Vertical Integration: Insurance

Several insurance companies, such as Berkshire Hathaway (BRK.A 0.14%) (BRK.B 0.06%) and Markel (MKL 0.04%), have both insurance and reinsurance operations. Here's what it means and why it can help reduce risk.

A full transcript follows the video.

This video was recorded on April 9, 2018.

Michael Douglass: The first: insurance. I think Warren Buffett's Berkshire Hathaway is, of course, the classic example of an insurer that is also in reinsurance.

Matt Frankel: Yeah. They're actually in a whole lot of businesses. [laughs]

Douglass: [laughs] Yeah, that's fair.

Frankel: But, in insurance, there's generally two transactions that take place. It's not just you paying a premium, as most people think. When customers pay a premium, say for auto insurance, like in Berkshire Hathaway's case, Geico, a lot of times the insurance company will purchase what's called reinsurance to lay off some of their risk. A big famous situation in insurance planning is Hurricane Andrew. What was that, about 30 years ago, almost, in Florida. A lot of insurance companies completely went bankrupt because they couldn't afford the massive losses they were sustaining. So, reinsurance allows them to purchase insurance on their insurance to prevent from catastrophic losses.

So, what a few companies have done -- Berkshire is not the only one. They're very notable example. Actually, Geico's their most well-known insurance company, but most of Berkshire's insurance business is reinsurance. A couple of other companies have done this as well. Markel is a big one. They're a very unique insurance play. They have a specialty insurance division, they insure risks that are really impossible for anyone else to gauge, but they do really well. And they also have a big reinsurance business. Two others I can think of off the top of my head are Aspen Insurance Holdings and XL Group, both of which have substantial businesses in both.

Where this helps is when you have, say, like we just had over the summer, where you have three major hurricanes, wildfires in California, a lot of insurance claims, the reinsurance side of the business is really going to take a hit. But the traditional insurance will end up being OK because of reinsurance. So, it kind of helps balance out the risk these companies are taking on.

Douglass: Yes, as long as it's diversified across different product lines, right? If you do, for example, home insurance, then you do reinsurance for that kind of insurance, that might be a little bit problematic. But as long as you're working across different sectors, and sectors that are not highly correlated to each other, I think that's where you can get that balancing.

And we've seen this happen with banks. Head over to Goldman Sachs just for a minute -- and we'll be talking more about them in a bit -- where their trading desk does very well when their wealth management side of their businesses is maybe struggling a little bit. And of course, the inverse occurs, as well. So, there are some benefits there to the business in terms of stability because of that ability to diversify their risk a little bit. It's an interesting trend, and I think it's something that, certainly Berkshire and Markel have made it look, well, maybe not easy, [laughs] but they certainly look pretty good while doing it. I think one of the big questions we'll have to ask long-term is some of the lesser-capitalized insurers, what this looks like for them long-term.