OK, Bash Buffett -- but Buy His Stock

Here's what Buffett had to say in his annual letter to Berkshire Hathaway shareholders:

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. We know, for instance, that in the 100 years before 2004, about 59 hurricanes of Category 3 strength, or greater, hit the Southeastern and Gulf Coast states, and that only three of these were Category 5s. We further know that in 2004 there were three Category 3 storms that hammered those areas and that these were followed by four more in 2005, one of them, Katrina, the most destructive hurricane in industry history. Moreover, there were three Category 5s near the coast last year that fortunately weakened before landfall.

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 doesn't claim to have the answers. But he does know what the prudent insurance company should do about the possibility of increased losses: raise premiums. "We've concluded," Buffett reports, "that we should now write policies only at prices far higher than prevailed last year."

So even if the 2006 hurricane season is as bad as that of 2005, General Re will have gone into it writing insurance with higher premiums and, probably as a consequence, writing fewer policies. Higher prices and less risk. That's a solid improvement for 2006.

Dogged by Derivatives

But the big storm losses in reinsurance weren't the only problems that General Re caused for Berkshire Hathaway in 2005. Quite frankly, it looks like someone slipped up when Berkshire Hathaway bought General Re in 1998. Not only did the company drag Buffett into the investigation about accounting fraud at American International Group(AIG Quote), General Re also brought along a huge book of derivative contracts that Buffett has belatedly moved to sell and shut down.

When Berkshire Hathaway bought General Re, the company had a book of 23,218 derivative contracts. A derivative in this case is a contract between two parties in which one sells risk and the other buys it for a price. The terms of how and when that risk will be transferred are extremely specific and highly variable, ranging from moves in interest rates and currencies to changes in the value or yield of specific securities. Time periods can also vary: One in the General Re book, Buffett notes, was set to run for 100 years.

The problem with derivatives of such widely varying terms and durations is that there isn't a liquid market for many derivatives. That makes them hard to trade and hard to price. Exactly how hard to trade is something Berkshire Hathaway discovered when it began to shut down General Re's derivatives book. Selling the first 20,000 contracts produced a $300 million loss. Selling the next 2,150 cost the company a loss of $104 million. At the beginning of 2006, only 741 contracts remained for disposal.