As of 2006, Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) wrote the third-largest amount of net premiums in the reinsurance industry -- an amazing feat for a firm that started out making textiles. One of the key foundations of Berkshire's reinsurance business is its super-catastrophe line, and the company's annual shareholder letters offer an incredibly valuable case study of that segment's success. Let's take a closer look at the integral components of Berkshire's reinsurance division.
Against all odds
Berkshire's success in super-cat reinsurance, which insures very large catastrophic loss events, becomes more impressive in light of the challenges it faced. Capable reinsurers such as RenaissanceRe (NYSE:RNR), XL Capital (NYSE:XL), and Montpelier Re (NYSE:MRH) compete fiercely for market share. In addition, barriers to entry are minimal, with recently formed reinsurers such as Flagstone Re (NYSE:FSR) and Greenlight Re (NASDAQ:GLRE) almost constantly emerging. Lastly, reinsurance is a commodity to some extent.
Thus, Berkshire boss Warren Buffett had to overcome considerable obstacles to build his reinsurance operations into the juggernaut they are today. Since day one, Buffett based his strategy on three simple strengths: speed, size, and security.
Speed: Fastest policy in the West
In Buffett's words, "We can supply a quote faster than anyone in the business." To most Fools, this might seem unnecessary. When multimillion-dollar policies with billion-dollar loss exposures are on the line, wouldn't both parties involved want to take their sweet time? Not necessarily.
Suppose you take a spin at a roulette table with 100 numbers on it. If the ball lands on the number 55, you suffer a crippling financial loss. How much would you pay to get out of this situation, and how quickly would you want to get out of it before the ball has a chance to land?
Sometimes, reinsurance customers find themselves in similar situations, sitting on ultra-large risks that could either cripple or bankrupt their company. What if an earthquake happens in a key metropolitan area tomorrow? In these cases, speed is critical, and Berkshire has a quick draw. The company benefits from favorable odds when customers are more concerned with speed, not price.
Size: Might makes right
As Buffett has said, "We will issue policies with limits larger than anyone else is prepared to write." The lower the policy limits are, the hotter the competition. This should make intuitive sense. For example, supposed you wanted to borrow a hundred bucks. You could go to your friend, your local bank, or your credit card company. Heck, some of them won't even charge you interest for a year.
Now, suppose you wanted to borrow $10 billion. The pool of possible lenders narrows dramatically. Only a handful of financial institutions would be prepared to write a $10 billion check, and they definitely wouldn't offer you a "one year interest-free!" teaser.
Similarly, Berkshire's ability to write ultra-large policies narrows the pool of competitors, helping to insulate the firm from competitive pressures, and allowing it to compete in the less commoditized (and thus higher-margin) portions of the market.
Security: In Berkshire we trust
Lastly, Berkshire's Fort Knox-like balance sheet makes it one of only eight U.S. companies to earn an AAA credit rating. The only other such firm that wrote insurance, General Electric (NYSE:GE), sold that portion of its business to Swiss Re.
A sterling credit rating reassures customers that Berkshire will be able to pay even under the most stressful conditions. Since Berkshire specializes in ultra-large risks, customers are extra-careful to do business only with insurers they know will pay up.
Although it wasn't in the super-cat area, a good example of this caution came when Lloyds wanted to get rid of its asbestos liability. The backers for those liabilities were Lloyd's "Names," a group of unfortunate wealthy individuals who agreed to take on insurance risks in exchange for a cut of the profits. A while back, those Names got blindsided by an avalanche of asbestos and environmental liabilities, a disaster that threatened Lloyds' very existence.
Asbestos liabilities have haunted the Names for more than a decade. They've begged for an end to the suffering, and many have stated, "I just want to sleep easy." Recently, Lloyd's turned to a reinsurer they knew would be able to make payments for decades to come. As the CEO of Equitas, the Lloyd's unit that assumed the liability, stated after transferring the risk to Berkshire, "We think we have just bought [the Names] the world's best mattress."
That sounds like a customer much more concerned with security than price, and it helps to explain how Berkshire continues to use its competitive advantages of speed, size, and security to build its super-cat reinsurance moat.
Berkshire has used similarly astute strategies to build enormously valuable competitive advantages in all of its insurance lines. That's one of the primary reasons why many investors are betting that Berkshire's intrinsic value far exceeds its current share price. Like Berkshire's nervous super-cat customers, it seems we'll have to spin the wheel and see how that bet turns out.
Further Foolishness that's super, cat:
Berkshire Hathaway is both an Inside Value and a Stock Advisor selection. See why by taking either service for a free 30-day trial run.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. Montpelier Re is both a Stock Advisor and a Hidden Gems recommendation. The Motley Fool's disclosure policy is always prepared for the worst.
