Buffett criticises traditional reinsurance model

In his much-anticipated and widely read annual letter to shareholders, Berkshire Hathaway chairman Warren Buffett has sparked much debate about the future of the reinsurance industry and its competing models after criticising the business model of some of its oldest and most established players.

In a lengthy and detailed letter, Buffett explained in unprecedented detail the way he views the insurance industry and the best way of making money in it. Many of his entities use the hedge fund style, or asset manager backed reinsurance strategy that is becoming increasingly prevalent in the industry.

He explained in detail the importance to such a strategy of what he calls the premium float. This is essentially money that his companies hold collected as premiums but not yet paid out as claims. He describes it as “money that doesn’t belong to us but that we can invest for Berkshire’s benefit”.

The size of Berkshire Hathaway’s float is now eye watering. Through making underwriting profits for the last 11 years in a row, its float has grown from $41 billion to $77 billion. This is even more remarkable given that in 1970 Berkshire Hathaway’s insurance float was $39 million.

This size combined with the diversity of its underlying operations allows it to make more risky investments than most reinsurance carriers or smaller hedge funds. Buffett also makes the point that when a company’s float is this big, any underwriting profits on top effectively become free money.

“If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it,” Buffett said in the letter.

He is also scathing of the intense competition generated by the reinsurance industry that often results in companies making underwriting losses. This loss, he says, is effectively what the industry pays to hold its float. When this dynamic is combined with investing the float in a conservative way, the industry does not then perform as well as it should.

The group’s biggest float by far is generated by Berkshire Hathaway Reinsurance Group, managed by Ajit Jain. While Jain is well known for insuring risks that no one else has the desire or the capital to take on, Buffett also puts this strategy in a wider context. So diversified is Berkshire Hathaway as a whole, he argues, that “he never exposes Berkshire to risks that are inappropriate in relation to our resources”.

Buffett contrasts this with the exposure many big reinsurers have to large one-off catastrophe events. “If the insurance industry should experience a $250 billion loss from some mega-catastrophe – a loss about triple anything it has ever experienced – Berkshire as a whole would likely record a significant profit for the year because of its many streams of earnings,” Buffett said. “And we would remain awash in cash, looking for large opportunities if the catastrophe caused markets to go into shock. All other major insurers and reinsurers would meanwhile be far in the red, with some facing insolvency.”

Buffett also highlighted the deep regard with which he believes Berkshire Hathaway is now held in the industry. He described insurance as simply the sale of promises and went onto say: “Berkshire’s promises have no equal, a fact affirmed in recent years by the actions of the world’s largest and most sophisticated insurers, some of which have wanted to shed themselves of huge and exceptionally long-lived liabilities, particularly those involving asbestos claims.

“That is, these insurers wished to “cede” their liabilities to a reinsurer. Choosing the wrong reinsurer, however – one that down the road proved to be financially strapped or a bad actor – would put the original insurer in danger of getting the liabilities right back in its lap. Almost without exception, the largest insurers seeking aid came to Berkshire.”