Berkshire Letter by Warren Buffett – 1992 (Part 4)
Jan 20th, 2007 by Martin Lee
Today’s post looks into insurance operations for “super-cat” coverages, which are the policies that other insurance companies buy to protect themselves against major catastrophic losses. Read on to understand how Warren Buffett views this industry and manages his operations.
Insurance Operations
Due to Hurricane Andrew, Berkshire suffered losses of $125 million, an amount roughly equal to their 1992 super-cat premium income.
The nature of the super-cat insurance is such that in any year, it would “either enormously profitable or enormously unprofitable” (even though both 1991 and 1992 came in close to break even).
Generally, these policies (most of them) are activated subjected to certain conditions.
1) There is a deductible or retention that the policyholder has to absorb before the policy kicks in.
2) Industry wide insured losses from the castastrophe must exceed some minimum amount.
3) Occurrence of second, third or fourth event.
4) Catastrophe of a specific type.
5) Specific geographical region.
It is difficult to price super-cat policies as insurers cannot simply extrapolate past events. For example, slight changes to the world’s climate might produce huge changes in weather patterns.
For some reason, the likelihood of super-cats happening is higher towards the end of the year, when the weather tends to kick up.
Therefore, Warren takes a conservative approach of defering the recognition of revenue until a loss occurs or until the policy expires.
This results in a slight biased in the quarterly results: Large losses may be reported in any quarter of the year, but significant profits will only be reported in the fourth quarter.
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