Insurance is at the heart of Berkshire Hathaway. The first significant act after Warren Buffett took control of Berkshire was the 1967 purchase of National Indemnity for £8.6m. There are two main attractions to holding a well-run insurance company within the Berkshire fold. First, it might – although most insurance firms don’t – make a profit on underwriting. That is, what is pays out on claims together with its operating costs (wages etc) is less than it takes in premiums.
Second, the delay between policyholders handing over premiums and insurance claims being paid leads to a “float” of money being held in the company. When Buffett took control of National Indemnity it had a float of $17.3m. That was a considerable sum of money for Buffett to invest; after all Berkshire Hathaway then had less than $30m net assets. His skill would lead to large returns on money under his command.
Technically, accountants treat float as a liability for Berkshire because it is set to one day be paid out in claims. In truth, float is a tremendous asset in the right hands.
Experiencing the excitement of making money from float while achieving profitable underwriting (in most years) in the 1970s Buffett was determined to build up the insurance side of the business. To National Indemnity, he added an array of other companies, the most significant of which was GEICO. By 1998 the insurance side had a float of over $7bn and was generating annual premiums totalling nearly $5bn.
Then Buffett went for a giant leap by trebling the size of Berkshire’s float from $7bn to $22.8bn by buying market-leading General Re. It was paid for, not with cash, but by the issue of A and B shares amounting to approximately 272,200 Class A equivalent shares in Berkshire. This raised its issued share capital by 22% and doubled the number of shareholders in Berkshire to about 250,000.
In other words, after the deal former General Re shareholders owned over one-fifth of the economic worth of See’s Candies, FlightSafety, NFM and the other wholly-owned business as well as over one-fifth of Berkshire’s marketable securities such as its 8.1% holding of Coca Cola (worth $13.4bn) and its 11.3% holding in American Express (worth $8.4bn).
Also by issuing new shares in Berkshire Hathaway Warren Buffett’s share of the economic benefit from the enterprises owned by the group went down from 43% to 34% (he and his wife Susan between them held 38.4% of the voting rights through their holdings of A shares).
But what did Berkshire receive in return?
Buffett thought he was getting a conservatively run insurance company that either made underwriting profits or small losses here and there. And he was getting a $15bn float, greatly increasing his firepower. On acquisition he almost immediately reduced General Re’s investment office from 150 to one person, himself, to direct that float.
But the company came with a whole heap of trouble. It took Buffett and Munger years to sort out the problems, which ranged from under-pricing of insurance and poor provisioning for likely insurance claims to a massive number of derivative deals (over 23,000 contracts involving 884 counterparties). General Re bled money after Berkshire purchased it. In the first four years it lost $7.5bn on underwriting.
By the end of 2001, after the terrorist attack on the Twin Towers in New York, things got so bad that Buffett said General Re would have gone bust had it not been for the deep pockets of Berkshire to bail it out. At that point many, including Buffett, thought the purchase a mistake.
But later it was to become what Buffett called a “treasure”. The story of its fall and rise is instructive to anybody interested in investing in insurance companies, not least the importance of having managers with the right cautious mindset for creating float at low cost through taking on underwriting business with a rational profit-focused determination.
To understand the significance of the General Re acquisition we need to go right back to basics both in terms of where Berkshire’s insurance business came from and in how the insurance industry works.
Building on National Indemnity
Following the purchase of National Indemnity and its sister company National Fire and Marine Insurance Buffett too………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Prof. Glen Arnold
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