View of Hurricane Katrina, 2005. Source: NASA Goddard Space Flight Center via Flickr.
Hurricane and tornado season may be on the downswing, but that doesn't mean the prospect of a disaster occurring within the U.S. or around the globe has really ebbed in a meaningful way.
According to statistics from the United Nations Development Programme from September, the last 20 years have seen disasters affect 4.4 billion people around the globe, kill 1.3 million people, and lead to $2 trillion in economic losses. UNDP actually speculates in its findings that the uncounted impact in low-income households could actually boost this 20-year impact a full trillion dollars to $3 trillion.
Furthermore, with the idea that global warming could be altering weather patterns in the discussion, UNDP estimates that the economic impact of disasters (hurricanes, tornadoes, and so on) is only growing. By 2030 UNDP projects an economic impact of $431 billion, more than triple the $138 billion reported in 2012.
Of course, the truth of the matter is that weather-related disasters are pretty much impossible to predict. Sure, the weatherman can arguably project where a hurricane will make landfall, but it's not possible, at least with today's technology and the absence of a crystal ball, to know when and where the next disaster will strike.
But he's not worried
Yet, ask Warren Buffett, the man behind conglomerate Berkshire Hathaway (BRK.A 1.18%) (BRK.B 1.30%), built his business upon the strength and stability of its insurance and reinsurance business, and he isn't the least worried about the possibility of natural disasters sacking his company's profits, or his ability for his insurance subsidiaries to take care of its members should a disaster arise.
In fact, according to a Buffett interview with CNBC in 2013, the Oracle of Omaha made it very clear that he hasn't changed his insurance game plan one bit because of U.S. or global catastrophes. Mind you, Buffett made these comments following the $725 million Berkshire Hathaway absorbed in after-tax losses from Hurricane Sandy in 2012, and its $2.5 billion in losses directly tied to Hurricane Katrina in 2005.
What's the secret to Warren Buffett's confidence? A lot of it has to do with Berkshire's ability to boost insurance premiums during years where there are, and aren't, catastrophes. You see, homeowners and car insurance are basic-needs services that most people can't go without. You can't register a car without providing proof of insurance, and no bank will lend money to a homebuyer unless the home is secured with homeowners insurance. For Berkshire Hathaway this means incredible pricing power and the ability to absorb catastrophic losses while taking care of its members with relative ease.
Source: Flickr user StockMonkeys.com.
Leveraging his success
In addition to relying on premium growth, one of the most underappreciated aspects of Berkshire Hathaway's business model is the leverage generated by its insurance business. According to Berkshire's annual letter for 2013, the company's combined insurance businesses generated a float of $77.2 billion, up $4.1 billion from the previous year. This "float" is another word for "other people's money" that its subsidiary insurers have collected upfront, and which doesn't have to be paid out until a later date. In other words, Berkshire's insurers are able to borrow money upfront and invest that money to effect substantial gains, minimizing the adverse effects that'll be caused by future catastrophes.
Perhaps The Economist put it best in 2012,
"Yet the underappreciated element of Berkshire's leverage are its insurance and reinsurance operations, which provide more than a third of its funding. An insurance company takes in premiums upfront and pays out claims later on; it is, in effect, borrowing from its policyholders. This would be an expensive strategy if the company undercharged for the risks it was taking. But thanks to the profitability of its insurance operations, Berkshire's borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period."
As The Economist further notes, Buffett's own early fortunes allowed him to purchase insurers with his own money and utilize the leverage of those insurers to grow his own wealth at an incredible rate.
Buffett's forecast for sunny skies
If there's a lesson to be learned from Buffett's success within the insurance industry it's that we can't avert disasters, but we can certainly control how we react to them. To put it another way, recessions and stock market crashes are going to happen whether we want them to or not, and there is no way to predict when these events will happen. Therefore, rather than changing your strategy with the passing of each storm (or in this case any somewhat major macroeconomic event), the smart strategy is to stay the course and stick to your long-term investing thesis. That's how Buffett made his fortune, and there's a good chance if you follow in those footsteps you'll retire comfortably as well.
