Portfolio manager’s Letter October 2001
Warren Buffett has spent his life building a castle. He has shaped his creation with painstaking attention to detail and infinite patience. Berkshire Hathaway’s financial strength is a tribute to the design and the builder. “Prepare for the unexpected because sooner or late it will happen” is the principle that guided this construction. For the insurance operation a huge moat has been built with enormous amounts of unused statutory surplus.
The acquisition of General Re, controversial for the last three years, because of lumpy earnings, can now be seen in a totally new light. Like much of what Warren Buffett was done in the past, it is often necessary for a few years to pass before his logic is clear to us ordinary people. Writing about reinsurance in the 1990’s Mr. Warren Buffett made the following observation.
“Major capacity withdrawals require a shock factor such as a natural or financial MEGADISASTER. One may occur tomorrow – or many years from now. The insurance business-even taking investment income into account-will not be particularly profitable in the meantime. When supply ultimately contracts, large amounts of business will be available for the few with large capacity, a willingness to commit it, and an in-place distribution system. We would expect great opportunities for our insurance subsidiaries at such a time.”
I see the long-term impact of the acts of this bush-league Hitler as largely positive for Berkshire Hathaway because it has demonstrated to the world the certainty of the unpredictable. While it is true that the attack has exposed risks for the insurance industry that were not contemplated when current policies were written. The lawyers and the actuaries should be a lot smarter today than they were two months ago and unacceptable risks can be written out of future contracts by way of contact exclusions and caps. Nuclear events, biological or chemical attacks and or multiple events, all can be excluded by contract language.
From the 1999 Chairman’s Letter: “In Ajit, we have an underwriter equipped with the intelligence to properly rate most risks; the realism to forget about those he can’t evaluate; the courage to write huge policies when the premium is appropriate; and the discipline to reject even the smallest risk when the premium is inadequate. It is rare to find a person possessing any one of these talents. For one person to have them all is remarkable.”
Alice Schroeder has been quoted as saying that it is likely that Berkshire Hathaway will be able to raise its rates enough that the increase will cover Berkshire Hathaway’s payment on WTC policies in considerably less than 12 months. Before the events of September 11, Warren Buffett was quoted as saying that cash was flowing into Omaha at the rate of 100 Million a week so an after tax payment of 1.5 billion will eat through only 15 weeks of cash flow.
The equation for writing reinsurance has changed dramatically. On one hand we have an industry whose capital structure has just taken a huge hit. Less capital means less statutory reserve, therefore the supply of reinsurance available to the world will decrease. Estimates of rate increases in property and casualty and reinsurance range from 15 to 20 percent on the low end to 200 to 300 percent on the high-end.
At the same time, the nature of this calamity is such that anyone who was buying reinsurance in the past will want to buy more now. Expect to see, “an exponential increase in the demand for transferring risk.” Primary insurance companies will what to buy reinsurance only from those companies with the strongest financial structure. Because if reinsurance is not paid the company buying the reinsurance still has to pay on its policies and it can be put into a position where it will fail.
Berkshire Hathaway historically writes a limited amount of insurance relative to their capital. I have read that Berkshire Hathaway writes about 20% premiums that would be allowed by its capital, while the normal insurance operation writes 80% to 90%. While some companies in the reinsurance business will be going broke and others will be restricting their activity because of limits imposed by statutory capital requirements, Berkshire Hathaway will have the capability to increase their insurance business by a factor of 4 or 5. Of course, we will not see an increase of that magnitude, but they do have the capacity.
We could conceivably reach a point where Berkshire Hathaway might be the only company left with enough capital to write reinsurance (particularly if the amount involved is large). Imagine Warren Buffett’s delight as companies come knocking on the castle door seeking coverage he knows no one else can write, and willing to pay what Berkshire Hathaway asks. As far back as 1994 Warren Buffett was commenting Berkshire Hathaway’s ability to write policies that others could not.
“The second benefit of our capital strength is that we can write policies for amounts that no one else can even consider. For example, during 1994, a primary insurer wished to buy a short-term policy for $400 million of California earthquake coverage and we wrote the policy immediately. We know of no one else in the world who would take a $400 million risk, or anything close to it, for their own account.”
This was a year in which Berkshire Hathaway’s statutory surplus was 13.4 billion and the float was 3.0 billion, today the statutory surplus is 41 billion and the float is 29 billion. Berkshire Hathaway’s revenue from insurance last year was 19.3 Billion about 13.8 billion of that was from reinsurance. I am no expert on insurance rates and have no idea how much rates will increase, but if losses where to return to a normal level then a lot of any increase in revenue would sink to the bottom line.
Premium increases in the 40-60 percent range would increase Berkshire Hathaway’s revenue by five to seven billion. If we add Alice’s estimate of 25 percent increase in new business that is another 5 billion. While a 12 billion increase in insurance revenue would only represent a 30% increase, in Berkshire Hathaway’s total revenue. The impact on the bottom line could be many times larger. In a “no event” year we are talking huge numbers.
In 1991 Warren Buffett then running an insurance operation only a faction of the size of today‘s, wrote: “Berkshire Hathaway continues to be a very large writer – perhaps the largest in the world – of “super-cat” insurance, which is coverage that other insurance companies buy to protect themselves against major catastrophic losses. Profits in this business are enormously volatile. As I mentioned last year, $100 million in super-cat premiums, which is roughly our annual expectation, could deliver us anything from a $100 million profit (in a year with no big catastrophe) to a $200 million loss (in a year in which a couple of major hurricanes and/or earthquakes come along).”
If intrinsic value is the discounted value of future cash flow, then is there any question that Berkshire Hathaway’s intrinsic value has increased dramatically in the last month? The only real question is how much. It is interesting to note that the rally of the last two weeks has seen a much bigger increase in the volume of the “A” shares than the “B” shares. This is an indication to me that the big money has been reworking their IV calculations. While Berkshire Hathaway may have been fairly priced at $70,000 a month ago, it may be really cheap today at $75,000.
Last week, with Berkshire Hathaway trading near a 52 week high, Morgan Stanley raised their recommendation from accumulate to strong buy. Earlier today CSFB upped its price target on BRKA to $92,000 from $80,000; saying, “no US Company is better able to take advantage of the new property-casualty reinsurance environment than Berkshire Hathaway, given the strength of its balance sheet and management’s willingness to accept risk.”