Berkshire Hathaway and Loss Portfolio Transfers: Do They Make Sense?

Transcription

1 Berkshire Hathaway the New Goliath: Strategies for the Boy David Berkshire Hathaway and Loss Portfolio Transfers: Do They Make Sense? Jonathan Terrell President, KCIC Washington, DC INTRODUCTION Through a series of loss portfolio transfers ( LPTs ), primarily accomplished through a financial instrument know as retroactive reinsurance, Berkshire Hathaway ( Berkshire ) has amassed the greatest concentration of legacy insurance liabilities in the industry and in history. Although LPTs are an ordinary part of the insurance industry, there is little ordinary about Berkshires Hathaway s focus on them. This phenomenon is about the most talked about subject among corporate policyholders, their coverage counsel and their defense counsel, yet it has been strangely ignored by conference organizers (ABA excepted!) and has been flying under the regulatory radar. Although I was aware of the significant retroactive reinsurance transactions that various insurance companies had entered into with Berkshire through my role as a provider of consulting services to corporate policyholders for many years, my particular interest in this subject dates from the transactions announced in 2006 between Berkshire and Equitas in which Berkshire agreed to reinsure the liabilities of Equitas and provide an 1

2 additional $7 billion in reinsurance protection. 1 Simply put, I thought Berkshire (or more accurately Ajit Jain, Warren Buffett s senior lieutenant who runs Berkshire s reinsurance operations) must be crazy. Who in their right mind would take on so significant a book of business, and then provide so enormous an increase in protection, for legacy liabilities dominated by some of the most volatile classes of claim, such as those related to asbestos personal injury? But upon further reflection and analysis, I could see that the transactions did make financial sense from Berkshire s standpoint. This paper explores why. LOSS PORTFOLIO TRANSFERS As is explored more extensively in the accompanying paper by Laura Foggan, LPTs are an accepted feature of the insurance industry. They offer many potential benefits for insurers. They are accomplished by a variety of mechanisms including Part VII Transfers (in the UK), acquisition, and through retroactive reinsurance. More recently, Statement of Statutory Accounting Principles No. 62, revised in December 2012, has provided another mechanism, Accounting for the Transfer of Property and Casualty Run- Off Agreements. In the case of the reinsurance mechanisms, there is nothing in the accounting literature that discusses the packaging of claims administration (also referred to as run-off services) as a part of the transactions. The two arguments most frequently made by insurers as to why policyholders might stand to gain something from a LPT are that a stronger, more creditworthy insurer may be substituted for the original one, and that the claims handling expertise may be greater with the new entity. The usual advantage cited for the exiting insurer is that it enables the insurer to focus on business lines that are considered core to its future and to improve its capital position. The use of terms like reinsurance and run-off agent are frequently argued to indicate that nothing has really changed for corporate policyholders subject to the transactions, but the common sense answer and economic reality for a corporate policyholder is that the counterparty to their insurance contract has changed, the claims department has changed, and the motivations, values and competence for the new regime may be different, sometimes vastly different. Throughout this article I will refer to Berkshire as the whole of the Berkshire Hathaway enterprise, National Indemnity Company ( NICO ), which is an insurance company and subsidiary of Berkshire and the entity through which Berkshire transacts most of its LPTs, and Resolute Management Inc. ( Resolute ), a Berkshire subsidiary and the principal claims handling entity for the LPTs. HOW MUCH LPT RISK IS BERKSHIRE CARRYING? This is an easy question to ask, but a hard one to answer accurately given the obfuscations of retroactive reinsurance accounting. 1 Equitas was established to reinsure and run-off the 1992 and prior years non-life liabilities of Names, or Underwriters, at Lloyds of London. 2

3 Firstly, what it is not. The AM Best Special Report on US Asbestos & Environmental Liabilities reports that net asbestos environmental reserves for the US Property and Casualty industry were $28.3 billion at year end It further reports that Berkshire s share of those liabilities was $2.6 billion, or 9.1%. In other words, a significant share, but nothing like the concentration I am describing in this article. A few caveats. First, Berkshire s LPT activity is not limited to asbestos and environmental claims, for example the HDI-Gerling deal dealt with a book of business primarily written after those classes of claims were excluded from the subject insurance policies. Second, Berkshire enters into more LPTs with non-us insurance companies than with US companies, for example the Equitas deal. As far as the first caveat is concerned, the majority of Berkshire s LPTs are for asbestos and/or environmental exposures, so the reference point is valid. As far as the second caveat is concerned, my intention is to use the total US reserves as a reference point to illustrate the enormity of the concentration at Berkshire rather than an attempt to quantify Berkshire s share of worldwide exposures. As mentioned above, the obfuscations of retroactive reinsurance accounting make this analysis challenging. Don t worry, I will not get into a dissertation on reinsurance accounting here. Suffice to say that retroactive reinsurance is a completely different animal economically and in accounting treatment than the (normal) prospective reinsurance that we all know and love. The statutory accounting rules are mindbendingly complicated, and are primarily designed to avoid the abuse of the transactions to manufacture statutory surplus. Other than certain additional disclosures, the ceding insurer (e.g. AIG) and the assuming reinsurer (e.g. NICO) still do their reserve accounting as though NOTHING has happened. The LPTs that Berkshire has accounted for as retroactive reinsurance do not show up in the numbers that AM Best uses for its special report as Berkshire liabilities at all. So let s have a look at Berkshire s retroactive reinsurance disclosures. Berkshire s insurance subsidiary, NICO, is the entity that Berkshire primarily uses as the counterparty to its retroactive reinsurance transactions. Not exclusively, as other entities are used as well, but having perused their financial statements, I can confirm that the vast majority of the risks are at NICO and I will confine, for the sake of simplicity, this analysis to NICO s disclosures. For this purpose I am referring to NICO s Annual Statement for the year ended December 31, 2012, obtained from the NAIC website and prepared according to statutory accounting principles. 3 NICO does not publish financial statements prepared according to generally accepted accounting principles. Note 23 section F contains the disclosures that are required by Statement of Statutory Accounting Principles No. 62. The disclosure is exhibited to this article. We learn many interesting things from this disclosure. First, according to NICO s reckoning, the original amount reserved for the liabilities reinsured under its retroactive 2 Best s Special Report: U.S. Asbestos & Environmental Liabilities (2013, October 28). Asbestos Losses Fueled by Rising Number of Lung Cancer Cases

4 reinsurance deals is $29.1 billion. These are the initial reserves that NICO established at the close of each deal. These are not necessarily the same as the reserves on the books of the ceding insurer at that time as there is no requirement for consistency and in many cases the reserves are different. Nevertheless, it is a staggeringly large number; NICO has historically taken on, by its own reckoning, more liabilities through retroactive reinsurance deals than the entire US property and casualty industry has currently reserved for asbestos and environmental exposures. We further learn that NICO currently reckons that the needed reserves for those same liabilities is $17.6 billion, $11.5 billion less, the result of $3.5 billion in claim payments and $8.0 billion in reserve reductions. We also note that NICO has received $22.1 billion in premiums under the retroactive reinsurance deals. The disclosure goes on to note limited details about the various deals. We observe that NICO discloses that it has assumed liabilities under 36 separate retroactive reinsurance deals, and we can see the carried reserves for each of them. For instance, we can see that NICO was carrying reserves of $2.1 billion with respect to its deal with AIG (for which is received a premium of $1.65 billion and wrote aggregate limits of $3.5 billion). 4 It is also interesting to note that out of the 36 deals, 22 are for non-us entities, and the carried reserves for the non-us entities are $11.2 billion out of the $17.6 billion. My own conservative estimate is that at least $13.8 billion of those carried reserves of $17.6 billion are for asbestos and environmental liabilities. Relating this back to the AM Best Special report, we can see that Berkshire s ordinary reserve disclosures of $2.1 billion for environmental and asbestos liability are only a small fraction of their real exposures, which are multiples of this amount and the largest concentration of long-tail risk in the industry and in history. THE ECONOMICS OF LPTs While retroactive reinsurance sounds complicated, and the accounting is extremely complicated, the fundamental economics are relatively straightforward. The economics of retroactive reinsurance can be understood from the following four elements: 1. Premium. The ceding insurance company pays a premium to Berkshire (usually to NICO). As discussed above, NICO discloses that is has received approximately $22.1 billion for the retroactive reinsurance deals currently on its books. 2. Limits. In return for the premium, NICO provides retroactive reinsurance subject to agreed limits. For instance, in the AIG deal discussed above, an overall aggregate limit of $3.5 billion is the limit of NICO s payment obligation under the contract. The limits are net of prospective reinsurance. This means that any prospective reinsurance assets of the counterparty to the retroactive reinsurance deal are transferred to NICO along with the liabilities under the subject direct 4 Chartis. (2011, April 20). Chartis to Transfer Asbestos Liabilities to National Indemnity Company [Press release]. 4

5 insurance policies. NICO can claim on those prospective reinsurance policies, and the aggregate limit of $3.5 billion is net of any such reinsurance recoveries. 3. Investment return. The premium provides float to the Berkshire venture to invest in its portfolio of companies. 4. Cash flow. As claims are made on the underlying insurance policies, Berkshire, through Resolute, administers the claims on behalf of the insurer, including payments for defense, indemnity and related expenses, and itself makes claims on the related prospective reinsurance policies. This causes a gradual expenditure of the premium received, and beyond, up to a maximum of the agreed limit. HOW DO THESE TRANSACTIONS MAKE SENSE FOR BERKSHIRE? Putting the above observations together to answer the question in the introductory paragraph, LPTs do make a lot of sense for Berkshire for four important reasons. THE IMPORTANCE OF FLOAT TO THE BERKSHIRE ENTERPRISE The generation of float through its insurance activities is a very important source of cheap capital to Berkshire. In the LPTs, a premium is paid up front and claims are paid out some time later. In the meantime, Berkshire gets to invest the premium. The piece of the premium that has not been paid out in claims is called float. Generating a return on float is an ordinary part of the insurance business for insurance companies, but with Berkshire it is the main event indeed, it is the principal driving force motivating Berkshire to enter into the transactions. Let s see what the Oracle of Omaha himself has to say about float. 5 Our insurance operations continued their delivery of costless capital. This business produces float ($70.6 billion) money that doesn t belong to us, but that we get to invest for Berkshire s benefit. We will profit just as we would if some party deposited $70.6 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit. Buffett has made a specialty of buying companies when others are selling or when credit is tight. Berkshire entered into at least 15 significant transactions from 2008 through 2009 at the height of the global financial crisis. Of these, eight transactions were valued at $1 billion or more. Float is an important source of cheap capital to finance these transactions. NICO S BALANCE SHEET AND INVESTMENT RETURN NICO s balance sheet looks nothing like that of a normal insurance company. Common stock comprises just 11% of the investment portfolios of the insurance industry as a whole (and 26% of the P&C industry), with the vast majority of investments assets in cash and bonds. 6 5 Buffett, W. E. (2011). Letter from Warren E. Buffet to the shareholders of Berkshire Hathaway Inc. Berkshire Hathaway Inc.: Shareholder letters. 6 NAIC Capital Markets Special Report (2013, September 24). Update on Insurance Industry Investment Portfolio Asset Mixes. 5

6 By marked contrast, the investments of NICO are concentrated in entirely different areas. Out of total assets of $127 billion, there are just $4.6 billion (3.6%) in bonds, $68 billion (53.3%) in common stock, and $44 billion (34.8%) in other investments, primarily in common stock equivalents. Most of NICO s investments in common stock or equivalents are very long term investments in relatively few companies. Sometimes the investments become so significant in particular companies that the accounting changes to that of a subsidiary company (e.g. BNSF). 7 NICO is able to enjoy a significantly superior investment performance than that of other insurance companies due to its focus on common stock investments. Although the risk-based capital treatment of such investments is less favorable than for other safer classes of asset, such as bonds, NICO has such a strong capital position that the regulatory restrictions have no impact on their investment choices. As a result of these investment choices, investment income is a far, far larger component of NICO s performance than for the P&C industry in general. In 2012, although NICO only accounted for 1.5% of net premiums written, it generated 19.1% of the $68 billion in investment returns. NICO is no ordinary insurance company. Warren Buffett s own preferred measure of performance is the annual percentage change in book value per share. The Berkshire empire is a complicated business to analyze given its myriad of component parts. The Buffett measure is a conservative one and is akin to looking at the liquidation value of the company and how that changes from year to year. The 2012 letter to shareholders tells us that the annual change in book value per share has been on average 19.7% over the life of the company, and $13.0% over the last four years. Based on the first three quarters of 2013, it looks like 2013 will be better than the four year average. THE PACKAGING OF RUN-OFF SERVICES Berkshire almost always seeks to package run-off services, and claims administration in particular, with its LPTs. These are no ordinary third party administration arrangements as are common in the industry, especially for classes of claims like workers compensation. The provision of run-off services is typically an intrinsic part of the NICO LPT contract, with very broad powers and great concentration of claims authority in very senior officers of NICO. We have also in recent years seen significant internal reorganization within Resolute, with the abandonment of their divisional structure and the consolidation of all claims activities under Thomas Ryan. Resolute has also ended arrangements that it formally had with other claims organizations, such as Cavell and the Equitas claims handlers, and consolidated as much as possible. 7 Berkshire Hathaway. Links to Berkshire Subsidiary Companies. 6

7 The result of these contractual and organizational arrangements is that NICO is able to manage the cash flows under its LPTs with at least as much control, and generally more control, than the original insurers. MARKET PRESENCE As discussed above, NICO has an enormous market presence. Between its LPTs with Equitas, the London companies, AIG, Continental etc., it is not unusual for a corporate policyholder to have upwards of 80% of its remaining long-tail coverage controlled by NICO. Combined with the consolidation of claims handling discussed in the previous paragraph, this represents a significant shift in the relative bargaining positions. Where a company may have deliberately diversified its placement of its insurance programs among a number of insurance companies, the LPTs have the opposite effect and consolidate risk and authority at a single entity. For a company that is very reliant on its insurance program for the reimbursement of its defense and indemnity costs, this can represent a material change in the quality of its insurance asset. This market presence and Resolute s claims handling philosophies extend into their relationships with the defense bar and ultimately the plaintiffs bar. Like a Walmart, Resolute is a bulk buyer of defense services from law firms and is able to negotiate fee discounts, substitute its preferred firms, and impose a defense strategy in a way that would have been unachievable for the individual insurance companies, now bundled together in the various LPTs. These same dynamics may allow it to negotiate with plaintiffs from a position of unity among the various insurance companies as never before. CONCLUSION LPTs offer an attractive source of cheap capital, especially during times of tight credit. Berkshire is able to deploy this capital in investments of a very different kind as compared to typical insurance companies, and thereby to generate returns that are far higher. Berkshire s market presence and the tight consolidation and control over claims handling mitigate the risks to Berkshire associated with actual cash flows under the contracts being higher than anticipated. Whether the LPTs are a good thing for policyholders, and whether this concentration of risk at a single entity is good public policy is another matter. Jonathan Terrell is the founder and President of KCIC, a consulting firm that focuses on providing quantitative, litigation and strategic consulting services to corporate policyholders and their legal counsel. He has decades of financial services experience gained in London, New York, Paris and Washington DC with a background that crosses accounting, finance, insurance and banking disciplines. Mr. Terrell has made a special study of Berkshire Hathaway s involvement with Loss Portfolio Transfers, and led an ABA roundtable on the subject two years ago. He has been retained as an expert witness in a number of cases concerning various aspects of these LPTs and in addition is in demand for testimony concerning insurance company solvency, economic damages and insurance asset valuation. 7

8 Before establishing KCIC, Mr. Terrell was an Executive Vice President with Zurich Financial Services, a Vice President in JP Morgan s Capital Strategy and Quantitative Analysis Group, and worked with major international clients at Price Waterhouse and Ernst & Young in the banking and insurance industries. 8

9 APPENDIX A 9

10 APPENDIX A Continued 10