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Berkshire’s Buffett still high on insurance despite catastrophe risk

Gen Re misfortunes overcome by Geico’s stellar performance, Buffett says

Warren E. Buffett, the billionaire chairman of giant Berkshire Hathaway, praises the performance of his primary insurance units, particularly Geico, in his annual letter to shareholders and acknowledges that concern over hurricanes has prompted his insurance subsidiaries to raise prices and underwrite more carefully.

Even with his concerns over catastrophe losses from future storms, Buffett appears confident in his insurance operations.

He suggests that auto insurer Geico is prepared to spend even more than its current $500 million annually on advertising to further increase its market share, and he hails the reentry of Geico into New Jersey as a success.

He also reports on the late-2005 acquisitions of a medical malpractice writer and a workers’ compensation firm.

But Buffet makes no mention of the legal and regulatory problems that have dogged his General Reinsurance unit because of allegedly inappropriate reinsurance deals with American International Group, although he does apologize for problems General Re is having exiting the derivatives business.

“Berkshire had a decent year in 2005,” Buffett writes, citing a gain in net worth for 2005 of $5.6 billion, which increased the per-share book value of its stock by 6.4 percent. Over the last 41 years since Buffett took over, book value has grown from $19 to $59,377, a rate of 21.5 percent compounded annually, according to his letter.

Berkshire posted net income for all of 2005 of $8.5 billion, up from $7.3 billion in 2004. Revenue for the year was $81.7 billion, compared to $74.4 billion in 2004.

General Re reported a $334 million underwriting loss while other Berkshire reinsurers’ losses topped $1 billion. But that result was overcome, thanks to Geico’s performance, and the insurance group posted an overall profit.

In his letter, Buffett forecasts that in order to deliver better gains in the future, Berkshire will need to make major acquisitions.

Insurance Despite $3.4 billion in losses from hurricanes Katrina, Rita and Wilma for General Re and National Indemnity, Berkshire Hathaway companies in the aggregate had an underwriting profit of $324 million on $1,270 million of volume, thanks to the performance of giant auto writer Geico and some of the smaller insurers in the Berkshire family.

“Credit Geico-and its brilliant CEO, Tony Nicely-for our stellar insurance results in a disaster-ridden year. One statistic stands out: In just two years, GEICO improved its productivity by 32 percent. Remarkably, employment fell by 4 percent even as policy count grew by 26 percent-and more gains are in store,” he said.

Hurricane season’s effects

In addition to causing financial damage, the 2005 hurricane season has raised questions at General Re and National Indemnity. “It’s an open question whether atmospheric, oceanic or other causal factors have dramatically changed the frequency or intensity of hurricanes. Recent experience is worrisome,” Buffett acknowledges.

He maintains that the outlook is uncertain. “Was this onslaught of more frequent and more intense storms merely an anomaly? Or was it caused by changes in climate, water temperature or other variables we don’t fully understand? And could these factors be developing in a manner that will soon produce disasters dwarfing Katrina?” Buffett asks.

Buffett admits that neither he nor his reinsurers knows the answers but he advises that in the absence of answers, insurers must proceed with caution, meaning higher prices and more selective underwriting.

“So guided, we’ve concluded that we should now write mega-cat policies only at prices far higher than prevailed last year-and then only with an aggregate exposure that would not cause us distress if shifts in some important variable produce far more costly storms in the near future.

“If prices seem appropriate, however, we continue to have both the ability and the appetite to be the largest writer of mega-cat coverage in the world,” the chairman wrote.

More acquisitions

Berkshire acquired five companies in 2005. Among them was the June 30 acquisition of Medical Protective Company (MedPro), a 106-year-old medical malpractice insurer based in Fort Wayne, Ind. Immediately after the purchase, Berkshire increased MedPro’s loss reserves by about $125 million to avoid any surprises in coming months and years. Buffet explains why:

“No one knows with any precision what amount will be required to pay the claims we inherited. Medical malpractice insurance is a ‘long-tail’ line, meaning that claims often take many years to settle.”

In December Buffet also agreed to buy 81 percent of Applied Underwriters, a company that offers a combination of payroll services and workers’ compensation insurance to small businesses. A majority of Applied’s customers are located in California.

Praise for Geico

Auto policies in force grew by 12.1 percent at Geico, increasing its market share of U.S. private passenger auto business from about 5.6 percent to about 6.1 percent. According to Buffett, each share point equates to $1.6 billion in sales.

Buffett believes the Geico brand has grown significantly, although he says it is hard to quantify. In 1996, Geico spent $31 million on advertising, whereas last year it spent $502 million. “And I can’t wait to spend more,” Buffett writes, proclaiming that the advertising works “because we have a great story to tell: More people can save money by insuring with us than is the case with any other national carrier offering policies to all comers.” Last year Geico achieved by far the highest conversion rate-the percentage of Internet and phone quotes turned into sales-in its history.

Geico’s reentry into the New Jersey auto market in August 2004 has been a success, according to the chairman. He claims that Geico is poised to become that state’s third largest auto insurer by 2007.

Gen Re derivatives

Berkshire lost $104 million pre-tax last year in its continuing attempt to exit Gen Re’s derivative operation. Its aggregate losses since it began trying to exit this business total $404 million. Buffett has little good to say about this Gen Re venture and he blames himself for not acting quickly to exit the line.

Originally Gen Re had 23,218 contracts outstanding. By the start of 2005 that number was down to 2,890 but “the blood has kept flowing.” According to Buffett, one of the contracts liquidated in 2005 had a term of 100 years. “It’s difficult to imagine what ‘need’ such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books.”

“The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation,” Buffett confesses to shareholders. Instead, he adds, he wasted several years trying to sell it.

He adds that when he finally winds up the Gen Re derivatives, his feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”


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