In October 2006, National Indemnity, a unit of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), signed a landmark deal to assume the assets, liabilities, and operations of Equitas, formed by Lloyds of London to assume its liabilities on policies written prior to 1992. As part of the deal, Berkshire agreed to provide Equitas as much as $7 billion in reinsurance coverage.

Figuring out how Berkshire makes money on these types of deals could help Fools understand Berkshire's insurance business better -- and gain insight into Buffett's and Berkshire reinsurance chief Ajit Jain's methods.

To provide some illumination, I contacted Marc Mayerson, a Harvard Law graduate and partner of Washington, D.C., law firm Spriggs & Hollingsworth. Mayerson also leads several national American Bar Association seminars devoted to Equitas, and provides analysis of Equitas' financial reports on his blog, InsuranceScrawl. The following is an email interview conducted with Marc; notes in italics are my comments.

Emil Lee: Can you walk us through the economics of the Equitas deal?

Marc Mayerson: Under the deal, [Berkshire subsidiary] National Indemnity will reinsure all of Equitas' liabilities and provide a further $7 billion of reinsurance coverage for Equitas. Equitas has [loss] reserves presently of $8.7 billion (as of March 31, 2006), and National Indemnity will commit an additional $5.7 billion of reinsurance capacity.

Once Equitas pays out $8.7 billion in future losses -- which will probably take a couple of decades -- Berkshire is on the hook for an additional $7 billion of coverage.

In phase 2 of the deal, National Indemnity will commit an additional $1.3 billion of reinsurance coverage, for a total of $7 billion of additional reinsurance.

Assuming phase 2 is approved, Berkshire's maximum loss exposure is $7 billion.

[The deal] is largely a cash-flow bet: Will the amount of money Berkshire earns on Equitas' current assets be more than it pays out in [future] claims?

Lee: So under what scenario will the deal work out for Berkshire?

Mayerson: Let me use a simplified model of the financial structure of the deal. Berkshire is committing to pay up to $7 billion for the back-end portfolio of claims.

Remember, Berkshire doesn't have to pay claims until losses exceed the current $8.7 billion in reserves.

In exchange for making that commitment, it is getting approximately $746 million for its $7 billion reinsurance commitment beginning around 2026.

That's assuming the current $8.7 billion reserve lasts for 20 years.

What this means is that National Indemnity makes money on this deal if any of the following occur:

A. It gets more than 5.75% real rate of return. If the return is 6.25%, [Berkshire] will make a nominal $1.4 billion (with a $123 million present value).

For those interested, here's the math -- though I warn you, it gets complicated. First, add an assumed 2.8% inflation rate to Marc's 5.75% break-even rate of return, for a nominal 8.55% return. $746 million compounded for 20 years at 8.55% = $3.85 billion.

Let's assume Berkshire starts paying claims out of its own pocket in 20 years, and pays the $7 billion it might owe evenly until 2041. (Actuaries believe Equitas' asbestos claims may last until then.) Dividing $7 billion by 15 years, the annual claims payment would be roughly $467 million.

The present value of a $467 million payment for 15 years at an 8.55% interest = $3.85 billion (with a slight rounding error).

B. The money in Equitas lasts longer than 20 years, allowing National Indemnity to grow its nest egg further.

C. The claim stream becomes less than Equitas is currently projecting.

... meaning that Berkshire's losses are less than expected.

Lee: Why do you think Berkshire was able to get this deal done, versus other finite reinsurers, like AIG (NYSE:AIG), out there?

Mayerson: Berkshire is somewhat unique, in that its shareholders have such large stakes (given the price per share) and have been inculcated by Warren Buffett to take the long-term view.

In contrast, other companies' shareholders or fund managers seem more focused on the shorter or medium term. As a result, Berkshire can do a deal today that it hopes will pay off for it two decades from now. Most other companies have neither the management nor the shareholders who are willing to reap the financial benefits two decades hence.

Lee: Obviously, Equitas was a unique situation, but do you think we'll be seeing other similar deals in the future?

Mayerson: We've seen some other deals like this, one involving Berkshire and an affiliate of what is now ACE (NYSE:ACE) and what was part of CIGNA (NYSE:CI). I think there will always be opportunities for companies to enter into "assumption reinsurance" arrangements that make business sense for both parties.

Related Foolishness:

Berkshire Hathaway is an Inside Value and Stock Advisor pick. Try any one of our investing services free for 30 days.

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. The Motley Fool holds stock in Berkshire Hathaway. The Motley Fool has a disclosure policy.