Berkshire Hathaway – Page 2

On the Structure of Berkshire Hathaway

Posted on 12 March 201413 March 2014 by David Merkel

Berkshire Hathaway [BRK] is a unique company. ?You have a property-casualty insurance giant owning many businesses directly through insurance subsidiaries, including huge businesses like a Class 1 Railroad — BNSF.

Yes, National Indemnity owns BNSF in entire, and many other businesses as well. ?I thought the pre-crisis org chart of AIG was complex — because of the many industries that it covers, BRK is far more complex. ? In the 2012 statutory statements, it runs for 22 pages. ?Let me list the top-level subsidiaries, and any significant lower level subsidiaries they own.

Affordable Housing Partners (common for reducing taxes w/ section 42 housing)
Albecca (Larson-Juhl)
AU Holding Company (Applied Underwriters
Ben Bridge Corporation
Benjamin Moore
Berkshire Hathaway Credit Corp (BH Media — all the little newspapers)
Berkshire Hathaway Finance Corp
BH Columbia Inc (Columbia Insurance, Medical Protective Corp [which owns Lubrizol debt])
BH Housing LLC
BH Shoe Holdings, Inc.
BH-IMC Holdings B.V. (“Iscar”)
BHSF (SF = Scott Fetzer)
Blue Chip Stamps, Inc. ?(Really, still around?)
Borsheim Jewelry Company
Brookwood Insurance Company
Business Wire, Inc.
Central States of Omaha Companies, Inc.
CORT Business Services Corp
CTB International Corp.
Cypress Insurance Company
Forest River, Inc.
Fruit of the Loom, Inc.
Garan, Inc.
Gateway Underwriters Agency
General Re Corporation (seems to own much of Fruit of the Loom)
Helzberg’s Diamond Shops
International Dairy Queen
Johns Manville Corp
Jordan’s Furniture
Justin Brands (Acme Brick)
Marmon Holdings
MidAmerican Energy Holdings (CalEnergy, HomeServices of America, Magma Power, NV Energy, Pacificorp)
MiTek Industries
MS Property
National Fire & Marine Insurance Company
National Indemnity (Flightsafety, BNSF, CLAL, GEICO, Clayton Homes, McLane, TTI)
National Liability & Fire Insurance Company
Nebraska Furniture Mart
NetJets, Inc.
Northern States Agency, Inc.
OTC Worldwide Holdings (Oriental Trading Company)
Precision Steel Warehouse, Inc.
R. C. Willey Home Furnishings
Richline Group, Inc.
See’s Candy Shops
Shaw Industries Group
Star Furniture Company
The Buffalo News, Inc.
The Fechheimer Brothers Company
The Lubrizol Corp
The Pampered Chef, Lrd.
US Investment Corporation
Wesco-Financial Insurance Company
XTRA Corp

BRK is huge, and Buffett prefers owning whole companies to portions of companies, because then the entire free cash flow is available to him, not just the dividends.

The first question to answer is why does Buffett have some industrial companies inside his insurers, and some not? ?That has to do with risk-based capital. ?P&C insurers have to put up capital equal to 22.5% on equity of affiliated insurers, and 15% on non-affiliated common stocks, and 20% on Schedule BA investments that are similar to stocks. ?These are more liberal than the standards for life companies, which ?have a 30% charge on stocks. ? (Which doesn’t make sense, because life insurers have longer balance sheets, and have a better ability to hold equities, but I digress…)

But even if they have to put up capital to own the companies, BRK has a negative cost of capital inside its insurers, because they make underwriting profits. ?What a business — make money on insurance, and on businesses owned by the insurance subsidiary.

One more thing about BRK’s insurance subsidiaries — in general, because they have so much asset risk, they don’t write as much insurance as other companies of their size would.

Tomorrow, I will write part 2 on this, regarding the one anomaly I found going through BRK’s statutory books, the Harney Investment Trust. ?Till then.

Full disclosure: long BRK/B for clients and me

A Letter to Warren, Part 2

Posted on 31 May 2013 by David Merkel

You might recall my letter to Warren Buffett, and his response to me.? A number of my readers made some very nice offers to help me on this project.? Many thanks to you all, but I found a way to shrink the size of the project.? Look at this table:

NAIC #	Assets	Liabs	Surplus	Name	Group	Notes	Pct
38865	443	199	244	CALIFORNIA INSURANCE COMPANY	AU		0.2%
28258	92	49	43	CONTINENTAL NATIONAL INDEMNITY CO	AU		0.0%
14144	347	322	25	APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.	AU	(2)	0.0%
35246	23	8	15	Illinois Insurance Company	AU		0.0%
21962	11	–	11	Pennsylvania Insurance Company	AU		0.0%
20044	1,083	346	737	BERKSHIRE HATHAWAY HOMESTATE INSURANCE COMPANY	BHH		0.6%
11673	762	336	426	REDWOOD FIRE & CASUALTY INSURANCE CO	BHH		0.3%
10855	1,065	858	207	CYPRESS INSURANCE COMPANY	BHH		0.2%
34630	459	321	138	OAK RIVER INSURANCE COMPANY	BHH		0.1%
11014	11	4	7	BROOKWOOD INS CO	BHH		0.0%
35939	9	2	7	CONTINENTAL DIVIDE INSURANCE CO	BHH		0.0%
34274	335	50	285	CENTRAL STATES INDEMNITY CO OF OMAHA	CSI		0.2%
82880	18	4	14	CSI LIFE INSURANCE COMPANY	CSI		0.0%
22063	19,090	11,072	8,018	GOVERNMENT EMPLOYEES INSURANCE CO	GEICO		6.3%
22055	6,444	3,695	2,749	GEICO INDEMNITY COMPANY	GEICO		2.1%
41491	1,713	1,051	662	GEICO CASUALTY COMPANY	GEICO		0.5%
14137	239	19	220	GEICO SECURE INSURANCE COMPANY	GEICO		0.2%
14139	249	36	213	GEICO CHOICE INSURANCE COMPANY	GEICO		0.2%
14138	249	41	208	GEICO ADVANTAGE INSURANCE COMPANY	GEICO		0.2%
35882	184	70	114	GEICO GENERAL INS CO	GEICO		0.1%
22039	15,533	4,840	10,693	GENERAL REINSURANCE CORP	GenRe		8.4%
27812	15,069	4,637	10,432	COLUMBIA INSURANCE COMPANY	GenRe		8.2%
86258	3,101	2,513	588	GENERAL REINSURANCE LIFE CORPORATION	GenRe		0.5%
37362	748	182	566	GENERAL STAR INDEMNITY CO	GenRe		0.4%
11967	251	69	182	GENERAL STAR NATIONAL INS CO	GenRe		0.1%
38962	190	55	135	GENESIS INSURANCE COMPANY	GenRe		0.1%
12319	176	76	100	PHILADELPHIA REINSURANCE CORP	GenRe		0.1%
32280	130	61	69	Commercial Casualty Insurance Company	GenRe		0.1%
20931	48	26	22	Atlanta International	GenRe	Runoff	0.0%
97764	20	5	15	IDEALIFE INSURANCE COMPANY	GenRe		0.0%
31470	512	363	149	NORGUARD INSURANCE COMPANY	Guard		0.1%
42390	416	316	100	AMGUARD INSURANCE COMPANY	Guard		0.1%
14702	104	71	33	EASTGUARD INSURANCE COMPANY	Guard		0.0%
11981	42	29	13	WestGUARD	Guard		0.0%
11843	3,013	1,938	1,075	MEDICAL PROTECTIVE CO	MedPro		0.8%
42226	586	173	413	Princeton Ins Co	MedPro		0.3%
13589	14	11	3	MedPro RRG Risk Retention Group	MedPro		0.0%
20087	127,340	48,479	78,861	NATIONAL INDEMNITY COMPANY	NI		61.7%
20079	5,597	1,739	3,858	NATIONAL FIRE & MARINE INSURANCE CO	NI		3.0%
62345	10,938	8,700	2,238	BERKSHIRE HATHAWAY LIFE INSURANCE COMPANY OF NEBRASKA	NI		1.8%
13070	1,841	692	1,149	BERKSHIRE HATHAWAY ASSURANCE CORPORATION	NI		0.9%
39136	1,203	487	716	Finial Reinsurance Company	NI	Runoff	0.6%
20052	1,419	705	714	NATIONAL LIABILITY & FIRE INS CO	NI		0.6%
42137	212	70	142	NATIONAL INDEMNITY CO OF THE SOUTH	NI		0.1%
20060	173	49	124	NATIONAL INDEMNITY CO OF MID-AMERICA	NI		0.1%
22276	90	19	71	STONEWALL INSURANCE COMPANY	NI		0.1%
37923	100	55	45	SEAWORTHY INSURANCE CO	NI		0.0%
36048	74	42	32	UNIONE ITALIANA REINS CO OF AMERICA	NI	Runoff	0.0%
11591	63	51	12	FIRST BERKSHIRE HATHAWAY LIFE INSURANCE COMPANY	NI		0.0%
10391	43	32	11	AMERICAN CENTENNIAL INSURANCE CO	NI		0.0%
13795	2	–	2	AttPro RRG Reciprocal Risk Retention Grp	NI		0.0%
25895	675	234	441	UNITED STATES LIABILITY INS CO	USLI		0.3%
26522	434	160	274	MOUNT VERNON FIRE INSURANCE CO	USLI		0.2%
35416	161	59	102	US UNDERWRITERS INSURANCE CO	USLI		0.1%
15962	171	23	148	KANSAS BANKERS SURETY CO	Wesco		0.1%

Total	223,315	95,444	127,871
			106,000	From 10K

This table lists all of Berkshire Hathaway’s domestically domiciled insurance subsidiaries, all 55-56 of them, maybe minus a few intermediate holding companies that are just shells.? The NAIC # uniquely identifies each company for the National Association of Insurance Commissioners.? Then comes the assets, liabilities, and surplus for regulatory purposes.? Then there are the groups that each subsidiary belongs to, and what percentage? of the total statutory surplus each one represents.

The table is sorted by the major subsidiary groups, and then in declining order of surplus.?? Here is the key to the groups:

AU = Applied Underwriters
BHH = Berkshire Hathaway Homestate
CSI = Central States Indemnity
GEICO (what else?)
GenRe = General Reinsurance
Guard = AmGuard
MedPro = Medical Protective
NI = National Indemnity
USLI = United States Liability Insurance
Wesco = Wesco Financial

A number of the companies are not writing new business; they are in what is called “runoff.”? Two companies may have the same name “APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.” but are domiciled in different states.

So, back to my challenge to understand the structure of Berkshire Hathaway.? The above table makes my life easy.? Really, I only need to get the reports of the following companies:

Berkshire Hathaway Homestate
General Reinsurance
GEICO
National Indemnity (really, the one most needed)
Medical Protective

Those five companies cover ~94% of the statutory surplus of? all of Berkshire’s insurance companies.? I can afford to get that data.? But how should I do it?

I can buy it though the NAIC
I could write Warren another letter asking for his approval to ask each company for their statutory statements.
I could ask each subsidiary for their statements, and see how they react.
I could troll the web, and see if they aren’t hiding out there.? One reader suggested that the Statements are out there on some state insurance department websites, but that would surprise me. That hasn’t been true in the past.

I am thinking of doing #2, but am open to advice.

As an aside, note that the sum of $128 billion of statutory surplus is far more than the $106 billion listed in the latest 10-K.? That is because of capital stacking, which is a form of double counting.? Lower lever subsidiaries surplus gets counted in their intermediate parent companies.? But if I eliminate all of the lower level companies, I only end up with $100 billion.

This is a different approach to Berkshire Hathaway, approaching it as a group of? insurance companies that owns businesses.? It is very different, yet successful.? When I get the data, I hope we all learn a lot.

On Questions to Buffett

Posted on 4 May 2013 by David Merkel

I’m going to comment on three articles written before Buffett’s party.? I am not picking on these because they are dumb.? I am picking on them because they are brighter than most, but still don’t get Buffett.

Copying Warren Buffett harder for investors today

No individual investor can copy Buffett in full, unless he buys BRK, which isn’t the worst idea around.? These two articles explain why almost no one can copy Warren:

In general, it is far better to follow the principles that Buffett has espoused — value investing, than to try to mimic Buffett himself.? Buffett is so big that he can’t look at the little opportunities that you and I can look at.? So take advantage of your small size, and buy some of the illiquid companies that Buffett can’t touch, because they don’t move the needle.

That said, if I were in the shoes of Todd Combs or Ted Weschler, I would create a “small cap bucket” for odd names that you know are cheap, but you only want to get at your level.? You don’t want to waste a lot of time on this, but you do want to take advantage of your insights, at least to the level that DFA does.

Buffett?s Bear: 5 Questions Doug Kass Should Ask

I think Doug Kass will have better questions than these, but they are simple enough that I can answer them in my imitation of Buffett’s voice:

1) Why the lackluster returns?

Charlie & I have often said our stock was overvalued.? We recently initiated a buyback, because we no longer thought so.? Since then, performance has been adequate.

But we don’t manage for market returns.? We manage the company to compound the net worth.? We can’t control the capitalization that outside investor might assign the company, so we focus on what we can control.

2) Why shouldn?t Berkshire break-up?

There are real financing advantages to being part of Berkshire Hathaway.? We have chosen firms that will do well in good times and bad and have conservatively financed them.? Further, one of our advantages is that those who sell companies to us know that the culture of the company will be preserved.? That gives us an advantage in acquiring firms that most of private equity does not have.? It makes us eclectic, but it is a good eclectic.

3) Is the stock market overvalued?

We don’t pay much attention to that, but we won’t overpay for investments, and we are not finding much attractive at present.? We just try to grow the net worth of our company.

4) Is Geico moving fast enough?

GEICO has done exceptionally well over the years, underwrites very well, and is one of the lowest cost operators? in personal insurance.? Speed is not what we are concerned with; we are more concerned about the quality of what we do rather than taking chances, as we believe some of the industry is regarding close monitoring of policyholder behavior.? If it truly works, our managers at GEICO will adopt it.

5) Is Berkshire?s business model preventing success?

I empower my managers to make all manner of decisions to enhance the value of the company.? This is not a weakness; they help me make money in good times and in bad times.? The stock market has had a hard run of late; please revisit what we do after the next correction in the market.

(I hope Doug Kass has better questions than these…)

Berkshire Annual Meeting: 5 Questions for Warren Buffett

1) Come on, Warren, isn?t it Ajit?

This isn’t obvious.? We have many excellent managers.? Ajit’s underwriting skills are considerable, as well as his general management skills.? He would do well to succeed me, but there may be others who are better.

2) About that Heinz deal??

Heinz was an excellent deal for us, and we would do more of them.? We have an excellent partner managing the investment, and if it does well, we have a disproportionate amount of the upside in the deal.? If it does middlingly, we do well also.

3) How does the economy look to Berkshire?

Really, we don’t care much about the economy in the short-run.? We are building a business to exist over the long-term.? We are bulls on America; no one has ever won in the long haul being bearish on America.

4) About those new stakes in Goldman Sachs and General Electric?

We have expressed our desires to be long-term holders of Goldman Sachs.? As for General Electric, we admire the company.? Who doesn’t?? That said, we will manage our stakes relative to our long-term expectations of their value.

5) Is your Twitter account due diligence?

We only buy companies where there is no competition, and where we think there is value and sustainable competitive advantage.? We created a Twitter account for me so that we could communicate with those who follow our company.

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I’m sure Buffett would sound better.? That said, even though it is the Wall Street Journal’s reporters, there are better questions to ask.? Hopefully Doug Kass will ask some of them.? That said, Berkshire Hathaway is well thought out.? I think a question that would surprise Buffett would be unlikely.? And if it did surprise Buffett, Charlie would give an adequate terse answer.

Buffett’s Career in Less Than 1000 Words

Posted on 27 March 201327 March 2013 by David Merkel

This post is at the behest of my friend Tom Brakke of The Research Puzzle.? It is meant to briefly describe how Warren Buffett’s investing changed over the years.

Compounding Capital

The basic idea of Warren Buffett’s investing is simple.? Try to compound your capital at the fastest rate consistent with a margin of safety.? That margin of safety might be a strong balance sheet, or it might be a product with high gross margins that faces little competition.? But compound capital over the long haul.? Do it, whether it is public or private investing.? Do it, regardless of the form of the asset.? Do it, if you have to change in midstream from being an asset manager, to being the manager of an investment-oriented conglomerate.

Those are themes I will explore in this essay, but who can explain Buffett well in less than 1000 words?

Buying Cigar Butts

Ben Graham had a huge influence on Buffett, but Buffett was his own man.? He had made money in many ways prior to working for Graham/Newman — he was a very driven, determined man.? But buying dud companies where the price was far lower than what the net assets were worth was a simple strategy that few followed.? It had great returns from the mid-30s to mid-60s or so.

Why? The Great Depression left the stock market in disarray, and convinced a generation not to touch stocks; they were not able to be analyzed.? So a few enterprising men analyzed and made a lot of money.

After Graham-Newman folded in 1956, Buffett started his own investing partnerships, which he eventually consolidated into one partnership in

But there were limits to this exercise.? Companies were sold for a profit, and the number of companies selling at bargain basement prices shrank dramatically.? Ben Graham folded; Warren Buffett adapted.

End of Buffett Partnership

Buffett ended his investment partnership as opportunities declined, and distributed out the shares to holders around 1969.? After a little delay, he consolidated his holdings under Berkshire Hathaway.? This was a significant move because now Buffett was running a business as an investor.? He had permanent capital, and could use it were he thought best.? Berkshire Hathaway itself was a failing textile producer.? In hindsight Buffett was too kind, and gave it too many chances, it would have been better to shut down the textile company earlier.

Textile Company to Insurance/Conglomerate Holding Company

Buffett discovered insurance early, through GEICO in 1952, and then through Berkshire Hathaway bought insurance companies which became the bedrock of the company, including buying 50% GEICO in 1974 to rescue it.? This would provide the capacity to finance/leverage investment insights.

Influence of Charlie Munger (Growth/Moat)

His friendship with Charlie Munger began in 1959, and he affected the way Buffett thought about investing.? Companies that had protected boundaries, or, sustainable competitive advantages deserved a premium valuation.? That insight began to free Buffett from the Cigar Butts, i. e., dud companies that have no growth potential, only sellout potential.? Such businesses could be bought in whole or in part, but they had to possess a durable advantage.? This would play a role as Buffett wold buy Coke, Capital Cities, American Express, Wells Fargo, and many other high quality businesses.

Willing to work Public or Private, and increasingly Private

Though Buffett was known in the 70s and 80s as a public equity manager inside a public company, he increasingly bought private companies like:

See’s Candies
Fecheimer
Kirby
Nebraska Furniture Mart
Borsheim’s
Scott Fetzer
World Book (no one is perfect)
Buffalo News (who could have predicted the Internet?)

This changed his view of what he was up to, and made him willing to run an abnormal conglomerate, one that would operate on a disaggregated basis.? Buffett would take the free cash flow from controlled companies, and the dividends from partially owned companies an reinvest them in the areas he thought had the most promise.

Scale rules out Arbitrage / Distressed Debt / Small Cap Equities / not Derivatives

Over time, Buffett invested in many ways, doing deal arbitrage, buying distressed debt, and buying small cap companies.? As time went on he had to abandon these for two reasons: he had too much capital to put to work, and competition increased, driving returns down.

Derivatives were different, Buffett was willing to take bets during times of economic stress so long as he did not have to post margin.? He took bullish bets on US Credit and Global Equities.? Much as he criticized derivatives as gambling, he was willing to take an intelligent bet where his downside was limited.

Buying companies with no auction / Tuck-in acquisitions

Buffett became the home for men who wanted to sell their companies, but preserve the culture.? Buffett didn’t pay the highest price, but he did not interfere with the new subsidiaries.

His subsidiary companies would do little tuck-in acquisitions that would further the vitality of BRK, without spending a lot.

Increasing Insurance Scale

And over time, bought all of GEICO, Gen Re, and many other smaller insurers.? Supposedly, at one point, Hank Greenberg said to Buffett, “Call me when you have a real insurance company!”? The two were frenemies for some time.? But today, the show is on the other foot — the largest insurer in the US in BRK.

The increased scale of insurance provided all the more capital to finance Buffett’s asset buys.? The underwriting discipline provided additional profits.

Opportunistic Provider of Capital

During the crisis in 2008-9, Buffett provided capital to well-regarded companies like GE and Goldman Sachs.? He was ready for odd opportunities like Burlington Northern, Lubrizol, and Heinz.

He was also willing to change his view on buying back shares, setting a line in the sand where he would but back shares, rather than doing a dividend.

Conglomerate Manager

Buffett never intended to run a conglomerate, but that is what he did, and did it very well, much like Henry Singleton, who was another compounder.

That’s what he does now.? There it is, in less than 1000 words.

A Letter to Warren

Posted on 26 March 2013 by David Merkel

[Address]

[Phone]

1 March 2013

Dear Mr. Buffett,

Four years ago, I contacted the IR department at AIG to ask for copies of all the 2008 statutory books for all the insurance subsidiaries.? To my surprise, they sent them, 60 pounds worth, and I wrote a report explaining how almost all of the domestic life subsidiaries had to be bailed out because of a funky securities lending agreement that allowed AAA subprime RMBS to used as collateral in place of T-bills.? The report was cited by SIGTARP in their review of the AIG bailout.

I am writing to you asking for copies of the 2012 statutory books for Berkshire Hathaway.? My purposes are different than with AIG.? You?ve done something unique with Berkshire Hathaway.? No one else has created such a multifaceted conglomerate, much less one with well-run insurance companies at the core, providing funding.

I have the capability of understanding the documents and doing a good job with them.? I am an actuary as well as a value investor, and have been a buy-side analyst in a hedge fund where I focused on the insurance industry.? (Todd Combs and I interacted a little when I was a buy-side analyst.? You chose well.)

My clients and I own ?B? shares of Berkshire Hathaway, so I am a small part of the Berkshire family.? If you are willing, please send me of the 2012 statutory books for Berkshire Hathaway.

Sincerely,

David J. Merkel, CFA

Principal, Aleph Investments

Writer at the Aleph Blog

And the deservedly terse handwritten response:

David, Sorry we get a lot of requests & it would be burdensome for a small staff to respond to these.

Warren

My Thoughts

Buffett is right, and I should have thought harder.? Everything BRK does is disaggregated, even filing Statutory Statements.? I am mentally stuck in the world of when I was an actuary engaged in financial reporting, where we would have a room where we would gather all the data to go to the states, rating agencies, etc.? I had to do that many times.

But Berkshire acts like a bunch of unaffiliated companies, and files their data separately.? To the best of my knowledge, that means I would have to ask 37 different entities for their Statutory Statements.? Here they are:

Company Name	State of Domicile	NAIC Number
CALIFORNIA INSURANCE COMPANY	CA	38865
COMMERCIAL CASUALTY INSURANCE COMPANY	CA	32280
CYPRESS INSURANCE COMPANY	CA	10855
FINIAL REINSURANCE COMPANY	CT	39136
GENERAL RE LIFE CORPORATION	CT	86258
GENESIS INSURANCE COMPANY	CT	38962
IDEALIFE INSURANCE COMPANY	CT	97764
NATIONAL LIABILITY & FIRE INSURANCE COMPANY	CT	20052
AMERICAN CENTENNIAL INSURANCE COMPANY	DE	10391
GENERAL REINSURANCE CORPORATION	DE	22039
GENERAL STAR NATIONAL INSURANCE COMPANY	DE	11967
APPLIED UNDERWRITERS CAPTIVE RISK ASSURANCE COMPANY, INC.	IA	14144
CONTINENTAL INDEMNITY COMPANY	IA	28258
ILLINOIS INSURANCE COMPANY	IA	35246
MEDICAL PROTECTIVE COMPANY (THE)	IN	11843
GEICO CASUALTY COMPANY	MD	41491
GEICO GENERAL INSURANCE COMPANY	MD	35882
GEICO INDEMNITY COMPANY	MD	22055
GOVERNMENT EMPLOYEES INSURANCE COMPANY	MD	22063
SEAWORTHY INSURANCE COMPANY	MD	37923
BERKSHIRE HATHAWAY HOMESTATE INSURANCE COMPANY	NE	20044
BERKSHIRE HATHAWAY LIFE INSURANCE COMPANY OF NEBRASKA	NE	62345
CENTRAL STATES INDEMNITY CO. OF OMAHA	NE	34274
COLUMBIA INSURANCE COMPANY	NE	27812
CSI LIFE INSURANCE COMPANY	NE	82880
NATIONAL INDEMNITY COMPANY	NE	20087
OAK RIVER INSURANCE COMPANY	NE	34630
REDWOOD FIRE AND CASUALTY INSURANCE COMPANY	NE	11673
STONEWALL INSURANCE COMPANY	NE	22276
ATLANTA INTERNATIONAL INSURANCE COMPANY	NY	20931
BERKSHIRE HATHAWAY ASSURANCE CORPORATION	NY	13070
UNIONE ITALIANA REINSURANCE COMPANY OF AMERICA, INC.	NY	36048
AMGUARD INSURANCE COMPANY	PA	42390
EASTGUARD INSURANCE COMPANY	PA	14702
NORGUARD INSURANCE COMPANY	PA	31470
PHILADELPHIA REINSURANCE CORPORATION	PA	12319
UNITED STATES LIABILITY INSURANCE COMPANY	PA	25895

How do you get the data in this case?

1) I suppose I could write each one and ask, but there is no guarantee that many would listen or act.

2) I could buy it from the NAIC, but it would run to around $700, and I am not doing that for a mere blog post.? Most insurers give you the statutory statements if you ask (in PDF form).? I never pay for Stat statements; I believe that they should be available in electronic form for free, or a nominal fee.

Maybe someone would want to pay it in exchange for credit on the series of articles that would flow from it?? Maybe SNL would pay for an article from me?? Or Bloomberg?? Or a competitor?? Or the sell-side wanting a guest piece? Or…

3) I could ask my readers for ideas.

Why would anyone care about this?

1) Alice Schroeder wrote the first sell-side analysis of Berkshire Hathaway.? In it she stated that the company had a waiver from the Risk-Based Capital rules from the states.? If true, that is quite a regulatory advantage, and I would want to verify that.? Current regulators might care.

2) Buffett is clever, and has the holding company and well-run insurers owning industrial, utility and service businesses.? If this is done well, and it is quite an accomplishment, because the alphas of prudent underwriting and ownership of well-run businesses get added together on one capital base.? Others might like to duplicate it.? I know that I have gotten pitches from consultants touting such ideas.

Anyway…

Well, it was worth a try.? Marc Hamburg did not return my phone calls, but I understand.? BRK is different from other companies — even the insurance is done subsidiary by subsidiary.? If any of you have ideas, I am all ears.

On the bright side, I do have a short note from the guy I have learned so much from.? I may frame it… 😉

Full disclosure: long BRK/B

A Few Notes from the Berkshire Hathaway 10K

Posted on 5 March 2013 by David Merkel

Letting the document speak, here are a few notes, starting with with the most significant part of the risk factors:

Investments are unusually concentrated and fair values are subject to loss in value.

We concentrate a high percentage of our investments in equity securities in a low number of companies and diversify our investment portfolios far less than is conventional in the insurance industry. A significant decline in the fair values of our larger investments may produce a material decline in our consolidated shareholders? equity and our consolidated book value per share. Under certain circumstances, significant declines in the fair values of these investments may require the recognition of other than-temporary impairment losses.

A large percentage of our investments are held in our insurance companies and a decrease in the fair values of our investments could produce a large decline in statutory surplus. Our large statutory surplus serves as a competitive advantage, and a material decline could have a material adverse affect our ability to write new insurance business thus affecting our future underwriting profitability.

Buffett does very well, but I know of no other insurer that invests so much in equities funded by insurance liabilities.? There is a real risk that if the markets fall hard, a la 1929-32, 1973-4, 2007-8. that BRK would be hard-pressed, particularly if there were some significant disaster like Katrina or Sandy, or set of disasters like 2004 or 2011.

And a note on the accounting change that Buffett mentioned in his letter, but did not decide to describe:

Underwriting expenses incurred in 2012 increased $586 million (21.1%) compared with 2011. The increase was primarily the result of a change in U.S. GAAP concerning deferred policy acquisition costs (?DPAC?). DPAC represents the underwriting costs that are eligible to be capitalized and expensed as premiums are earned over the policy period. Upon adoption of the new accounting standard as of January 1, 2012, GEICO ceased deferring a large portion of its advertising costs. The new accounting standard was adopted on a prospective basis and as a result, DPAC recorded as of December 31, 2011 was amortized to expense over the remainder of the related policy periods in 2012. Policy acquisition costs related to policies written and renewed after December 31, 2011 are being deferred at lower levels than in the past. The new accounting standard for DPAC does not impact the cash basis periodic underwriting costs or our assessment of GEICO?s underwriting performance. However, the new accounting standard accelerates the timing of when certain underwriting costs are recognized in earnings. We estimate that GEICO?s underwriting expenses in 2012 would have been about $410 million less had we computed DPAC under the prior accounting standard and that, as a result, GEICO?s expense ratio (the ratio of underwriting expenses to premiums earned) in 2012 would have been less than in 2011.

The point is that BRK’s underwriting result would have been very good without the accounting change.? The accounting change was a good thing, though.? Companies trying to inflate profits look for every marketing expense that they can deem an “investment.”? All of those costs would be spread over the life of the policies, rather expensed in the current year.? The new accounting standard limits what costs can be expensed to those that are truly marginal to the business produced.

Final note: They lost money on annuity reinsurance and retro at Berkshire Hathaway Reinsurance Group [Pp 34-36].? Retro sprang from new claims.? On annuities:

The annuity business generated underwriting losses of $178 million in 2012, $118 million in 2011 and $114 million in 2010. Annuity underwriting losses reflect the periodic discount accretion of the discounted liabilities established for such contracts as well as adjustments for mortality experience.

I am not sure I would want to reinsure annuities; I’m not sure that it is possible to insure long term investment guarantees, no matter how truncated.

Full disclosure: long BRK/B

Comments on the Berkshire Hathaway Annual Letter

Posted on 2 March 2013 by David Merkel

I’ll let Buffett speak, and I will add a few comments.

When the partnership I ran took control of Berkshire in 1965, I could never have dreamed that a year in which we had a gain of $24.1 billion would be subpar, in terms of the comparison we present on the facing page.

But subpar it was. For the ninth time in 48 years, Berkshire?s percentage increase in book value was less than the S&P?s percentage gain (a calculation that includes dividends as well as price appreciation). In eight of those nine years, it should be noted, the S&P had a gain of 15% or more. We do better when the wind is in our face.

To date, we?ve never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. (The record is on page 103.) But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five year wins will end.

One thing of which you can be certain: Whatever Berkshire?s results, my partner Charlie Munger, the company?s Vice Chairman, and I will not change yardsticks. It?s our job to increase intrinsic business value ? for which we use book value as a significantly understated proxy ? at a faster rate than the market gains of the S&P. If we do so, Berkshire?s share price, though unpredictable from year to year, will itself outpace the S&P over time. If we fail, however, our management will bring no value to our investors, who themselves can earn S&P returns by buying a low-cost index fund.

I appreciate Buffett & Munger not changing their metric.? They could have said that the market return beat the S&P in 2012, but they didn’t.? Buffett is a compounder.? He figures that if he compounds net worth at an above average rate, he will beat the market returns of the S&P 500 over the intermediate term.? I agree; building intrinsic value will almost always lead to outperformance, unless the stock was significantly overvalued at the beginning.

On Searching for Acquisitions

Our luck, however, changed early this year. In February, we agreed to buy 50% of a holding company that will own all of H. J. Heinz. The other half will be owned by a small group of investors led by Jorge Paulo Lemann, a renowned Brazilian businessman and philanthropist.

We couldn?t be in better company. Jorge Paulo is a long-time friend of mine and an extraordinary manager. His group and Berkshire will each contribute about $4 billion for common equity in the holding company. Berkshire will also invest $8 billion in preferred shares that pay a 9% dividend. The preferred has two other features that materially increase its value: at some point it will be redeemed at a significant premium price and the preferred also comes with warrants permitting us to buy 5% of the holding company?s common stock for a nominal sum.

Once again, we don’t know all of the details, but it really looks like Buffett got the better part of the deal, and by a decent margin.? He continues:

Our total investment of about $12 billion soaks up much of what Berkshire earned last year. But we still have plenty of cash and are generating more at a good clip. So it?s back to work; Charlie and I have again donned our safari outfits and resumed our search for elephants.

As many expected, Buffett has more than enough cash to deploy if he sees the right deal.? With valuations being high, I don’t see how they fire the elephant gun, unless a company with protected boundaries wants to sell.

Though I failed to land a major acquisition in 2012, the managers of our subsidiaries did far better. We had a record year for ?bolt-on? purchases, spending about $2.3 billion for 26 companies that were melded into our existing businesses. These transactions were completed without Berkshire issuing any shares.

Charlie and I love these acquisitions: Usually they are low-risk, burden headquarters not at all, and expand the scope of our proven managers.

The tuck-in acquisitions of BRK are particularly valuable.? Done out of the spotlight, they get done at reasonable terms, and grow BRK organically.

The new investment managers, Combs and Weschler, did well in 2012, and Buffett is giving them more assets to manage.

As noted in the first section of this report, we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money.

Now interest rates are low, and underwriting standards are far tougher across the industry than if we were in a high interest rate environment.

Let me emphasize once again that cost-free float is not an outcome to be expected for the P/C industry as a whole: There is very little ?Berkshire-quality? float existing in the insurance world. In 37 of the 45 years ending in 2011, the industry?s premiums have been inadequate to cover claims plus expenses. Consequently, the industry?s overall return on tangible equity has for many decades fallen far short of the average return realized by American industry, a sorry performance almost certain to continue.

What Buffett is saying is that his float is unique because:

His company underwrites carefully.
There is a decent amount of long-tailed business.
The short-tailed business (GEICO) is growing, which makes short-dated float feel long — in essence Buffett can borrow short and invest long, for now.

A further unpleasant reality adds to the industry?s dim prospects: Insurance earnings are now benefitting [sic] from ?legacy? bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years ? and perhaps for many years beyond that. Today?s bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over.

He is overstating the case here.? Most P&C insurers run short asset portfolios and have already adjusted to the low interest rate environment.

Now regarding the non-insurance operating businesses of BRK, they almost all had good years in 2012.? I’m not going to say more, though I will say that Buffett spent too much ink on newspapers; it is a teensy part of BRK.

Finally. Buffett talks about dividends.? There are two major ideas here:

Dividends are tax-disadvantaged versus buybacks.
If you can compound earnings at an above-average rate, there is no reason to ever pay a dividend.

What this might mean is that when a future CEO of BRK concludes that “there are no more worlds left to conquer” a la Alexander the Great, it would be reasonable to pay a dividend.? That said, he could also:

Centralize HR, legal and other functions.
Streamline subsidiaries, and make fewer managers manage more of BRK.
E.g., turn BRK into a real company.

There would be many ways to reshape BRK post-Buffett.? There are benefits and costs to doing that, but I think the benefits would be significant, unless the new CEO could keep the “hands off” way that Buffett does private equity.

Full Disclosure: Long BRK/B

Another Note on the Purchase of Heinz

Posted on 20 February 2013 by David Merkel

I need to correct one thing that I wrote yesterday: 3G and Berkshire Hathaway each own 50% of Heinz, once the transaction is done.? I mistakenly thought that both sides were putting up equal amounts of capital, when they are only putting up equal amounts of common equity.

So when you look at the financing of the $23 billion purchase price for Heinz it should look like this:

Financing	Amount
Common Equity 3G	$4.0B
Common Equity BRK	$4.0B
Warrants BRK	$0.1B
Preferred Stock BRK	$8.0B
New debt for HNZ (to be raised by JPM and WFC)	$7.1B
Total Consideration	$23.2B

The equity interest of BRK is equal to that of 3G, and if things go well with Heinz, whatever the form of the warrants are, Buffett can add to his equity interest by paying a fixed price.? We don’t know the terms of the warrants — how much stock it covers, what is the strike price, how long does it last, and any other provisions.? What we do know is that though Berkshire claims to be the passive investor here, it possesses the right to become the dominant investor economically, even if it does not take control as a result.? This is a major reason to reject the thesis that BRK is 3G’s banker.? Far better to say that 3G is Buffett’s highly paid servant.? They will do the dirty work, the grunt work, and Buffett will benefit more under most scenarios.

Also, Wells Fargo & JP Morgan will be raising the debt portion of this offering.? I see it looking something like this: an entity allied with Berkshire and 3G floats bonds and raises cash.? The cash goes to shareholders, along with the cash from BRK and 3G, paying off HNZ shareholders at $72.50/share.? The debt attaches to Heinz and not BRK or 3G.? Another way would be a bridge loan prior to the merger that gets paid off by a debt offering and special dividend after the merger.

This of course makes the bond market jumpy.? The long debt of Heinz has sold off, whereas the shorter debt has not.? Here is an example of one that is in-between.? The bond market fears a lot of long-dated issuance, and a possible downgrade to junk.? $7 Billion of new debt is a lot, when you only have $5 Billion of debt, and another $8 Billion of preferred stock coming.? That is a quadrupling of common stock leverage.

What we don’t know:

The exact mechanics of how the debt portion of the deal gets done.
The terms of the warrants.

Now think for a moment about this from the perspective of 3G: Heinz has $1B of net income.? Buffett gets $720 million of preferred stock dividends. New debt might absorb $200 million in interest after tax.? That leaves around $80 million of profits, half of which go to Berkshire, for your $4 billion outlay, a 1%/yr return.? But consider if active management raises income to $2B, profits become $1,080 million half of which go to Berkshire, and returns to you are 13.5%/yr, leaving aside dilution from BRK option exercise.

What I am trying to show is that the tables are skewed here in favor of Buffett, again.? He has set up a deal where his partner will be very motivated to cut costs, realize synergies, etc., because they don’t make much if they don’t, while he makes out fairly well under most scenarios:

Heinz does very well — BRK exercises warrants gets majority of economics and control
Heinz muddles — BRK receives preferred dividend, does well.
Heinz does badly — BRK receives preferred dividend, does well. Might have to write down equity stake.
Heinz does very badly — BRK preferred dividend halted, buys remainder of Heinz by converting his preferred stock to equity.? 3G loses it all.? Buffett brings in competent management for his now wholly-owned subsidiary.

It’s a lot easier for Buffett to win relative to 3G.? 3G needs strong demand to win.? Buffett doesn’t.

Final note: I am not that impressed with William Johnson, the present CEO — earning? a <4%/yr return on your stock over 15 years does not even double capital for those who were willing to hang on so long.

Yes, sales have grown, but what matters to corporations if profit, not volume.? On thing thing I learned in the insurance industry — it’s easy to get sales. What is hard is getting profitable sales.? Yet how many CEOs gain bonuses partially off of sales and other meaningless criteria — far better to use something like five-year increase in fully converted tangible book value per share.? It better measures how value has? grown for shareholders.

A Note on the Purchase of Heinz

Posted on 19 February 2013 by David Merkel

I participate in an online group of Johns Hopkins students and Alumni, mainly discussing company analysis and valuation.? This is what I posted on the Heinz acquisition by 3G and Buffett:

There are two ways to look at this: like Buffett or like 3G. Let’s look at both:

(1) 3G will be the active partner. Their stake is equity only, and own 70%. They very well may have cost savings or product or marketing synergies. They are businessmen, not speculators. They will use Heinz to create a better & more global company.

(2) Buffett gets 30% of the equity for $4B, and $8B of preferred stock paying a 9% coupon. It doesn’t matter much where he places the equity in his holding company, but the preferred will go into some of the insurance companies, where it will be financed by cost-free float, require minuscule amounts of capital, and be taxed at preferential rates.

Over a long enough period of time (~20 years), the preferred pays for the whole deal, and any value of owning 30% of Heinz is gravy. (They sell gravy too.)

After the Burlington Northern acquisition, I wrote this post to justify the price paid: The Forever Fund. Regarding Heinz, ask the same questions — what would take to create a company like Heinz from scratch, i.e. replacement cost, including all of the regulatory hurdles.

Between Buffett and 3G, you likely have the financing and the savvy for a significant joint venture that will be mutually profitable. Nothing is a slam-dunk, but this looks good.

Full disclosure: long BRK/B

To sum this up: Buffett gets focused talent; he doesn’t have to concern himself with managing Heinz. He gets a stable asset that he can cheaply finance that will throw off a minimum of 6% on average (assuming 3G performs adequately; they have done better than adequate in the past).

3G gets patient capital.? They can take short and long-term steps to maximize the value of Heinz without a lot of interference or second guessing.? And if they do it very well, their upside is levered by Buffett’s preferred financing.

If they blow it… that’s another thing, but Buffett would hold the option of restructuring Heinz with a new partner, or finding talent to run it internally at BRK.? After all, it”s not like he doesn’t have the liquidity to do it.

Full disclosure: long BRK/B

Berkshire Hathaway & Variable Annuities

Posted on 14 February 201314 February 2013 by David Merkel

Sometimes I miss stuff in the news… last week Berkshire Hathaway reinsured the remainder of the variable annuity business that Cigna reinsured in the 1990s.? Four articles:

It was the last that attracted my attention, and led me to the rest of the articles cited.? To that article I commented:

This is very similar to the reinsurance deals that Buffett has done regarding asbestos.? Long-tail, upfront premium, with capped downside to Buffett.? He can invest the $2.2B of proceeds as he likes, and make additional money.? My guess is this leads to a profit of $500 million or so for Berkshire, plus any incremental from reinvestment of the $2.2B.

CIGNA was the patsy of the poker game of variable annuity reinsurance in the ’90s — this ends that ugly performance.??

Full disclosure: long BRK.B

In the past, CIGNA gave disclosures on its variable annuity liabilities.? From the most recent 10-K (pages 58-59):

Future policy benefits ? Guaranteed minimum death benefits (?GMDB? also known as ?VADBe?)

These liabilities are estimates of the present value of net amounts expected to be paid, less the present value of net future premiums expected to be received. The amounts to be paid represent the excess of the guaranteed death benefit over the values of contractholders? accounts. The death benefit coverage in force at December?31,?2011 (representing the amount payable if all of approximately 480,000 contractholders had submitted death claims as of that date) was approximately $5.4?billion.

Liabilities for future policy benefits for these contracts as of December?31 were as follows (in?millions):

?2011 ? $1,170

?2010 ? $1,138

Current assumptions and methods used to estimate these liabilities are detailed in Note?6 to the Consolidated Financial Statements.

And…

Accounts payable, accrued expenses and other liabilities, and Other assets, including other intangibles – Guaranteed minimum income benefits

These net liabilities are calculated with an internal model using many scenarios to determine the fair value of amounts estimated to be paid, less the fair value of net future premiums estimated to be received, adjusted for risk and profit charges that the Company anticipates a hypothetical market participant would require to assume this business. The amounts estimated to be paid represent the excess of the anticipated value of the income benefit over the value of the annuitants? accounts at the time of annuitization.

The assets associated with these contracts represent receivables in connection with reinsurance that the Company has purchased from two external reinsurers, which covers 55% of the exposures on these contracts.

Liabilities related to these contracts as of December?31, were as follows (in?millions):

? 2011 ? $1,333

? 2010 ? $ 903

As of December?31, estimated amounts receivable related to these contracts from two external reinsurers, were as follows (in?millions):

? 2011 ? $712

? 2010 ? $480

Current assumptions and methods used to estimate these liabilities are detailed in Note?10 to the Consolidated Financial Statements.

At 2010, the net liability was less than $1.6B.? 2011, near $1.8B.? Buffett gets a $2.2B premium, and from what was said on the conference call, the net liability declined in 2012.? Thus I estimate Berkshire Hathaway as being $500M to the good on this transaction, subject to future market conditions.

Okay, so assume the duration on these liabilities is 10 years on average.? At the limit of $4 billion in claims, Berkshire Hathaway would have to earn somewhat less than 7%/yr in order to fund payments.? That’s more than achievable for Buffett.

From Roddy Boyd’s work on AIG, by the late 80s, Hank Greenberg was running out of places to expand in P&C insurance.? As such, he began to expand with life insurance and financial services.? Greenberg liked the fact that it diversified his risk exposures, and while it was small enough, did not threaten the solvency of the whole.

Buffett has always had a wider field to play on than AIG.? In some ways, life & annuity reinsurance does diversify BRK.? It is a little more complex for Buffett, because he has a decent number of bets against the equity markets & credit falling dramatically.? This deal is similar, in that the liabilities decrease as the equity market rises, and increase as the market falls.

Buffett does not have to maintain the hedges that Cigna currently does, but if it doesn’t Buffett might have to make some promises to the regulators like a BRK parental guarantee of the subsidiary reinsuring the variable annuities.

Buffett tends to think more in book value terms — he will try to over accumulate the implied returns in reinsuring the variable annuities.? From my angle, odds are he will succeed.? The only real concern is if he does not continue the hedge, and the markets fall for a considerable period, like 1973- 1982, or 2000-2008.? That would drive up the cost of the liability considerably, if left unhedged.? That said, Buffett, of all investors tends to do well after market declines, often finding compelling investments while others are afraid to commit.

Of itself, this deal is not large enough to materially materially harm BRK if the markets do badly.? It does add on to the “long bias” of BRK if left unhedged.

A note to those who get to question Buffett at his annual meeting: Ask him about this deal.? Cigna wrote a lot about this, held a teleconference, etc.? It was a big deal for them.? BRK said nothing.? Ask Buffett if he decided to continue hedging, or whether his investing in portfolio companies or wholly owned companies constitutes an internal pseudo-hedge that he thinks will outcompete hedging.

Personally, I expect that he does not hedge.? After all, he didn’t on his equity and credit index wagers.? Buffett is a bull on the US an the world; it would not be like his past behavior to hedge.? Besides, that’s why he keeps cash around, and hey, this gave him $2.2B more cash.

Full disclosure: long BRK.B

PS — one more article about variable annuity guarantees — they give me the willies.? Much as I like insurers, I avoid insurer that offer a lot of variable annuities.? I believe they are mis-reserved.? When I listened to Cigna’s conference call and their reserving off of “thousands of scenarios” I could not help thinking of how such methods could be tweaked or abused.? There is no good underlying theory for long dated options with uncertain payoff patterns.