Last year, when BRK [Berkshire Hathaway] reported their annual earnings with the letter, report, and 10K, I concluded:

From an earnings growth standpoint, there was nothing that amazing about the earnings in 2014. ?A few new subsidiaries like NV Energy added earnings, but existing subsidiaries? earnings were flattish. ?Comprehensive income was considerably lower because of the lesser degree of unrealized appreciation on portfolio holdings.

On net, it was a subpar year for Berkshire Hathaway. ?The annual letter provided a lot of flash and dazzle, but 2014 was not a lot to write home about, and limits to the BRK business model with respect to float are becoming more visible.

What I said one year ago would be a good summary for this year, though Buffett was more upbeat about outcomes this year, with BRK’s book value advancing while the S&P 500 fell on a total return basis.

Overall, BRK had a mediocre year. ?Insurance wasn’t that great. ?Here are my summary points:

1. BRK is reducing reinsurance — i suspect they aren’t getting the rates that they want. ?There are too many reinsurance wannabes attempting to write business to generate float that they can invest against. ?Typically, writing insurance in order to invest usually doesn’t work out. ?People forget how much money was lost writing marginal insurance business in soft markets thinking they would more than make up the losses with investment income. ?BRK is showing some discipline here — good.
2. Aside from new lines of business (specialty insurance), growth is slowing; BRK is trying to remain a conservative underwriter.
3. Reserving conservatism has not changed.
4. Asbestos position has not materially changed.
5. GEICO had a bad year for claims — maybe they grew too much, and maybe picked up a lower class of auto driver.
6. Profit margins falling
7. Float growth slowing
8. Continued problems with workers’ comp and long-term care at Gen Re. ?Also problems with payment annuities (blames FX, should blame longevity) and Life Reinsurance.

A few?quotes from the 10K on insurance issues:

“We define pre-tax catastrophe losses in excess of $100 million from a single event or series of related events as significant. In 2015, we recorded estimated losses of $136 million in connection with a property loss event in China.”

and on GEICO:

“Losses and loss adjustment expenses incurred in 2015 increased $2.7 billion (17.1%)?over 2014. Claims frequencies (claim counts per exposure unit) in 2015 increased in all major coverages over 2014, including property damage and collision coverages (three to five percent range), bodily injury coverage (four to six percent range) and personal injury protection (PIP) coverage (one to two percent range). Average claims severities were also higher in 2015 for property damage and collision coverages (four to five percent range), bodily injury coverage (six to seven percent range) and PIP coverage (two to four percent range). We believe that increases in miles driven, repair costs (parts and labor) and medical costs, as well as weather conditions contributed to the increases in frequencies and severities.”

Regarding Gen Re:

“The property/casualty business generated pre-tax underwriting gains in 2015 of $944 million compared to $1.4 billion in 2014. In 2015, we incurred losses of $86 million from an explosion in Tianjin, China. There were no significant catastrophe losses in 2014. Underwriting results in 2015 included comparatively lower gains from property catastrophe reinsurance and the run off of prior years? business.”

I found the mention of two large loss events in China interesting — maybe it was just one event of $136 million, but they could have been more clear.

Float Note

Before I leave the topic of insurance, I do want to set the record straight on how valuable float is. ?This is my best article on the topic. ?Buffett is a bit of a salesman in his annual letter, but generally an honest one.

Float is only as good as the insurance business generating it. ?If it is generating underwriting losses, the investments will have to earn at least as much per year as the losses divided by the average duration of how long the float will exist in years, in order to break even.

We’re coming off of years where there have been no underwriting losses, so float is?magical — but the P&C insurance industry is getting more competitive, and float will no longer be costless.

Widespread use of float for financing is like trying to finance off of other seemingly costless liabilities — in the hands of some?investors, that can lead to disaster — after all, consider all of the disasters that I have written about where people finance short to invest long.

Conservative insurers invest their premium reserves in cashlike instruments, and their loss reserves they invest in bonds of a similar duration. ?They typically don’t invest float in equities, and certainly not whole businesses.

Buffett has done just that and done well. ?That said, he runs his insurers at lower levels of leverage than most insurers, to allow room for taking more investment risk.

Note that BRK doesn’t guarantee the debts of BNSF, BHE, etc., but does guarantee the debts of the finance arms.

There is room for another article on float and cost of capital — not sure when I will get to it, but it will be a WACC-y article. 😉

Final Notes:

1) Note that Buffett keeps profits overseas also. Quoting the 10K: “We have not established deferred income taxes on accumulated undistributed earnings of certain foreign subsidiaries. Such?earnings were approximately $10.4 billion as of December 31, 2015 and are expected to remain reinvested indefinitely.” ?My guess is that he will use them to buy a foreign subsidiary.

2) BRK Pays taxes at about a 30% rate.

3) Regarding his comments on goodwill amortization — he thinks some of it is economically valid, and some not. ?Buffett has the option of putting more data on the income statement if he wants. ?Or put it in note 11 (goodwill). ?He already does that by breaking apart revenues and expenses by corporate divisions on the income statement. ?Do us all a favor, BRK, and split the goodwill into what you think is economically valid, and what is not.

4) Buffett gives an extended defense of Clayton Homes lending. ?In general, I thought his points were good — even before Buffett, Clayton was the “class act” in manufactured housing, and financing it.

5)?Even BRK has underfunded pension plans, and it has a relatively conservative 6.5% expected return on assets.

6) I note a modest change in 10K risk factors — BNSF and the automatic braking issue. ?BNSF will have to spend a lot of money to deal with the need to stop runaway trains remotely. ?True of all?US and Canadian railroads.

7)?BRK has less free cash flow to invest in new projects because more of their businesses are capital-intensive. ?BRK invested $16B in property, plant and equipment.

8 ) BNSF had a good year. ?BH Energy had a good year, mostly from a new Canadian Transmission utility, and their home brokerage arm.

9) BRK bought Precision Castparts, Van Tuyl (auto dealerships), and AltaLink (the Canadian Transmission utility). ?Also bolt-ons to existing subsidiaries.

10) Kraft merged with Heinz.?Heinz preferred will be redeemed.

11) The big four publicly traded firms owned by BRK didn’t have a good year. AXP, KO, IBM, WFC — he bought more of IBM and WFC. ?Buffett argues that the retained earnings of the firms benefit BRK. ?I’m dubious. ?IBM has particularly been a dog — look at free cash flow. ?Much of the earnings at IBM?aren’t real. ?You can’t use what they don’t dividend.

12) Quoting Buffett from his section?on optimism about the US, he tempered it by saying: “Though the pie to be shared by the next generation will be far larger than today?s, how it will be divided?will remain fiercely contentious.”

Well, you can say that again, but fairness is a squishy concept. ?Is fairness:

• Even division (from each according to his ability, to each according to his needs)
• Proportionate to productivity
• Equal to what you negotiate
• Derived from the formula of a bureaucrat
• What you can negotiate through the political process
• Impossible
• Or something else?

Buffett worked with the easy stuff, and waved his hands at the hard stuff. ?I’ll phrase it this way: in general, the US has done well because we have not wrangled as much as the rest of the world over distribution issues, and have left a lot of room for people to?gain a lot from their own productivity. ?That has led to a lot of wealth, and in general, a growing pie for everyone to benefit from.

Productivity goes in waves, and labor plays catchup with capital after technological progress. ?We have seen people redeployed from agriculture and servanthood/slavery in the past 150 years. ?We will see them redeployed from manufacturing in the next 100 years. ?They will provide services to their fellow men, should there continue to be peace and tranquility, allowing labor income to catch up with that of capital.

Full disclosure: long BRK/B

As I mentioned yesterday, there wasn’t anything that amazing and new in the annual letter of Berkshire Hathaway. ?Lots of people found things to comment on, and there is always something true to be reminded of by Buffett, but there was little that was new. ?Tonight, I want to focus on a few new things, most of which was buried in the insurance section of the annual report.

Before I get to that, I do want to point out that Buffett historically has favored businesses that don’t require a lot of capital investment. ?That way the earnings are free to be reinvested as he see fit. ?He also appreciates having moats, because of the added pricing power it avails his businesses. ?Most of his older moats depend on?intellectual property, few competitors, established brand, etc. ?Burlington Northern definitely has little direct competition, but it does face national regulation, and dissatisfaction of clients if services can’t be provided in a timely and safe manner.

Thus the newer challenge of BRK: having to fund significant capital projects that don’t add a new subsidiary, may increase capacity a little, but are really just the price you have to pay to stay in the game. ?From page 4 of the Annual Letter (page 6 of the Annual Report PDF):

Our bad news from 2014 comes from our group of five as well and is unrelated to earnings. During the?year, BNSF disappointed many of its customers. These shippers depend on us, and service failures can?badly hurt their businesses.

BNSF is, by far, Berkshire?s most important non-insurance subsidiary and, to improve its performance, we?will spend $6 billion on plant and equipment in 2015. That sum is nearly 50% more than any other railroad?has spent in a single year and is a truly extraordinary amount, whether compared to revenues, earnings or?depreciation charges.

There’s more said about it on pages 94-95 of the annual report, but it is reflective of BRK becoming a more asset-heavy company that requires significant maintenance capital investment. ?Not that Buffett is short of cash by any means, but less will be available for the “elephant gun.”

Insurance Notes

Now for more arcane stuff. ?There are lots of people who write about Buffett and BRK, but I think I am one of the few that goes after the insurance issues. ?I asked Alice Schroeder (no slouch on insurance) once if she thought there was a book to be written on Buffett the insurance CEO. ?Her comment to me was “Maybe one good long-form article, but not a book.” ?She’s probably right, though I think I have at least 10,000 words on the topic so far.

Here are two articles of mine for background on some of the issues involved here:

• Understanding Insurance Float
• On Berkshire Hathaway and Asbestos

Here’s the main upshot: reserving is probably getting less conservative at BRK. ?Incurred losses recorded during the year from?prior accident years is rising. ?Over the last three years it would be -$2.1B, -$1.8B, and now for 2014 -$1.4B. ?(See page 69 of the annual report.) ?Over the last three years, the amount of reserves from prior years deemed to be in excess of what was needed has fallen, even as gross reserves have risen. ?In 2012, the amount of prior year reserves released as a proportion of gross reserves was greater than 3%. ?In 2014, it was less than 2%.

In addition to that, in general, the reserves that were released were mostly shorter-tailed reserves, while longer-tailed reserves like asbestos were strengthened. ?In general, when longer-tailed lines of business are strengthened in one year, there is a tendency for them to be strengthened in future years. ?It is very difficult to get ahead of the curve. ?Buffett and BRK could surprise me here, but delays in informing about shifts in claim exposure are a part of longer-tailed lines of insurance, and difficult to estimate. ?As I have said before, reserving for these lines of business is a “dark art.”

From page 91 of the annual report:

In 2014, we increased estimated ultimate liabilities for contracts written in prior years by?approximately $825 million, substantially all of which was recorded in the fourth quarter. In the fourth quarter of 2014, we?increased ultimate liability estimates on remaining asbestos claims and re-estimated the timing of future payments of such?liabilities as a result of actuarial analysis. The increase in ultimate liabilities, net of related deferred charge adjustments,?produced incremental pre-tax underwriting losses in the fourth quarter of approximately $500 million.

This was the only significant area of reserve strengthening for BRK. ?Other lines released prior year reserves, though many released less than last year.

There were a few comments on insurance profitability. ?In addition to asbestos, workers’ compensation lost money. ?Property-catastrophe made a lot of money because there were no significant catastrophes in 2014, but rates are presently inadequate there, and BRK is likely to write less of it in 2015.

My concern for BRK is that they are slowly running out of profitable places to write insurance, which reduces BRK’s profitability, and reduces the float that can be used to finance other businesses.

Maybe BRK can find other squishy liabilities to use to create float cheaply. ?They certainly have a lot of deferred tax liabilities (page 71). ?Maybe Buffett could find a clever way to fund pensions or structured settlements inexpensively. ?Time to have Ajit Jain put on his thinking cap, and think outside the box.

Or maybe not. ?Buffett is not quite to the end of his “low cost of informal borrowing” gambit yet, but?he is getting close. ?Maybe it is time to borrow at the holding company while long-term rates are low. ?Oh wait, he already does that for the finance subsidiary.

Final Notes

From an earnings growth standpoint, there was nothing that amazing about the earnings in 2014. ?A few new subsidiaries like NV Energy added earnings, but existing subsidiaries’ earnings were flattish. ?Comprehensive income was considerably lower because of the lesser degree of unrealized appreciation on portfolio holdings.

On net, it was a subpar year for Berkshire Hathaway. ?The annual letter provided a lot of flash and dazzle, but 2014 was not a lot to write home about, and limits to the BRK business model with respect to float are becoming more visible.

Full disclosure: long BRK/B for myself and clients, for now

This piece has kind of a long personal introduction to illustrate my point. ?If you don’t want to be bored with my personal history, just skip down to the next division marker after this one.

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There will always be a soft spot in my heart for people who toil in lower level areas of insurance companies, doing their work faithfully in the unsexy areas of the business. ?I’ve been there, and I worked with many competent people who will forever be obscure.

One day at Provident Mutual’s Pension Division [PMPD], my friend Roy came to me and said, “You know what the big secret is of the Pension Division?” ?I shook my head to say?no. ?He said, ” The big secret is — there is no secret,” and then he smiled and nodded his head. ?I nodded my head too.

The thing was, we were ultra-profitable,?growing fast, and our financials and strategies were simple. ?Other areas of the company were less profitable, growing more slowly, and had accrual items that were rather complex and subject to differing interpretations. ?But since the 30 of us?(out of a company of 800) were located in a corner of the building, away from everyone else, we felt misunderstood.

So one day, I was invited by an industry group of actuaries leading pension lines of business to give a presentation to the group. ?I decided to present on the business model of the PMPD, and give away most?of our secrets. ?After preparing the presentation, I went home and told my wife that I would be away in Portland, Oregon for two days, when she informed me we had an important schedule conflict.

I was stuck. ?I tried to cancel, but the leader of the group was so angry at me for trying to cancel late, when I hung up the phone, I just put my head on my desk in sorrow.

Then it hit me. ?What if I videotaped my presentation and sent that in my place? ?I called the leader of the group back, and he loooved the idea. ?I was off and running.

One afternoon of taping and $600 later, I had the taped presentation. ?It detailed marketing, sales, product design, risk control, computer systems design, and more. ?If you wanted to duplicate what we did, you would have had a road map.

But the presentation ended with a hook of sorts, where I explained why I was so free with what we were doing. ?We were the smallest player in the sub-industry, though the fastest growing, and with one of the highest profit margins. ?I said, “The reason I can share all of this with you is that if you wanted to copy us, you would have to?change an incredible amount of what you do, and kill off areas where you have invested a lot already. ?I know you can’t do that. ?But maybe you can imitate a few of our ideas and improve your current business model.”

So my colleague took the tape to the meeting, and when he returned, he handed me a baseball cap that had the word “Portland” on it. ?He said, “You did it, Dave. ?You won the best presentation of the conference award. ?Everyone sent their thanks.”

Sadly, that was one of the last things I did in the Pension Division, as corporate management chose me to clean up another division of the company. ?That is another story, but one I got few thanks for.

Today I call that hat “the $600 hat,” and I wear it to my kids baseball and softball games as I keep score.

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The secret of Berkshire Hathaway is the same as my story above. ?There is no secret.?Buffett’s methods have been written about by legions; his methods are well known. ?The same applies to Charlie Munger. ?That’s why in my opinion, there were?no significant surprises in their 50th anniversary annual letter. (There were some small surprises in the annual report, but they’re kinda obscure, and I’ll write about those tomorrow.) ?All of the significant building blocks have been written about by too many people to name.

Originally, this evening, I was going to write about the annual report, but then I?bumped across this piece of Jim Cramer’s on Buffett. ?Let me quote the most significant part:

…Cramer couldn’t help but wonder if things in the business world could be different if we approached other CEOs the way that Buffett is approached.

Perhaps, if the good CEOs were allowed to stay on longer like Buffett has or if people treated them as if they were their companies the way that Buffett is treated in relation to Berkshire, things could be different?

“Clearly something’s gone awry in the business world if we can praise this one man for everything he does, and yet every other chief executive feels shackled into being nothing like him,” Cramer said.

Cramer is very close to the following insight: the reason why more companies don’t imitate Berkshire Hathaway is that they would have to destroy too much of their existing corporations to make it worth their while. ?As such, the “secrets” of Berkshire Hathaway can be hidden in plain view of all, because the only way to create something like it would be to start from scratch. ?Yes, you can imitate pieces of it, but it’s not the same thing.

Creating a?very profitable diversified?industrial conglomerate financed by insurance liabilities is a very unique strategy, and one that few would have the capability of replicating. ?It required intelligent investing, conservative underwriting, shrewd analysis of management teams so that they would act independently and ethically, and more.

Indeed, an amazing plan in hindsight. ?Kudos to Buffett and Munger for their?clever business sense. ?It will be difficult for anyone to pursue the same strategy as well as they did.

But in my next piece, I will explain why one element of the strategy may be weakening. ?Until then.

Full disclosure: long BRK/B for myself and clients

Warren Buffett has made such an impression on value investors and insurance investors, that they think that float is magic. ?Write insurance, gain float, invest cleverly against the float, and make tons of money.

Now, the insurance industry in general?has been?a great place to invest, but we need to think about float differently. ?Float is composed of two things: claim reserves and premium reserves.

• Claim reserves are the assets set aside to satisfy all claims that likely will be made as of the current date.
• Premium reserves are the assets set aside representing prepaid premiums that have not been earned yet.

Claim reserves can be long, short or in-between. ?Last night’s article dealt with long claim reserves — asbestos, environmental, etc. ?Those reserves can be invested in stocks, real estate, long bonds, etc. ?But most claim reserves are pretty short, like a year or so for most personal insurance auto & home claims — those typically get settled in a year.

The there are classes of insurance business that are in-between — workers comp, D&O, E&O, commercial liability, business continuation, etc. ?Investing the claim reserves should reflect the length of time it will take until ultimate payoff.

The premium reserves are very short. ?If premiums are paid annually, the average period for the premium reserves?is half a year. ?If premiums are paid more frequently, the average period for the float falls, but the premiums rise disproportionately to reflect the insurance company’s desire to have the full year’s premium on hand. ?It usually makes sense for policyholders to pay at the longest period allowed — thus, thinking about premium reserves as having a ?duration of half a year on average makes sense. ?Except auto — make that a quarter of a year.

Earnings financed by?float should be divided into two pieces — non-speculative, and speculative. ?The non-speculative returns on float reflect what can be earned by investing in high quality bonds that match the time period over which the float will exist. ?Short for premium reserves, longer for claim reserves. ?So, the value of float is this:

Present value of (investment earnings of high quality duration-matched assets plus underwriting gains [or minus losses]).

This is a squishy calculation, because we do not know:

• the number of years to calculate it over
• future underwriting gains or losses

The speculative earnings from float come from assuming that float will stay at the same levels or grow over many years, and so the insurer invests more aggressively, assuming that float will be a permanent or growing thing. ?He speculates by financing stocks or whole businesses using the float that could reduce, or that could become more expensive.

How could that happen? P&C insurance often gets very competitive, and the cost of maintaining float in a soft underwriting environment is considerable. ?Also note the claim reserves mean that the company took a loss. ?That the company earns something while waiting to pay the loss does not help much. ?Far better that there were fewer losses and less float.

Smart P&C insurance companies reduce underwriting in soft markets, and in such a time, float will shrink. ?Let aggressive companies undercharge for bad business, and let them choke on it, while we make a little less money.

Well-run insurers let float shrink – they don’t depend on float being the same, much less growing. ?If it does grow, great! ?But don’t invest assuming it will always be there or grow forever. ?That way lies madness.

Berkshire Hathaway has benefited from intelligent underwriting and intelligent investment over a long period. ?That is not normal for insurance companies. ?That is why it has done so well. ?Float is a?handmaiden to good results, but not worth the attention paid to it. ?After all, all?insurance companies have float, but none have done as well as Berkshire Hathaway. ?Better you should focus on underwriting earnings rather than float.

Underwriting insurance produces premium float. ?Underwriting bad business produces claim reserve float. ?Float is not an unmitigated good. ?Good underwriting is an unmitigated good. ?So focus on underwriting, and not float.

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Berkshire Hathaway has been in the fortunate position of having had wise underwriters, and and ability to expand into new markets for many years. ?Guess what, that was AIG up until 2003 or so. ?After that, they could not find more profitable markets to underwrite, and results began to deteriorate. ?They ran up against the limits of their ecosystem.

Buffett is a brighter man than Greenberg; he can consider a greater realm of possibilities in how to run an insurance conglomerate, and the results have been better. ?All that said, there is only so much insurance to underwrite in the world, and big insurers will eventually run out of places to write insurance profitably.

All that said — float is a sideshow. ?Focus on profitable underwriting — that is what drives the best insurers.