Early Days
Sid Ferenc, a former vice president of finance at Newsweek, started Applied in the San Francisco Bay Area in 1994 with Steven Menzies, a math whiz with a degree from Columbia University. Small companies would hire them to arrange workers’ compensation coverage and handle payroll and tax reporting.
Eventually, they purchased a company to provide insurance directly. By bundling policies with a service that sent paychecks to workers, Applied got direct access to payroll information, a key component to pricing coverage.
Buffett warmed to the business after a top lieutenant, Ajit Jain, wrote a reinsurance policy for Applied, taking on some of the company’s revenue and risk. In 2006, Berkshire bought 85 percent of the insurer, which by then had moved most of its operations to Buffett’s hometown of Omaha, Nebraska. The sale price wasn’t disclosed, but Menzies later said in a legal filing that he received more than $60 million. He and Ferenc “started on a shoestring only 12 years ago,” Buffett wrote in a 2006 letter to investors, “and it will be fun to see what they can accomplish with Berkshire’s backing.”
Even then, there were signs Applied didn’t always play in the center of the court. In 2004, California said the company owed $27 million for evading state unemployment taxes. Applied fought the matter in court and lost. Ferenc and Menzies declined to comment for this story.
Loss Sensitive
Around the time Berkshire bought a controlling stake, Applied introduced new products. Big employers already could buy workers’ comp coverage in which premiums were adjusted based on actual claims. Such so-called loss-sensitive plans could save money if an employer operated without major accidents, but they could be pricey to set up and so complex that they were better-suited for sophisticated businesses with resources to handle the expense if claims piled up. That’s why some states have been reluctant to let insurers sell certain types of loss-sensitive coverage to small firms.
Menzies and other Applied executives devised and patented a workaround. It started with a workers’ comp policy that was filed with state regulators and looked like what most small businesses buy. The math on these kinds of fixed-cost plans is usually simple and standardized. States say what factors can be used to determine premiums and set rates insurers can charge for different types of work. Those rates are then multiplied by a company’s payroll.
Applied added a layer of complexity with what the insurer called a “profit-sharing plan,” according to sales documents and court records. Employers were required to fund an account that would reinsure, or backstop, a portion of Applied’s losses. If the business didn’t have any claims, the plan would deliver substantial savings over the basic policy. But, if there were injuries, the cost would climb, up to a guaranteed maximum.
Just how much had to be held in the account, and what the final bill would be, was governed by a dense legal document. Business owners and their brokers had to make sense of “loss development” and “exposure group” factors, as well as terms like “cession point,” “loss pick containment amount” and “run-off term.” Customers and their brokers often saw the agreement only toward the end of the sign-up process, according to court records.