Berkshire’s Buffett Still High on Insurance Despite Cat Risk

Warren E. Buffett, the billionaire chairman of giant Berkshire Hathaway, praises the performance of his primary insurance units, particularly Geico, in his annual letter to shareholders and acknowledges that concern over hurricanes has prompted his insurance subsidiaries to raise prices and underwrite more carefully.

Even with his concerns over catastrophe losses from future storms, Buffett appears confident in his insurance operations.

He suggests that auto insurer Geico is prepared to spend even more than its current $500 million annually on advertising its brand to further increase its market share, and he hails the reentry of Geico into New Jersey as a success.

He also reports on the late-2005 acquisitions of a medical malpractice writer and a workers’ compensation firm.

He even offers some advice from Hank Greenberg– the baseball, not insurance, slugger.

Buffet makes no mention of the legal and regulatory problems that have dogged his General Reinsurance unit because of allegedly inappropriate reinsurance deals with American International Group, although he does apologize for problems General Re is having exiting the derivatives business.

“Berkshire had a decent year in 2005,” Buffett writes, citing a gain in net worth for 2005 of $5.6 billion, which increased the per-share book value of its stock by 6.4 percent. Over the last 41 years since Buffett took over, book value has grown from $19 to $59,377, a rate of 21.5 percent compounded annually, according to his letter.

Berkshire posted net income for all of 2005 of $8.5 billion, up from $7.3 billion in 2004. Revenue for the year was $81.7 billion, compared to $74.4 billion in 2004.

General Re reported a $334 million underwriting loss while other Berkshire reinsurers’ losses topped $1 billion. But that result was overcome, thanks to Geico’s performance, and the insurance group posted an overall profit.

In his letter, Buffett forecasts that in order to deliver better gains in the future, Berkshire will need to make major acquisitions.

Insurance results
Despite $3.4 billion in losses from hurricanes Katrina, Rita and Wilma for General Re and National Indemnity, Berkshire Hathaway companies in the aggregate had an underwriting profit of $324 million on $1,270 million of volume, thanks to the performance of giant auto writer Geico and some of the smaller insurers in the Berkshire family.

“Credit Geico – and its brilliant CEO, Tony Nicely – for our stellar insurance results in a disaster-ridden year. One statistic stands out: In just two years, GEICO improved its productivity by 32 percent. Remarkably, employment fell by 4 percent even as policy count grew by 26 percent – and more gains are in store,” Buffett tells shareholders.

As is his tradition, Buffett bases his analysis of his 2005 insurance results on the amount of premium dollars available for investment, or “float, ” which reached $49 million in 2005:

“Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an insurer earns an underwriting profit – as has been the case at Berkshire in about half of the 39 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money. For most insurers, however, life has been far more difficult: In aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so,” he explains to shareholders.

The hurricanes spoiled the chance for no-cost float, or an underwriting profit, in reinsurance lines for 2005. Berkshire suffered hurricane losses of $3.4 billion. But Berkshire’s other insurers picked up the slack.

Hurricane season’s effects
In addition to causing financial damage, the 2005 hurricane season has raised questions at General Re and National Indemnity. “It’s an open question whether atmospheric, oceanic or other causal factors have dramatically changed the frequency or intensity of hurricanes. Recent experience is worrisome,” Buffett acknowledges.

He maintains that the outlook is uncertain. “Was this onslaught of more frequent and more intense storms merely an anomaly? Or was it caused by changes in climate, water temperature or other variables we don’t fully understand? And could these factors be developing in a manner that will soon produce disasters dwarfing Katrina?” Buffett asks.

Buffett admits that neither he nor his reinsurers knows he answers but he advises that in the absence of answers, insurers must proceed with caution.

“What we do know is that our ignorance means we must follow the course prescribed by Pascal in his famous wager about the existence of God. As you may recall, he concluded that since he didn’t know the answer, his personal gain/loss ratio dictated an affirmative conclusion,” Buffett writes.

Following Pascal’s example means higher prices and more selective underwriting. “So guided, we’ve concluded that we should now write mega-cat policies only at prices far higher than prevailed last year – and then only with an aggregate exposure that would not cause us distress if shifts in some important variable produce far more costly storms in the near future. To a lesser degree, we felt this way after 2004 – and cut back our writings when prices didn’t move. Now our caution has intensified.

“If prices seem appropriate, however, we continue to have both the ability and the appetite to be the largest writer of mega-cat coverage in the world,” the chairman maintains.

More acquisitions
Berkshire acquired five companies in 2005. Among them was the June 30 acquisition of Medical Protective Company (MedPro), a 106-year-old medical malpractice insurer based in Fort Wayne. “Malpractice insurance is tough to underwrite and has proved to be a graveyard for many insurers. MedPro nevertheless should do well. It will have the attitudinal advantage that all Berkshire insurers share, wherein underwriting discipline trumps all other goals. Additionally, as part of Berkshire, MedPro has financial strength far exceeding that of its competitors, a quality assuring doctors that long-to-settle claims will not end up back on their doorstep because their insurer failed. Finally, the company has a smart and energetic CEO, Tim Kenesey, who instinctively thinks like a Berkshire manager,” Buffett reports.

In December Buffet also agreed to buy 81 percent of Applied Underwriters, a company that offers a combination of payroll services and workers’ compensation insurance to small businesses. A majority of Applied’s customers are located in California.

Buffett says his firm got to know the principals of Applied Underwriters, Sid Ferenc and Steve Menzies, a year ago when Applied entered into a reinsurance agreement with Berkshire’s National Indemnity. “They started on a shoestring only 12 years ago, and it will be fun to see what they can accomplish with Berkshire’s backing,” Buffett says of Ferenc and Menzies.

Immediately after the purchase, Berkshire increased MedPro’s loss reserves by about $125 million to avoid any surprises in coming months and years. Buffet explains why:

“No one knows with any precision what amount will be required to pay the claims we inherited. Medical malpractice insurance is a ‘long-tail’ line, meaning that claims often take many years to settle. In addition, there are other losses that have occurred, but that we won’t even hear about for some time. One thing, though, we have learned – the hard way – after many years in the business: Surprises in insurance are far from symmetrical. You are lucky if you get one that is pleasant for every 10 that go the other way.”

He contrasts Berkshire’s approach to MedPro’s reserves with how other insurers might react. “Too often, however, insurers react to looming loss problems with optimism. They behave like the fellow in a switchblade fight who, after his opponent has taken a mighty swipe at his throat, exclaimed, ‘You never touched me.’ His adversary’s reply: ‘Just wait until you try to shake your head.'”

Praise for Geico
Auto policies in force grew by 12.1 percent at Geico, increasing its market share of U.S. private passenger auto business from about 5.6 percent to about 6.1 percent, according to the company. According to Buffett, each share point equates to $1.6 billion in sales.

Buffett believes the Geico brand has grown significantly, although he says it is hard to quantify. In 1996, Geico spent $31 million on advertising, whereas last year it spent $502 million. “And I can’t wait to spend more,” Buffett writes, proclaiming that the advertising works “because we have a great story to tell: More people can save money by insuring with us than is the case with any other national carrier offering policies to all comers.” He qualifies that boast by noting that “some specialized auto insurers do particularly well for applicants fitting into their niches; also, because our national competitors use rating systems that differ from ours, they will sometimes beat our price. ”

There is more good news about Geico. Last year Geico achieved by far the highest conversion rate – the percentage of Internet and phone quotes turned into sales – in its history. “This is powerful evidence that our prices are more attractive relative to the competition than ever before,” he comments.

Geico’s reentry into the New Jersey auto market in August 2004 has been a success, according to the chairman. He claims that Geico is poised to become that state’s third largest auto insurer by 2007. “Drivers in that state love us. Our retention rate there for new policyholders is running higher than in any other state, and by sometime in 2007, GEICO is likely to become the third largest auto insurer in New Jersey.”

Gen Re derivatives
Berkshire lost $104 million pre-tax last year in its continuing attempt to exit Gen Re’s derivative operation. Its aggregate losses since it began trying to exit this business total $404 million. Buffett has little good to say about this Gen Re venture and he blames himself for not acting quickly to exit the line.

Originally Gen Re had 23,218 contracts outstanding. By the start of 2005 that number was down to 2,890 but “the blood has kept flowing.” According to Buffett, one of the contracts liquidated in 2005 had a term of 100 years. “It’s difficult to imagine what ‘need’ such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books.”

“The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation,” Buffett confesses to shareholders. Instead, he adds, he wasted several years trying to sell it.

He adds that when he finally winds up the Gen Re Securities derivatives, his feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”

Hank Greenberg
Finally, Buffett leaves his shareholders with some advice for compensation committees on the tendency to overpay chief executives. The advice is from Hank Greenberg— the former Detroit baseball, not the former AIG insurance, slugger who was a boyhood hero.

“Hank’s son, Steve, at one time was a player’s agent. Representing an outfielder in negotiations with a major league club, Steve sounded out his dad about the size of the signing bonus he should ask for. Hank, a true pay-for-performance guy, got straight to the point, ‘What did he hit last year?’ When Steve answered ‘.246,’ Hank’s comeback was immediate: ‘Ask for a uniform.'”

Buffett is preparing for Berkshire’s annual meeting in Utah on May 6, a gathering he calls the “Woodstock for Capitalists.”