Buffett's Risky Bet on Reinsurance

National Indemnity Company, a subsidiary of Berkshire Hathaway (BRKA Quote), is making big bets on retroactive reinsurance, which helps distressed insurers offload past losses.

While this might seem like a dicey business, Berkshire Chairman Warren Buffett has said that he expects National Indemnity to earn enough interest by investing the premiums it acquires with the claims to offset expected losses.

But this strategy assumes that National Indemnity has enough time to invest enough of this money before it has to pay it out in claims -- a concept known in the insurance industry as the "time value of money." Based on the $2.2 billion statutory loss it recorded in the first quarter of 2007, it's not clear that it will have enough.

According to the company's latest regulatory filing, the entire amount stemmed from a single retroactive reinsurance contract with Equitas, a liability run-off reinsurer for Lloyds of London, just one year earlier, in March 2006. (National Indemnity's financial health is rated "B" by TheStreet.com Ratings.)

National Indemnity is Berkshire's largest insurance unit, and it is among the world's largest sellers of retroactive reinsurance. Still, the magnitude of recorded losses related to the Equitas deal in the first quarter makes you wonder if the extent of the liabilities were adequately disclosed.

To put the size of this loss in perspective, the insurance industry as a whole reported a 1.9% decline in net income for the first quarter over the same period of 2006. But if we exclude National Indemnity's results, the industry would have reported a 2.4% year-on-year gain in net income. (Net income would amount to $17.7 billion compared with $16.9 billion as of first-quarter 2007.)