National Indemnity Company, a subsidiary of Berkshire Hathaway (BRKA), 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.)
Retroactive reinsurance provides coverage for insured losses under contracts written in the past, often many years ago. And although the contracts are subject to some aggregate loss limit, most often the losses paid will exceed the premiums received, in some instances by a wide margin. Still, the insurance companies involved in this business can profit, at least in theory, if they have enough time to put the original premiums to work before losses are paid out. It's an innovative concept but also a risky one. A spokesman for Berkshire Hathaway declined to comment beyond what National Indemnity has disclosed in regulatory filings. Equitas was set up in 1996 to reinsure longstanding claims related to asbestos, natural disasters and other liabilities. The transaction with National Indemnity ensures that Lloyd's will not run out of money, in which case obligation for the liabilities would have gone back to the U.K. insurance market's individual investors, known as "Names." National Indemnity has several years of experience reinsuring asbestos and environmental claims, and it has enough capital to absorb the loss recorded in the first quarter. As of March 31, it had assets of $74.4 billion. However, the loss it recorded on behalf of Equitas appears to have dented its policyholder surplus, which fell to $33.8 billion from $35.5 billion at the end of 2006.
But the question is not whether National Indemnity settle this loss, but whether it expects to pay out so much so fast. How much will the company end up paying if figures this size are showing up soon after the agreement, and can it earn enough by investing the remaining premium to make a profit? In exchange for assuming Equitas' exposure, National Indemnity received the U.K. reinsurers' $7.1 billion in assets. It also set aside an additional provision of $5.7 billion out of its own funds. The aggregate limit of indemnification, or the maximum it will have to pay out, is approximately $13.8 billion. With a $2.2 billion recorded statutory loss as of first-quarter 2007, nearly 16% of the reserve that has been set up has already been used. National Indemnity declined to comment on its agreement with Equitas beyond the material in its statutory statement for the first quarter. The Equitas deal accounts for just over half, or 53%, of National Indemnity's retroactive reinsurance business. Among its other deals is one entered into in March of this year to assume the liabilities of Sompo UK, a unit of Sompo Japan Insurance, through its own U.K. unit, Transfercom. The transfer of liabilities involves business written between 1950 and 2001, including policies with substantial asbestos claims and significant exposure to the World Trade Center losses.
National Indemnity has yet to file a statutory statement for the second quarter, so it's not clear whether the company has paid out any claims assumed from Sompo yet. There is a set limit of $482 million to pay for claims; $174 million is earmarked for claim liabilities, and an extra $308 million is available to meet reserve deterioration. Transfercom also has $43 million in share capital. This means it has a total of $525 million in total resources available to meet claims liabilities. You have to wonder what lies ahead when we see an insurer such as National Indemnity record a loss of this magnitude for a retroactive reinsurance agreement. We can only hope reinsurers are not taking on more liabilities than they can really afford.