I come not to bury Warren Buffett but to praise him.In the last week or so, two other financial pundits, Jon Markman on
Berkshire as Cash MachineBut one of the advantages of holding a stock for a while -- and I've owned Berkshire Hathaway in my personal portfolio since June 2003 -- is that you come to appreciate qualities that escaped you on first acquaintance. In this case, owning Berkshire Hathaway has given me a deep appreciation for exactly what an amazing cash-flow machine an insurance company can be. Insurance companies take in money in premiums from customers long before they have to pay it out in claims. They invest this float in stocks, bonds, real estate, pieces of other companies or whole companies and reap the returns until this money has to be paid out to customers who file claims. Thus an insurance company has two ways to make money: First, there's underwriting profit if the company succeeds in writing policies at a high enough premium that, when claims on those policies are paid out, there's something left over. (The industry uses something called the combined ratio as a measure of this underwriting profit. A combined ratio of 90%, for example, means that the company has paid out in claims just 90% of what it collected in premiums. It has earned 10 cents in profit on every dollar of premium collected.) Second, there's investment income. The company invests the float in some mixture of assets, looking for the highest return commensurate with the need to avoid losses that would endanger the company's ability to pay out claims. The insurance company also wants to build up its financial strength, as assessed by agencies, such as A.M. Best, that rate insurance companies. Many customers buy insurance on the basis of a company's financial strength.
Stormy Weather for ReinsurersFrom that point of view, 2005 was something of a test for Berkshire Hathaway. The company's General Re and National Indemnity reinsurance units took a huge hit from the combination of hurricanes Katrina, Rita and Wilma, losing $3.4 billion from the storms. Reinsurers buy risk by, in effect, insuring the ability of other insurance companies to pay claims in case of a catastrophic event. But thanks to Berkshire Hathaway's low-cost auto-insurance business, Geico, the company's insurance business as a whole showed a slim underwriting profit for the year of $53 million. That underwriting profit meant that in 2005, again, Berkshire Hathaway didn't pay a cent to use the capital that makes up its float. And since Berkshire Hathaway's float amounts to some $49 billion, that's a huge cost advantage in the investment business. While banks have to pay interest to depositors, and hedge funds have to share profits with their investors, Berkshire Hathaway can invest a no-cost $49 billion.
Battening Down, Raising PremiumsNeither Warren Buffett nor anyone else can predict how the 2006 hurricane season will shape up, though some readers have written me noting that water temperatures in the Gulf of Mexico are already higher than normal for this time of year, which is often a sign of a strong hurricane season to come. But after a disaster, a prudent insurance company always raises premiums and may indeed cut back on the risks it takes. And that, Buffett says, is exactly how General Re is approaching 2006.
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.