With a beginning containing apologies and "bad news," the conclusion of the letter where Mr. Buffett reprises "Owner Related Business Principles" shows the Chairman at his optimistic, incisive and feisty best. Overall, it was a really good, fundamental business year, and shareholders who can hold without the comfort of a dividend should be well rewarded. There are a few cautions, however.
InsuranceThe typical comment about BRK is that it is a property-casualty ("P-C") insurance company at its core. That is true, to an extent. The share of net income attributable to shareholders provided by the Insurance operations was 30% in 2012, down from 36% in the prior year and from almost 40% in 2010. The decline in the net income contribution share in 2012 was driven by a sharp decline in the y-o-y investment income contribution share from the Insurance operations. It's no surprise that an insurance analyst is among the BRK bulls appearing on the panel at the Annual Meeting. BRK's Insurance operation's performance and financial strength have been extraordinary, almost magically consistent by industry standards. In the Chairman's words these businesses "shot the lights out" in 2012, and that is not an understatement.
Berkshire Hathaway Reinsurance ("BH Re") is run by the rightly, oft-praised Ajit Jain. BH Re generated $35 billion in 2012 float, comprising 48% of the float provided by all the businesses in the segment. It also swung from an underwriting loss in 2011 to a $304 million profit in 2012, quite an achievement.
General Re produced a float of $20 billion and generated an underwriting profit of $355 million. The P-C industry is characterized by classic underwriting cycles. When conditions are flush, companies chase new business by taking on more risk with inadequate premiums; if economic conditions deteriorate and extraordinary losses hit, combined ratios go haywire. Books shrink and the adjustment of premiums to appropriate levels takes some time. In 37 of the past 45 years, the P-C industry's combined ratios have exceeded 100%, which is another way of saying that premiums failed to cover claims plus expenses.
BRK's reinsurers seem to not participate in the industry game of chasing business, which is why the Chairman seems to call out the Jain and Montross on a regular basis.
GEICO's year-end float was some $400 million higher than 2011 at $11.6 billion in 2012. However, its underwriting profit was $680 million on a GAAP basis, but $1.1 billion excluding the effects of an industry-wide change in accounting standards that didn't affect cash or the fundamental numbers; the adjusted underwriting profit was 91% above the prior-year level. Vehicle losses from Hurricane Sandy were more than three times higher for GEICO than the losses from Katrina. The Chairman "rubs his eyes" at these numbers, and I have to scratch my head. They are quite extraordinary.
The insurance businesses earned $34,545 million in premiums in 2012, compared to $32,075 in 2011, an incremental $2,470 million in earned premiums. Against this, insurance losses and adjustment expenses were $20,113 million in 2012, compared to $20,829 million in 2011, a decline of $716 million. This cushion allowed the businesses to absorb a significant increase in underwriting expenses and higher life, annuity and health benefit payouts to produce an underwriting profit of $1,625 million in 2012 compared to a profit of $248 million in the prior year. Yes, they did shoot the lights out.
An Ernst and Young study about the effects of the low interest rate environment on insurer portfolios says that the fixed income portion of the portfolios will continue to be under pressure. Ernst and Young estimate that bond yields in the general accounts of P-C insurers could decline by 50 basis points from current levels, over three years. For most companies, this signal would flash yellow.
I strongly suspect that one of the reasons that Todd Combs and Ted Wechsler were brought on as new investment managers was to manage the fixed income portfolio aggressively to mitigate these kinds of pressures on the fixed income portfolios. These are big stakes, given the size of BRK's insurance businesses.
However, the way BRK is structured, there are many layers of liquidity to support the businesses. If indeed the general accounts of other insurers are pressured, and they were to pull back from writing new, or renewing old, business, this would be an ideal scenario for BRK's businesses to gain share with the appropriate premium levels. I can see why insurance analysts are bullish, particularly on the opportunities for GEICO.