Last month, 94-year-old Warren Buffett published his annual letter to shareholders. The yearly letter from the greatest investor of all time typically offers timeless bits of investing and business wisdom, tinged with homespun humor.
However, this year's letter had a chilling warning on a subject Buffett doesn't usually address: climate change.
Remember, while Buffett is known for his investing, Berkshire Hathaway's (BRK.A 0.26%) (BRK.B 0.15%) core business is insurance. In fact, it's the insurance business that enables the investing business, as it raises the float for Buffett and his team to reinvest in equities or buy entire businesses.
Given the seemingly inevitable acceleration in climate disasters that Buffett highlights, insurers will likely be on the hook for larger and larger damages in the future. So, should Buffett's stark warning worry Berkshire investors?
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Key Data Points
Climate change "announcing its arrival"
In the letter published Feb. 22, Buffett wrote:
Insurance pricing strengthened during 2024, reflecting a major increase in damage from convective storms. Climate change may have been announcing its arrival. However, no "monster" event occurred during 2024. Someday, any day, a truly staggering insurance loss will occur – and there is no guarantee that there will be only one per annum.
Interestingly, Buffett hasn't addressed climate change this directly in prior letters, despite property and casualty (P&C) insurance being the core of what Berkshire does. So, does this year's mention mean there's a heightened threat? If so, does that mean you should sell the stock?
The threat of climate change is very real
According to a study published last year by the Potsdam Institute for Climate Impact Research (PIK) in the industry journal Nature, climate disasters could cost the global economy a whopping $38 trillion per year by the middle of this century. That would be a massive 90-fold increase from the estimated $417 billion in estimated economic losses the world experienced last year from natural catastrophes.
Increasingly damaging catastrophes, such as the recent $164 billion Los Angeles wildfires, have been the result of something called "compound weather." Compound weather occurs when a combination of two different climate change symptoms occurs together, making the combined effect worse than the two factors on their own. So, one plus one equals more than two -- only in this case, the higher number isn't good.
In the case of the Los Angeles fires, the city saw two years in a row of above-normal rain during the winter, spurring lots of vegetation growth. However, the summer and fall of 2024 were among the warmest on record, causing a rapid drought. The drought dried out all that extra vegetation, essentially producing lots of kindling. We all know what happened next: Record-high winds in January created wildfires, which had more "fuel" to burn.
Compound weather is becoming an increasingly damaging phenomenon. It has been linked to recent fires in South Carolina, flash floods in Malaysia, and the 2021 deep freeze in Texas. Judging by the PIK study, these unfortunate events seem likely to occur more frequently.
Image source: The Motley Fool.
Why Buffett is "not deterred by the dramatic and growing loss payments" in insurance
Despite the ominous forecasts, Buffett still likes Berkshire's insurance business. In the letter, he astutely points out that increased risk is not only a part of the insurance business, but risk is actually the single source of the industry's growth:
P/C insurance growth is dependent on increased economic risk. No risk – no need for insurance. Think back only 135 years when the world had no autos, trucks or airplanes. Now there are 300 million vehicles in the U.S. alone, a massive fleet causing huge damage daily.
However, there is a caveat: Berkshire and other insurers still need to price their policies profitably. Otherwise, the industry's losses will escalate along with that top-line growth.
In this year's letter, Buffett suggested some other ways that escalating risks can be mitigated. For instance, P&C insurers may begin writing shorter-term policies to adjust pricing more rapidly. Buffett points out that this has already happened in auto insurance, where insurers have largely transitioned to six-month policies from one-year policies. While that reduces float, or the amount of cash that insurers receive up front to invest, Buffett notes it has made for better underwriting.
Why Berkshire still looks like a safe bet despite the risks
All in all, I feel quite comfortable holding my Berkshire shares. In fact, Berkshire's insurance business is not only not a reason to sell, but increasing climate disasters may actually be a reason to buy more.
After all, Buffett recently did that himself, with Berkshire buying the stock of Chubb, a leading P&C insurer, last year, making it Berkshire's ninth-largest public stock holding. So, even Buffett himself is adding insurance industry exposure these days.
That's likely because increasing climate change-fueled damage will further the need for insurance, growing Berkshire's franchises along with it. And while escalating costs may threaten the solvency of some insurers, Berkshire has a few competitive advantages that should enable it to underwrite profitably going forward. Chubb's franchise also has an advantage with its no-hassle, fast claim-paying ethos that caters to higher-end clients willing to pay higher premiums. That pricing power likely spurred Berkshire to purchase Chubb shares last year.
If you think about it, competitively advantaged insurers may get a doubly positive financial result from climate change. Not only should insurance premiums grow a lot in the years ahead along with risks, but less-advantaged competition may pull back on certain lines of business or go bankrupt, leaving even more profits for the remaining few.
Berkshire's advantages are the key
In the letter, Buffett points to a few competitive advantages specific to Berkshire's insurance operations, of which all shareholders should be aware. First, Berkshire is so large and well financed that it doesn't have to buy reinsurance for itself. The extra "protection" other insurers must buy to mitigate massive losses is an increased operating cost. Therefore, by being able to bear larger risks itself, Berkshire can price certain policies below competitors.
Second, Buffett has instilled a culture that permits and even encourages Berkshire's insurance managers to shrink their businesses when pricing is inadequate. Many stand-alone insurers, especially public ones, may feel the need to grow year after year. But that impulse may come at the expense of underwriting, which can get dangerous if larger-than-expected losses emerge later on. But since Berkshire is so large and diversified, there isn't the same pressure to grow any single insurance line in any given year.
Third, Buffett and his head of insurance, Ajit Jain, have instilled a culture of caution when picking managers. "No optimists!" Buffett noted in his letter and then went on to quote the executive who recruited Ajit Jain in the first place, who said, "We want our underwriters to daily come to work nervous, but not paralyzed."
Finally, Buffett and his lieutenants are some of the best value investors one might find. While this speaks to the investment side of the insurance business, the two sides of Berkshire are inherently intertwined, with Buffett's investments and operating businesses providing further ballast against insurance damages.
The main takeaway from Buffett's letter is this: While climate change poses increasing risks, it's also likely to grow the insurance industry. As long as Berkshire sticks with its pragmatic underwriting philosophy and leans into its competitive advantages, it should be fine. In fact, Berkshire may even have the opportunity for outsize earnings growth in the era of severe climate change.
