Berkshire Earnings Hit by Sept. 11th

Berkshire Hathaway’s boss Warren Buffett didn’t become America’s most successful investor, and one of its richest men, by making mistakes, so when General Re suffered a $2.4 billion hit from the WTC attacks, everyone waited to see what the impact would be on Berkshire’s earnings, and how he would handle it.

The answer came on March 9 when the giant investment company reported a net profit of $795 million for the year 2001, compared to $3.3 billion the year before, a 76 percent drop. Even worse, if $842 million in capital gains were removed Berkshire would have had an operating loss for the year of $47 million.

Buffett’s credo over the years has been to invest in companies that make products he understands – Coca Cola, carpets, paints, and to a great extent insurance companies. They make up around 60 percent of Berkshire’s investment portfolio, headed by General & Cologne Re and GEICO. If the insurance industry falters, which is perhaps too mild a term to describe what happened last year, Berkshire’s earnings suffer accordingly.

The problem isn’t Buffett’s, it’s the industry’s. An insurance company is only as good as the underwriters who accept the risks the company insures, and General Re’s were supposed to be among the best.

In his annual letter to Berkshire shareholders Buffett reiterated the importance of “underwriting discipline.” In September he brought in a new team at General Re, appointing Joe Brandon as the new CEO and Ted Montross as the new president. They’re “committed to producing underwriting profits,” he told shareholders.

In a cogent explanation of the cost of the “float,” i.e. the funds available for investment that an insurer holds as premiums paid against future claims, Buffett admitted that, although he had foreseen the possibility of a Sept. 11 type disaster, he hadn’t reacted. “Why, you might ask, didn’t I recognize the above facts before September 11th?” he wrote. “The answer, sadly, is that I did—but I didn’t convert thought into action. I violated the Noah rule: Predicting rain doesn’t count; building arks does. I consequently let Berkshire operate with a dangerous level of risk—at General Re in particular. I’m sorry to say that much risk for which we haven’t been compensated remains on our books, but it is running off by the day.”

In acknowledging that the Sept. 11 attacks were beyond any previous experience, but still happened, Buffett confirmed the insurance industry’s increasing need to develop probabilistic modeling to try and gauge the full spectra of possible risks, not just those that have happened before. A company the size of General Re, backed by Berkshire, can afford such losses—once. But the terrorist attacks brought home in the most forceful way possible the necessity of adequately analyzing the risks and pricing the coverage accordingly.

“Insurers have always found it costly to ignore new exposures. Doing that in the case of terrorism, however, could literally bankrupt the industry,” Buffett warned. While no one can accurately predict the probability of another Sept.11, or of related perils such as the explosion of a nuclear device or biological and chemical attacks, Buffett stated that, “The probability of such mind-boggling disasters, though likely very low at present, is not zero.” He feels that the probabilities are actually increasing, and that “the war against terrorism can never be won. The best the nation can achieve is a long succession of stalemates. There can be no checkmate against hydra-headed foes.” He also sees such attacks as causing “astronomical workers’ compensation claims.”

His conclusion is sobering.

“Under a ‘close-to-worst-case’ scenario, which could conceivably involve $1 trillion of damage, the insurance industry would be destroyed unless it manages in some manner to dramatically limit its assumption of terrorism risks. Only the U.S. government has the resources to absorb such a blow. If it is unwilling to do so on a prospective basis, the general citizenry must bear its own risks and count on the government to come to its rescue after a disaster occurs.”

General Re, GEICO, National Indemnity and Berkshire’s other insurance holdings aren’t alone in their reluctance, indeed refusal, to cover risks related to terrorism, although Buffett noted that in selected instances the companies would write terror coverage within specifically defined limits. In fact National took over insurance coverage for the 2002 Soccer World Cup when AXA pulled out after Sept. 11.

Buffett’s unwavering commitment to underwriting discipline comes through clearly in his list of the three “key principles” observed by the best underwriters, as follows:

They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.

They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.

They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.

Unlike windstorm and earthquake models, losses from urban terrorism haven’t had a top of the scale, once in a century, probability.
They do now.

Topics Catastrophe Profit Loss Market