Investment Manager’s Letter October 2006
The most interesting thing about Berkshire Hathaway’s third quarter earnings will be the underwriting gain of its insurance companies and their unearned premiums. I, as investment manager, have written a lot about the impact of the current hard market in property and casualty insurance and in the third quarter we should start to see some of the benefit work down to Berkshire Hathaway’s bottom line. To come up with a figure, let’s start with last year’s third quarter. In last year’s third quarter Berkshire Hathaway experienced $2.6 billion worth of catastrophic losses from Katrina and Rita (40 million GEICO, $2.06 billion at Berkshire Hathaway Re; and $429 million at General Re). Since there are no catastrophic losses in this year’s third quarter, we can add that $2.6 billion back into our calculation of Berkshire Hathaway’s underwriting gain. That calculation alone would leave us with pretax insurance operating profit of $1.73 billion.
However, the above figure includes nothing for any increase in business that Berkshire Hathaway wrote during the year. At this stage I, as investment manager, can only guess at a figure for growth, and since Berkshire Hathaway only includes income from catastrophic coverage after the policy has expired any new business and rate increases from this year’s business will not show up in the bottom line yet. So, maybe, the most interesting part of the third quarter report will be its unearned premiums, which is where most this years premium increases will appear.
In last year’s in the third quarter, unearned premiums increased by $600 million from the previous year. If we assume that most (80%) of that increase was from catastrophic business this revenue will show up on the bottom line in this years third quarter.
Last year in the third quarter, investment income amounted to $900 million, by the second quarter of this year that figure had increased to $1.1 billion so I, as investment manager, think we can add a couple hundred million to last years figure for an estimate of investment income. This produces the following figures for underwriting gains.
2005 pretax profit without Katrina and Rita. $1.731 billion.
Last year’s increase in unearned premiums $.480 billion.
Increase in investment income $.200 billion.
Insurance pretax operating profit third-quarter 2006 $2.411 billion.
Pretax underwriting gain $1.311 billion.
(Subtract Investment income from operating Profit)
In the first quarter of this year, earnings before taxes from the non-insurance operating businesses amounted to $1.309 billion. By the second quarter that figure had increased to $1.517 billion. My, as investment manager, guess is that in the third quarter with ISCAR added in and allowing for incremental growth in the other businesses that figure could reach $1.7 billion. Using this guess (let me, as investment manager, emphasize the word guess) we arrive at a pre tax operating profit of $4.111 billion for the insurance and the non-insurance operating companies. Estimating a tax rate of 36% would deduct $1.5 billion and leave us with an after-tax operating profit of 2.6 billion of the third quarter compared to $2.05 billion in the Second quarter, $1.8 billion in the first quarter of 2006 and $100 million in the third quarter of last year.
We cannot even guess at what this figure will be, but we know that in the second quarter investment gains amounted to about $300 million. So I, as investment manager, can say that if the investment gains stay that same as in second quarter (they won’t) Berkshire Hathaway’s net income in the third quarter would be a little less than 3 billion, or about $1900 per share.
No matter what investment gains turn out to be, Wall Street will be impressed, because last year’s per-share figure for the third quarter was $381 per share thanks to Katrina and Rita. With the stock market making new highs at the end of the third quarter, I, as investment manager, think it likely that investment gains will be higher than they were in the second quarter, simply because Warren Buffett may decide to sell equities into the market’s strength.
Investment gains is a total wild card in any given quarter. The figure can come in anywhere from zero to several billion dollars, and this is probably one reason why intelligent people do not attempt to estimate Berkshire Hathaway’s earnings. Based on recent history, however the $300 million figure represents the low end of its range. The actual result is not likely to be lower than this and could easily be substantially higher.
As far as the future is concerned, things should continue to get better for a while. In the fourth quarter, underwriting gains should be a good deal stronger. Traditionally the fourth quarter is the best quarter for underwriting gains, normally running at about twice the rate of the other three quarters. Additionally, since it appears that the hurricane hard market began to bite in the fourth quarter of last year this should help this year’s fourth quarter. The gains should carry into the second and third quarter of 2007 because insurance rates were still increasing in the second and third quarter of this year. Beyond that, as we get into 2008. I, as investment manager, think we can expect to see underwriting gains ease up because with no big losses this year, premium pricing will start to soften in 2007.