Warren Buffett’s Letter – 1980
Posted in Accounting, Berkshire Annual Letter, Insurance on Dec 28th, 2005
First of all, I have to apologise for the delay in this update. My computer broke down recently and it took a while before I managed to get it repaired.
This letter starts with a simplified lesson on accounting. For a subsidiary company that is more than 50% owned, the earnings, expenses, etc will be fully consolidated into the parent company’s accounts.
If the ownership lies between 20-50%, the earnings will simply be reflected as a one liner based on the percentage ownership of the company.
If the ownership is less than 20%, only dividends received will be reflected in the accounts.
Most of Berkshire’s holdings held by the insurance companies belong to the third category. Conventional acccounting will only allow a small proportion of Berkshire’s earnings to be reported, the rest of it will be hidden from view.
As an example, GEICO was purchased for $47 million in 1976. Based on the present dividends, reported earnings amount to only about $3 million annually. However, Berkshire’s share of their earnings is estimated to be about $20 million annually.
In Warren’s own words, “The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage.“
In the long run, the retained earnings of those non-controlled holdings will be translated into gains in market value.
In another accounting convention, insurance companies are allowed to carry their bond holdings at amortized cost, regardless of the market value. With the recent drop in bond prices, some companies could find even themselves in negative net worth if their bond holdings were valued at market.
It is strange that a significant drop in the stock portfolio of an insurance company will threaten it’s survival, yet a greater drop in bond prices produces no reaction at all. This can lead to a few negative effects:
1) Companies unwilling to sell off the bonds to ‘realise’ the losses even when there are superior ways to deploy the capital.
2) If money is required to pay off insurance claims, stock holdings might be sold off to raise the money instead. This is a case of selling the better assets and keeping the biggest losers.
3) Another way of raising the money to pay off insurance claims is to underwrite new business no matter what the potential underwriting losses are. Unfortunately, this is the preferred option and ultimately leads to suicidal underwriting among the different insurance companies.