The Berkshire Hathaway Letter to Shareholders is always an eagerly anticipated event on the financial calendar. It was published this past weekend with Berkshire Hathaway’s 2014 Annual Report and the National Indemnity Company Annual Statement.
I gave the documents an initial read last weekend, focusing on areas of the Berkshire business model most relevant to KCIC’s corporate clients. This letter is published 50 years after Warren Buffett first took charge of Berkshire and, as such, is a more expanded report than usual. It includes special reflections on Berkshire Past, Present and Future, written by both Warren Buffett and Charlie Munger.
Here are things that struck me from my initial reading:
- Given that both Warren Buffett and Charlie Munger are in their golden years, speculation about their successors has been rife for some time. This report identifies two leading contenders to replace Warren Buffett: Greg Abel, who runs Berkshire’s energy business, and Ajit Jain, head of the reinsurance business. Buffett for years has singled out Mr. Jain in the Annual Letters to Shareholders: “If you meet Ajit at the annual meeting, bow deeply”. Charlie Munger describes both as “World Leading” and, in some important ways, each as a “better executive than Buffett”.
- Seeing Mr. Jain singled out as a potential successor to Mr. Buffett is particularly significant in that Mr. Jain is the head of National Indemnity Company (NICO) and the main architect of its retroactive reinsurance strategy, through which it has amassed the largest concentration of asbestos and pollution liability in the industry and in history.
- By Mr. Buffett’s preferred measure of performance — change in Book Value per Share as a proxy for change in Intrinsic Value per Share — 2014 was a mediocre year by Berkshire standards, with an 8.3% increase. This compares with the 19.4% compounded annual gain achieved over the last 50 years, and 14% achieved over the previous five years. Intrinsic Value per Share (essentially the present value of the future income — something that no two analysts will ever agree on) is likely significantly higher than the easy-to-calculate proxy of Book Value per Share.
- Over the years, Berkshire has moved away from owning quoted securities to owning and operating large businesses. Because of this, the gap between Berkshire’s intrinsic value and its book value has materially widened, according to Mr. Buffett. For that reason, this year’s report marks the first time that Berkshire introduces a new set of data — a historical record of its change in stock price, which is compared to change in Book Value per Share.
- By this measure, Market Value per Share increased 27% in 2014 (versus Book Value increase of 8.3%), compared to 13.1% for the S&P 500. This compares with a compounded gain of 21.6% over the last 50 years, and 13.8% over the previous five years.
- Buffett makes no bones about the importance of the Berkshire insurance operations. What I had not previously realized is that NICO, which became the core of Berkshire’s insurance operations, was a very early investment, from 1967, and he paid $8.6 million for it without any audited financial statements! Now, 48 years later, here is what Mr. Buffett says about their insurance operations:
“Berkshire’s huge and growing insurance operation again operated at an underwriting profit in 2014 — that makes 12 years in a row — and increased its float. During that 12-year stretch, our float — money that doesn’t belong to us but that we can invest for Berkshire’s benefit — has grown from $41 billion to $84 billion. Though neither that gain nor the size of our float is reflected in Berkshire’s earnings, float generated significant investment income because of the assets it allows us to hold”.
- Buffett goes on to write that the insurance industry “has been the engine that has propelled our expansion since 1967 when we acquired NICO”. NICO today has a net worth of $111 billion, more than any other insurer in the world.
- Buffett does not write much about the retroactive reinsurance contracts, which concentrate such unprecedented amounts of risk at Berkshire. But he does make a few important mentions:
“Last year, our premier position in reinsurance was reaffirmed by our writing a policy carrying a $3 billion single premium. I believe that the policy’s size has only been exceeded by our 2007 transaction with Lloyds, in which the premium was $7.1 billion”.
- Buffett is, of course, referring to the retroactive reinsurance deal with Liberty Mutual covering asbestos, environmental and worker’s compensation liabilities announced in July 2014. Under the deal, Liberty ceded $3.3 billion in existing liabilities to Berkshire, with an additional limit of $3.2 billion for additional adverse development.
- Buffett goes on to comment on the concentration of risk at Berkshire:
“In fact, I know of only eight P/C policies in history that had a single premium exceeding $1 billion. And, yes, all eight were written by Berkshire. Certain of these contracts will require us to make substantial payments 50 years or more from now.”
- Well, it is fairly easy to recognize that most, if not all of those transactions were retroactive reinsurance deals concentrating asbestos and environmental risk at Berkshire including: Liberty Mutual, Equitas, AIG (Eaglestone), Continental, One Beacon (Potomac), and ACE (Century).
- The Berkshire Hathaway Annual Report does in fact disclose (page 111) estimated liability under retroactive reinsurance contracts for asbestos, environmental and latent injury of $12.7 billion. This is in addition to its liabilities under direct insurance policies of approximately $2.4 billion.
- NICO also filed its statutory financial statements over the weekend. These show an increase in admitted assets of $15 billion, primarily represented by an increase in its cash position of that amount, to $19 billion. This is a large amount of cash for NICO to keep handing around on its balance sheet, as it usually up streams excess cash to the parent. Berkshire as a whole is, in fact, awash with cash, with approximately $58 billion on its balance sheet — an increase of $16 billion over the previous year.
- The NICO investment machine continued to deliver stellar results in 2014. Net Investment Income Earned was $13.5 billion, and Realized Capital Gains of $2.2 billion (total $14.8 billion) were a staggering increase of 78% over 2013. To put this in perspective, compared to industry-wide 2013 investment income and realized capital gains (industry-wide 2014 results are not yet available), NICO represented 23%.
- NICO’s premium income also increased significantly in 2014, up over 300% to $23.7 billion.
- With the concentration of long-tail risk at Berkshire already the largest in the industry and in history, 2014 shows the highly successful strategy continuing, with record levels of surplus, and record levels of investment earnings generated by the strategy.