GEICO does not operate in every casualty insurance line. Although personal injury and property insurance are both important business lines for GEICO, they have the lowest profit margins.

GEICO also has a substantial automobile collision insurance business, which was a highly profitable line in 1950. In the first half of 1951, almost all insurers lost money in property-casualty insurance, with personal injury and property insurance being especially unprofitable. GEICO’s margin fell to slightly above 9%; by comparison, Massachusetts Insurance Company lost 16%, New Amsterdam Casualty Company lost 8%, and Standard Casualty Company lost 9%.

Because GEICO was in a rapid growth phase, its cash dividends remained relatively low. From 1948 6 1 to 1951 11 10, stock dividends and stock splits (1-for-25 split) expanded the number of shares outstanding from 3000 shares to 25 ten-thousand shares. The company also issued warrants to subscribe for shares in an affiliated subsidiary.

Benjamin Graham’s investment fund acquired a large stake in GEICO and took it public in 1948; Graham has been chairman of the board ever since. Leon Goodwin is the company’s president, an outstanding executive who has guided GEICO ever since he took office. At the end of 1950, the 10 directors on the board collectively held about one-third of GEICO’s outstanding shares. The company earned 3.92 dollars per share in 1950 and 4.71 dollars per share in 1949 (when its total business was smaller). These figures exclude unearned premium reserves, which were substantial in both years. Profits in 1951 were lower than in 1950, but the broad rate increases this summer will be reflected in 1952 earnings. Between 1947 and 1950, the company’s investment income quadrupled, reflecting the growth of its assets. At the current share price, At the current price, the valuation is 8 times earnings for 1950 (a terrible year for the industry), which seems to fully discount the company’s enormous growth potential.

2024.12.31

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