This is the second installment of a three-part series in response to reader questions.
The first article, published on June 21, was about performance disclosures for Berkshire’s investment managers:
Should Berkshire Hathaway Disclose Performance for Investment Managers?, June 21, 2023
Today’s article covers questions about the following topics:
- Reinsurance Outlook
- Inflation
- Insider Ownership
- Worst Case Scenarios
In a few days, I will publish the third and final article covering questions on Berkshire’s retained earnings test and return on invested capital.
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Reinsurance Outlook
“What is your outlook for Berkshire’s reinsurance businesses? I recall Chris Bloomstran saying that rising interest rates would result in large bond portfolio losses for the competition. Also Ajit mentioned at the Annual Meeting all the cat reinsurance they wrote at the end of Q1 + Warren snapped up Alleghany.”
Business conditions appear to be improving in the reinsurance industry after several years of unsatisfactory results. Toward the end of 2022 and into early 2023, a number of articles appeared about the emergence of a “hard market” in reinsurance. As an example, Insurance Journal published S&P Predicts Reinsurers Will Continue Pricing Momentum During 2023 on January 30 which is worth reading in its entirety.
Reinsurance price increases were “global and broad” according to S&P, necessitated by several years of poor financial returns for reinsurers and a difficult 2022 impacted by losses due to the war in Ukraine, inflation, and catastrophes including Hurricane Ian. Additionally, most reinsurers have a diminished capital position due to mark-to-market losses on fixed maturity investments caused by rising interest rates. Some reinsurers have exited lines of business and imposed new exclusions.
Insurance Journal’s article touches on the role of “alternative capital” which has been an important factor in recent years. With interest rates at microscopic levels for the better part of a decade, alternative capital was attracted to innovations such as insurance-linked securities, a subject that I wrote about several years ago. Now that interest rates are at more attractive levels, the incentive for alternative capital to take risk has been reduced, resulting in reduced exposure to investment vehicles taking catastrophe risk. This adds to the upward pressure on reinsurance pricing.
Berkshire Hathaway has significant advantages starting with the unsurpassed capitalization of its insurance subsidiaries which facilitates the ability of Ajit Jain and Warren Buffett to take on unusually large risks when the price is right.
As I discussed in March in quite a bit of detail, Berkshire’s fixed maturity portfolio is minuscule relative to its equity investments and cash holdings. Berkshire’s fixed maturity portfolio duration is also very short-term which has resulted in minimal mark-to-market losses. I don’t think it is an exaggeration to say that Ajit Jain is in the catbird seat when it comes to taking risks … for the right price.
At the Berkshire Hathaway annual meeting on May 6, Ajit Jain made a number of comments about the reinsurance business during the morning session. I suggest listening to that segment of the video (Question #21).
Here are some of the highlights from my notes:
- Property catastrophe has been a difficult business for the past fifteen years. Prices have been unattractive so Berkshire’s presence in property cat has been minimal. In other words, Berkshire just refuses to play when prices are low.
- Capacity increased at the end of 2022 which led to Berkshire not deploying as much capital as they hoped to for the December 31 renewal date, an important one in the reinsurance industry. However, the result of that discipline is that they had a lot of “dry powder” for the April 1 renewal date when prices “zoomed up”.
- Berkshire is heavily exposed to property catastrophe. Exposure in early May was fifty percent greater than what it was around the start of the year and they have written “as much as our capacity will allow us to write”.
- Berkshire has a very “unbalanced portfolio”. If there is a big hurricane in Florida, then Berkshire will face a “very substantial” loss. How substantial? If a major hurricane takes place, Berkshire could lose as much as $15 billion! If not, there will be a profit of “several billion dollars”. (I have been visiting this site frequently.)
- Size of exposure is about 5% of $300 billion of capital. This is a level of risk that Ajit Jain and Warren Buffett are willing to accept, obviously at the right price.
Ajit Jain had the following to say about Alleghany:
“In terms of Alleghany, that’s an easy response. We treat our operating units independent of each other. And as far as Alleghany is concerned, they have a major presence in the reinsurance business under the brand name of TransAtlantic Re.
That company will operate the way it’s been operating in the past. There will be no change in terms of strategy or management. And they will keep doing what they’re doing. They’ve been very successful, and hopefully will keep being successful.”
For reporting purposes, Allegheny’s TransAtlantic Reinsurance business has been placed under the Berkshire Hathaway Reinsurance segment, but it appears that decision-making authority for that business will rest with Joe Brandon who has remained CEO of Allegheny under Berkshire’s ownership.
Inflation
“Is there a way to judge how BRK will be able to handle inflation going forward (whether it be low-, middle-, or high-)? Is there a way to estimate pricing power capacity among the wholly-owned companies versus the partially-owned publicly traded companies?”
Warren Buffett mentioned inflation in his 2022 letter to shareholders in a section related to federal taxes:
“Berkshire also offers some modest protection from runaway inflation, but this attribute is far from perfect. Huge and entrenched fiscal deficits have consequences.”
From the context of this comment, Mr. Buffett clearly believes that large fiscal deficits have inflationary consequences. Perhaps he is referring to the massive monetization of government debt implemented by the Federal Reserve since the financial crisis. Whatever the cause might be, Mr. Buffett’s concerns about inflation go back many decades. In 1977, he published How Inflation Swindles the Equity Investor which should be required reading for all investors in today’s environment.
It is difficult to analyze the effect of inflation for Berkshire at the holding company level given that it is comprised of a very large number of businesses with dramatically different economic characteristics. However, we can look at a few examples of businesses that have been impacted by inflation over the past two years:
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