One of the more important aspects of security analysis involves looking beyond the financial statements of the target company and also examining the financial reports of vendors, competitors, and customers depending on the nature of the business. In the case of insurance companies, it can be interesting to examine both sides of a deal particularly in cases where the transaction is much more important for one party than for the other. In such situations, the smaller company usually provides more information due to a higher level of materiality of the transaction. Such is the case with CNA’s retroactive reinsurance transaction with Berkshire Hathaway.
In this article, we take a close look at the retroactive reinsurance transaction from the perspective of CNA Financial which just filed its 10-K earlier this week. The disclosures provided by CNA appear to be more detailed compared to Berkshire’s prior disclosures on the transaction and could shed some light on the potential profitability of the transaction for Berkshire as well as potential impacts for 2010 earnings.
Berkshire Hathaway is scheduled to release fourth quarter and full year 2010 earnings on Saturday, February 26, 2011 so we do not yet know the specific disclosures that will be provided for the CNA Financial transaction. However, we can see that the disclosure in the third quarter report is fairly limited:
Premiums earned in the third quarter of 2010 included approximately $2.25 billion from a contract with Continental Casualty Company, a subsidiary of CNA Financial Corporation, and several of its other insurance subsidiaries (collectively the “CNA Companies”). Under the terms of the reinsurance agreement, BHRG assumed certain asbestos and environmental pollution liabilities of the CNA Companies subject to an aggregate limit of indemnification of $4 billion of covered losses and allocated loss adjustment expenses. The premiums earned related to this contract were offset by a corresponding amount of losses incurred (comprised of estimated loss reserves of approximately $2.45 billion less a deferred charge asset of approximately $200 million), thus resulting in no immediate impact on pre-tax underwriting results.
It is possible, although not likely, that more information will be provided on this specific transaction when the annual report is released. The reason Berkshire does not provide voluminous details on every conceivable transaction is mainly due to the question of materiality. Generally, disclosures are provided at a level of depth that corresponds with how material a transaction or event is on overall results.
In this article, we will take a brief step back to consider the nature of retroactive reinsurance and the impact of such transactions on Berkshire. We will look at Warren Buffett’s past statements on this topic to consider Berkshire’s motivation for entering into such contracts. Then we will look at the other side of the table and ask why a company like CNA Financial would be motivated to seek such coverage.
What is retroactive reinsurance? Generally, such policies are designed to provide large but limited indemnification of losses related to past loss events that can be expected to be paid over long periods of time often stretching for decades into the future. Retroactive policies involve “long tail” lines and are often in sectors that have proven to be troublesome due to evolving legal theories. Asbestos and environmental liabilities generally top the list of risks that have been assumed by insurers in years past who now wish to “wipe the slate clean” and cede such risks to others.
Warren Buffett devoted a significant portion of his 2006 letter to shareholders to the topic of retroactive reinsurance and focused on the accounting treatment of the Equitas transaction that took place during that year. We encourage interested readers to review the letter for additional details. The following quote sums up why insurers tend to call on Berkshire when the need for retroactive reinsurance arises:
Berkshire has done many retroactive transactions – in both number and amount a multiple of such policies entered into by any other insurer. We are the reinsurer of choice for these coverages because the obligations that are transferred to us – for example, lifetime indemnity and medical payments to be made to injured workers – may not be fully satisfied for 50 years or more. No other company can offer the certainty that Berkshire can, in terms of guaranteeing the full and fair settlement of these obligations. This fact is important to the original insurer, policyholders and regulators.
As we will see, CNA Financial was attracted to these qualities when management decided to pursue a retroactive reinsurance transaction in 2010.
CNA Financial is run by sophisticated executives and is a 90 percent owned subsidiary of the Loews Corporation which has long been run by the Tisch family, a group known for adhering to value investing principles in their business activities. However, even in cases where the individuals sitting on the other side of the table are not as well regarded, one must always ask: If the deal is good for Berkshire, what is motivating the other side?
In the Loews Corporation 2010 10-K report, released this week, management tells us precisely why they pursued the transaction. Per the terms of the deal, CNA recognized a net loss of $328 million which essentially represents the premium paid to Berkshire in excess of CNA’s best estimate of the remaining net liabilities associated with the coverage that was ceded. Here is how management justified incurring the loss:
The net loss of $328 million related primarily to the risk margin necessary to secure the $4.0 billion of reinsurance protection on such a volatile component of CNA’s reserves. However, CNA believes the benefits to it are compelling. The benefits include:
• improves CNA’s earnings outlook and financial stability by significantly mitigating A&EP reserve risk going forward;
• effectively eliminates credit risk on $1.2 billion of third party A&EP reinsurance recoverables effective January 1, 2010; and
• eliminates an area of uncertainty from the perspective of rating agencies.
From the perspective of management, the volatility and perceived risk associated with continuing to maintain coverage for the risks in question will add uncertainty to the company’s future prospects in the eyes of the investment community and the ratings agencies. Therefore, taking an up-front hit to earnings in exchange for ceding liability (up to the $4 billion cap) is believed to provide major benefits by essentially removing a cloud hanging over the company.
The Nuts and Bolts of the Transaction
Note 9 of the Loews Corporation 10-K provides a great deal of information regarding the nature of the transaction. Here are the key salient points:
- CNA Financial ceded approximately $1.6 billion of net claims to National Indemnity under the retroactive reinsurance agreement with an aggregate limit of $4 billion.
- The $1.6 billion figure is net of $1.2 billion of ceded claims under existing third party reinsurance contracts. Under the agreement, National Indemnity is assuming credit risk on the existing third party reinsurance related to the claims CNA previously ceded.
- CNA paid National Indemnity a reinsurance premium of $2 billion and transferred third party reinsurance receivables with net book value of $215 million net of $100 million for doubtful accounts. Essentially, National Indemnity is assuming not only CNA’s primary risk associated with the insurance claims but also the risk that reinsurers with whom CNA has contracted may default on their obligations.
- National Indemnity deposited $2.2 billion in a collateral trust account as security for its obligations to CNA. The required balance of this account will decline in future years as National Indemnity pays claims under the reinsurance.
- Berkshire Hathaway has guaranteed National Indemnity’s performance obligations under the transaction.
Clearly CNA Financial believed that only dealing with a reinsurer of Berkshire’s strength would adequately lift the clouds hanging over the company with respect to the asbestos and environmental liabilities and the potential risk that other reinsurers would fail to satisfy prior agreements.
Q4 2010 Developments
CNA reported that a “ground up review” of exposures under the relevant policies in the fourth quarter revealed adverse development due to higher severity of claims. Based on this, CNA recorded $80 million of gross unfavorable claims which were ceded to National Indemnity under the terms of the reinsurance agreement. As of December 31, 2010, $2.3 billion of the $4.0 billion limit remains available under the retroactive reinsurance agreement. Net losses paid under the reinsurance transaction was $154 million from contract inception to December 31, 2010.
Based on the accounting for retroactive reinsurance described by Warren Buffett in his 2006 letter to shareholders, at the inception of a retroactive reinsurance transaction, there is no net impact on pre-tax underwriting results because the premiums earned are offset by the estimate of anticipated losses incurred. Over time additional losses may be incurred based on developments subsequent to the original transaction. Based on CNA’s disclosures for Q4, we could expect to see a charge in Berkshire’s results corresponding to the unfavorable loss development discovered during CNA’s “ground up review”.
It’s All About Float
Ultimately, retroactive reinsurance transactions are not designed to generate underwriting profitability and will end up resulting in underwriting losses over the term of the coverage which could extend for decades. Berkshire will only profit from such a transaction if the new float can be invested at rates of return in excess of the cost of float. Since we cannot know the cost of float emanating from a retroactive reinsurance transaction until many years later and the returns on float are not known, we cannot effectively evaluate whether such transactions are profitable when they are originally agreed to.
As we will discuss in more detail in our upcoming report Berkshire Hathaway: In Search of the Buffett Premium, assumptions related to the cost of float are all-important when it comes to estimating Berkshire’s intrinsic value. The report will be published in early March once data from Berkshire’s annual report are incorporated.
Disclosure: Long Berkshire Hathaway