Notes On Berkshire Hathaway’s Insurance Policies

Notes On Berkshire Hathaway’s Insurance Policies
By Mark Hirschey (Work of Mark Hirschey) [<a href="">CC BY-SA 2.0</a>], <a href="">via Wikimedia Commons</a>

Notes On Berkshire Hathaway's Insurance Policies

Letting the document speak, here are a few notes, starting with with the most significant part of the risk factors:

Investments are unusually concentrated and fair values are subject to loss in value.

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We concentrate a high percentage of our investments in equity securities in a low number of companies and diversify our investment portfolios far less than is conventional in the insurance industry. A significant decline in the fair values of our larger investments may produce a material decline in our consolidated shareholders’ equity and our consolidated book value per share. Under certain circumstances, significant declines in the fair values of these investments may require the recognition of other than-temporary impairment losses.

A large percentage of our investments are held in our insurance companies and a decrease in the fair values of our investments could produce a large decline in statutory surplus. Our large statutory surplus serves as a competitive advantage, and a material decline could have a material adverse affect our ability to write new insurance business thus affecting our future underwriting profitability.

Warren Buffett does very well, but I know of no other insurer that invests so much in equities funded by insurance liabilities.  There is a real risk that if the markets fall hard, a la 1929-32, 1973-4, 2007-8. that Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) would be hard-pressed, particularly if there were some significant disaster like Katrina or Sandy, or set of disasters like 2004 or 2011.

And a note on the accounting change that Buffett mentioned in his letter, but did not decide to describe:

Underwriting expenses incurred in 2012 increased $586 million (21.1%) compared with 2011. The increase was primarily the result of a change in U.S. GAAP concerning deferred policy acquisition costs (“DPAC”). DPAC represents the underwriting costs that are eligible to be capitalized and expensed as premiums are earned over the policy period. Upon adoption of the new accounting standard as of January 1, 2012, GEICO ceased deferring a large portion of its advertising costs. The new accounting standard was adopted on a prospective basis and as a result, DPAC recorded as of December 31, 2011 was amortized to expense over the remainder of the related policy periods in 2012. Policy acquisition costs related to policies written and renewed after December 31, 2011 are being deferred at lower levels than in the past. The new accounting standard for DPAC does not impact the cash basis periodic underwriting costs or our assessment of GEICO’s underwriting performance. However, the new accounting standard accelerates the timing of when certain underwriting costs are recognized in earnings. We estimate that GEICO’s underwriting expenses in 2012 would have been about $410 million less had we computed DPAC under the prior accounting standard and that, as a result, GEICO’s expense ratio (the ratio of underwriting expenses to premiums earned) in 2012 would have been less than in 2011.

The point is that Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s underwriting result would have been very good without the accounting change.  The accounting change was a good thing, though.  Companies trying to inflate profits look for every marketing expense that they can deem an “investment.”  All of those costs would be spread over the life of the policies, rather expensed in the current year.  The new accounting standard limits what costs can be expensed to those that are truly marginal to the business produced.

Final note: They lost money on annuity reinsurance and retro at Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) Reinsurance Group [Pp 34-36].  Retro sprang from new claims.  On annuities:

The annuity business generated underwriting losses of $178 million in 2012, $118 million in 2011 and $114 million in 2010. Annuity underwriting losses reflect the periodic discount accretion of the discounted liabilities established for such contracts as well as adjustments for mortality experience.

I am not sure I would want to reinsure annuities; I’m not sure that it is possible to insure long term investment guarantees, no matter how truncated.

Full disclosure: long BRK/B

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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