Buffett's Recent Losses Translate to Junk Bond Rates
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By Miles Weiss
Washington, Dec. 6 (Bloomberg) -- Warren Buffett, armed with a rare ``AAA'' credit rating, is paying the same rates as junk bond issuers for money to invest.
Buffett's Berkshire Hathaway Inc. had insurance underwriting losses that meant it was in effect paying 10 percent to borrow policyholder premiums that the company uses to invest. The reason is a Berkshire subsidiary, General Re Corp., that sustained about $1.7 billion in losses from the Sept. 11 terrorist attacks.
The billionaire has warned that General Re and other Berkshire insurance units will eventually pay for losses from a major catastrophe. Buffett didn't refer to that situation in a Nov. 9 letter to shareholders in which he chose to reprimand General Re rather than attribute its World Trade Center losses to fate. Investors say his ultimate concern is the cost of premiums that are temporarily invested, otherwise known as ``float.''
``Everything Buffett does in insurance is to create zero-cost float,'' said Tony Russ, a money manager at Fairholme Capital Management LLC, which had about 43 percent of its stock portfolio invested in Berkshire shares at Sept. 30. ``If you accept this idea,'' Russ said, ``then his criticism of General Re becomes understandable.''
Float, as defined by Buffett, is money that insurers such as Berkshire hold but don't own. Insurers get to invest the premiums they collect from policyholders in stock and bonds until claims must be paid, often many years later.
Many insurance companies have been willing to write insurance policies at unprofitable prices to gather float. By investing these funds until claims were paid, usually in long-term bonds, insurers more than made up for the losses incurred underwriting policies.
Cost of Float
Buffett refers to these underwriting losses as the ``cost'' of float. In contrast to many other insurers, Berkshire Hathaway has usually had an underwriting profit or, failing that, an underwriting loss that, in percentage terms, was lower than the year-end yield on long-term government bonds.
``An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds,'' Buffett said in his 1997 letter to shareholders. ``But the business is a lemon if its cost of float is higher than market rates for money.''
Berkshire, since acquiring General Re in 1998, has seen its cost of float rise to lemon-like levels, a process that accelerated this year. Berkshire's cost of float has been at or above the market rate for money for the past three years, and much of the problem stems from losses at General Re.
Underwriting Loss
Berkshire's insurance operations, including General Re and businesses such as National Indemnity Co., had a $3.07 billion pretax underwriting loss during the first nine months of this year. Based on Berkshire's average float for the year of $30.6 billion, the company's cost of float is about 10 percent. Annualized, it would exceed 13 percent.
The numbers get worse if General Re is singled out. Its float at the end of 2000 was $15.5 billion, and its pretax underwriting loss for the first nine months of this year was $2.4 billion. Assuming that General Re's float hasn't increased much this year, its cost of float would be more than 15 percent.
Berkshire officials didn't return telephone calls seeking comment. However, in a quarterly report filed with the Securities and Exchange Commission, Berkshire said its cost of float ``will be exceptionally high'' in 2001.
Highest Rating
Assigned the highest credit rating available from Standard & Poor's, Berkshire could raise money more cheaply by issuing bonds than selling insurance. The current yield on 10-year bonds issued by industrial companies that have a AAA rating is now under 6 percent.
This is not the first time that Berkshire has paid high rates for its float -- witness 1984, when the applicable figure reached 19 percent. And Buffett has said his shareholders should look at the average cost of float over several years rather than focus on a single year.
In addition, the nature of the reinsurance business exposes General Re to the risk of losses such as those from the Sept. 11 attacks. General Re receives a cut of premiums from insurers in exchange for shouldering some of the risk they assume when writing policies for catastrophes such as hurricanes and earthquakes.
Three Basic Rules
Still, in the Nov. 9 letter to shareholders, Buffett placed more emphasis on mistakes by General Re than on the nature of the reinsurance business in discussing Berkshire's losses from the World Trade Center bombing. He said General Re broke the three basic rules of running an insurance company, including a maxim to underwrite only policies that carry an expectancy of profit.
General Re has had a persistent problem of not charging premiums that are high enough to cover the risks assumed through policies it has written. In the quarterly report filed with the SEC, Berkshire said that property-casualty insurance should generate an underwriting profit if properly priced.
``This has not occurred during the period subsequent to Berkshire's acquisition of General Re,'' the filing said.
Even losses from the Sept. 11 attacks are the product of poor pricing in Buffett's eyes, though not just at General Re. His Nov. 9 letter noted that General Re and others wrote reinsurance that included only pricing for natural catastrophes, overlooking man- made insurance debacles such as the World Trade Center attacks.
Common Practice
``In effect, we, and the rest of the industry, included coverage for terrorist attacks,'' the letter said, ``and received no additional premium for doing so.''
In underpricing its insurance coverage, General Re was following a practice common throughout the industry. And the formula of using investment income to offset underwriting losses worked well as long as the bonds that insurers invested in sported yields of 10 percent or more.
With 30-year Treasury bonds now sporting a yield below 6 percent, Buffett said in the quarterly report that insurers need to change their strategy in regard to float.
``The value of float generated by the insurance business has decreased in recent years,'' the Berkshire report said. ``Significant underwriting profits will need to be realized in order to achieve a reasonable return on capital employed.'' |
