From the 10K:

BHRG periodically assumes risks under retroactive reinsurance contracts. Retroactive reinsurance contracts afford protection to ceding companies against the adverse development of claims arising under policies issued in prior years. Coverage under such contracts is provided on an excess basis or immediately with respect to losses payable after the inception of the contract. Coverage provided is normally subject to a large aggregate limit of indemnification. Significant amounts of environmental and latent injury claims may arise under the contracts. Under certain contracts written over the last five years, the limits of indemnification provided are exceptionally large. In March 2007, an agreement became effective between NICO and Equitas, a London based entity established to reinsure and manage the 1992 and prior years? non-life liabilities of the Names or Underwriters at Lloyd?s of London. Under the agreement NICO is providing up to $7 billion of new reinsurance to Equitas. In 2009, NICO agreed to provide up to 5 billion Swiss Francs (approximately $5.3 billion as of December?31, 2011) of aggregate excess retroactive protection to Swiss Reinsurance Company Ltd. and its affiliates (?Swiss Re?). In 2010, BHRG entered into a reinsurance agreement with Continental Casualty Company, a subsidiary of CNA Financial Corporation (?CNA?), and several of CNA?s other insurance subsidiaries (collectively the ?CNA Companies?) under which BHRG assumed the asbestos and environmental pollution liabilities of the CNA Companies subject to a maximum limit of indemnification of $4 billion. In 2011, BHRG entered into a contract with Eaglestone Reinsurance Company, a subsidiary of American International Group, Inc. (?AIG?). Under the contract, BHRG agreed to reinsure the bulk of AIG?s U.S. asbestos liabilities up to a maximum limit of indemnification of $3.5 billion.

Retroactive insurance is an interesting business, and one that few insurers have as a core skill.? It is my estimate today that BRK is good at it, unlike most.? With Retroactive insurance, typically you are rescuing another insurer from some claim exposure that threatens their existence.? The insurer needs certainty, or something near it, and so they approach a much large and stronger insurer to absorb some of the risk of an exposure that is already incurred, but uncertain to to ultimate payout.

The rescuing insurer will charge a lot, and insist that the rescued insurer still have some risk on the matter, and probably limit its total payout, after which the rescued insurer is on the hook again.? That limit will likely be so high that the rescued insurer will say, “It’s never going to get that high.”? Fine, and maybe true, but this allows the rescuing insurer to have some certainty itself, that it will never pay an unlimited amount in the rescue.

For BRK, there is another angle, and that is that retroactive insurance produces a lot of float, and in most cases (Asbestos & Environmental) the float lasts a long time.? Thus BRK thinks it has an advantage in investing the float.? Together with their size, and the acumen of Ajit Jain, it makes them a unique place for insurers in trouble to seek shelter, for a tidy fee of course.

That doesn’t mean this can’t go wrong, but if properly managed, since BRK is one of the few companies that can do this, they probably make very good money on this.? (Ugh, they have AIG and Swiss Re as clients, which are large savvy firms.? If they need protection from BRK, and are willing to pay up, guess what — BRK is in the driver’s seat, because there is no one in the private sector capable of doing this.)

Insurance subsidiaries? investments are unusually concentrated and fair values are subject to loss in value.

Compared to other insurers, our insurance subsidiaries may concentrate an unusually high percentage of their investments in equity securities and may diversify their investment portfolios far less than is conventional. A significant decline in the fair values of our larger investments may produce a large decrease in our consolidated shareholders? equity and can have a material adverse effect on our consolidated book value per share. Under certain circumstances, significant declines in the fair values of these investments may require the recognition of losses in the statement of earnings.

This is potentially BRK’s largest weakness, and why I would love to see the statutory books for their insurers.? This goes beyond the large public companies that they have purchased.? Where are all of the private businesses lodged on the BRK balance sheet?? They may be there with really low valuations — I don’t know, because I have never looked — and that is why I want to ask BRK for their statutory statements.? I believe it would be intriguing.

Berkshire Hathaway Inc. has guaranteed debt obligations of certain of its subsidiaries. As of December?31, 2011, the unpaid balance of subsidiary debt guaranteed by Berkshire totaled approximately $16 billion. Berkshire?s guarantee of subsidiary debt is an absolute, unconditional and irrevocable guarantee for the full and prompt payment when due of all present and future payment obligations. Berkshire also provides guarantees in connection with long-term equity index put option and credit default contracts entered into by a subsidiary. The estimated fair value of liabilities recorded under such contracts was approximately $10.0 billion as of December?31, 2011. The amount of subsidiary payments under these contracts, if any, is contingent upon future events. The timing of subsidiary payments, if any, will not be fully known for several decades.

Add in $8 billion of holding company debt, and that is the risk that the holding company faces, which isn’t that much for a company the size of BRK.? BRK has bought a series of businesses that produce consistent cash flow, so don’t worry about holding company debt.

BRK has more debt than that, but Buffett lets bond investors take the risk by not guaranteeing subsidiary debt.? In acquisitions, Buffett never guarantees the debt.? But even with new debt issues, many BRK subsidiaries offer their own non-BRK-guaranteed debt, whether it is Burlington Northern, or a Mid-American sub offering debt to back a solar power plant.? Now bond investors know the BRK would never walk away from a subsidiary’s bonds, right?

No, actually they don’t know that, though Buffett’s record has been good with the debts of non-guaranteed subsidiaries.? Buffett is a better risk than most, but at the subsidiary level, you can’t be sure.? Buffett could save money and take on more risk by borrowing at the holding company, but he typically does not do that.

P/B Multiple Compression

Over the last decade, BRK’s P/B multiple has shrunk, and shrunk to the point where Buffett has drawn a line in the sand saying that subject to liquidity and market conditions, he will buy back stock at levels below 110% of stated book value.? (And, I suspect that is one reason why he spent so much time in the recent letter attempting to explain why the goodwill at BRK represented value.)? I think that means that there is now a limit, a floor to the price of BRK common stock, of course, subject to continued adequate performance.

Book Value and Insurers

Some have criticized Buffett’s growth in Book Value vs. the total return of the S&P 500 table, partly because of the declining P/B multiple.? I would simply say that this is endemic to an insurance mindset, where all we do care about is growth in net worth (book value).? Insurance is a mature, stable business.? No one has a way of obsoleting it, so we suspect.? It’s difficult to start a new insurer of any significant size, so we have protected boundaries to a degree.

Thus the focus on growing book value.? If we grow book value, eventually market value will follow, right? Right?!

Ugh, I think so, but sometimes I wonder, particularly with all of the insurers trading under book when they have little risk of insolvency.? Buffett can draw his line in the sand, but what of other insurers, many of which trade well below book?? Should they draw their own line in the sand, and defend a valuation level?

Personally, I would announce a generalized buyback without a lot of hoopla; make it boring, this is insurance after all so that should not be hard; get some actuaries to toss in big words to aid in obfuscation, so few conclude that the company will buy back significant stock.? Then start nibbling; be the bid or just behind it on days when things are weak. Don’t be a pig; rule #1 here is that the market should doubt that you are there.? But subject to that, buy, buy, BUY!!

The great Buffett after announcing his buyback only bought back 0.03% of all shares so far.? Most insurers can do much more quietly, with far less fanfare.? After all, Assurant bought back 14% of its shares last year.? Wow.? (This was the insurer that was offered in full to Buffett, and he said it was too complex… even the great one can goof.)

Now, maybe Assurant is my extreme case in buying back, and doing it at good valuations, but that in my opinion should be the goal of most public businesses with low valuations that are earning a lot, and not getting the proper respect.? Money talks, but be quiet, not brash, and suck in shares quietly at low valuations.? Let the financial statements do the bragging for you when investors realize that you have been building value doubly through operations and buybacks.

Summary

Even if you don’t invest with him, you can learn a ton from Buffett.? He is a consummate investor, businessman, and insurance executive.? Though I have never met him, I consider myself blessed to have learned from him.

Full disclosure: long AIZ

Though part of a series, this post is different.? I went back through the last 35 years of shareholder letters to analyze Buffett’s approach to acquisitions.? As Charlie Munger has said, Buffett is scary smart.? I say this because he adjusted through many different eras, while running a business that was part conglomerate, part closed-end fund.

In some ways the early years were different — more arbitrage, public investments take up more time in the shareholder letter.? But what I find fascinating is that from the earliest days, it didn’t matter to Buffett whether he owned whole businesses, or parts of them.

Part of this feeds off of Felix Salmon’s recent piece on acquisition language, where he contrasts tuck-ins and bolt-ons, correctly concluding that the difference is only one of size, even though that is an informal distinction.

But since the ’80s Buffett has always talked about acquisitions. Here’s a graph indicating Buffett’s use of the term acquisition(s):

You will note that his use of phrases like “tuck-in” and “bolt-on” occur only in the 2000s.? But the ideas were there long before that.? There were many cases in the ’90s, and to a lesser extent, the ’80s, where subsidiaries of BRK made acquisitions.? Buffett was always looking for ways to profitably deploy excess capital, and he knew that acquisitions facilitating organic growth was often far more effective than buying something totally new.? Buffett was doing tuck-in and bolt-on acquisitions for 15 years before he mentioned the terms.

Buffett always saw the public and private markets as being complementary.? He doesn’t care where he makes money; he just wants to make money.? Below there is a list of BRK acquisitions by year, with slight commentary.

One thing to understand about BRK is that full and partial ownership of private public businesses was always a part of the plan.? Growing out of a textile manufacturing business as a holding company, that should be obvious, as it should be when considering See’s Candies, BRK’s first acquisition.

Public and private, full and partial did not matter to Buffett.? He was simply interested in what could grow the intrinsic value of the the overall enterprise best, within the concept of a margin of safety.

1987-1989 was kind of an inbetween era for BRK, where Buffett would talk about his Sainted Seven private firms inside BRK, until he bought Borsheim’s in 1989, which gave him no good way to describe his private holdings with a simple moniker.

As it is, when he began doing more acquisitions, the 1991-1993 era included the “Shoe Group,” which was not among his finer moments.? But starting in 1995, with the purchase of the remainder of GEICO, is the start of the modern BRK.? Acquisitions become a regular part of the plan.? What makes that plain, was that post-1990 in years where BRK had no acquisitions, Buffett would discuss his theory on acquisitions for shareholders.? He did this because when there are few promising targets to invest in, it is usually a sign that valuations are stretched.

And in general, Buffett chose wisely with the private businesses.? Yes, there have been some that ended up being losers, or, not big winners, like the “Shoe Group,” and Scott & Fetzer’s untimely purchase of World Book, which was about to be obsoleted by Encarta, and then Wikipedia.

Buffett understood the need for sustainable competitive advantage.? He also knew how much he could afford to risk in acquiring private firms.? His “bite size” increased gradually until he could take down monsters like Burlington Northern.? He bought businesses that would be hard to obsolete.

One thing I found interesting about reading through the older letters of Buffett was that his ideas on acquisitions were developed early, long before BRK ceased to be predominantly a public company value investor, which is the way that many still regard BRK.

And as a result, it should be no surprise that as BRK grew, given Buffett’s desire for owning as much of great businesses as he could, that BRK became a conglomerate, albeit one dominated by its leading insurance businesses.

Though we can look at the different strategies employed by Buffett over the years, and see how some played a larger role early on like arbitrage and distressed investing, Buffett had a singular focus for the investments that offer decent returns in the size range that will make a difference for BRK investors.

Once BRK got big, that meant becoming a conglomerate, albeit a special one, was the logical outcome.? And I could be wrong, but that is the final corporate form for BRK.? There may come a day in a post-Buffett era when it may do many things, such as spin off companies, or centralize functions.? At present that won’t happen because BRK is the acquirer of choice for those that want to cash out, but don’t want the unique character of their organizations to change, which Buffett points at in the present Shareholders’ Letter as a unique competitive advantage.? BRK does not compete on price in acquisitions; it does compete by saying that unless something goes badly wrong, BRK will be more than happy to let the management do its thing.? It’s as if Buffett says, “Just make money, and send us back the excess.? If you have need of cash for promising opportunities, let us know.”

And then, it lets a thousand flowers bloom, and a thousand schools of thought contend, so long as you make money and grow the value of the business.? BRK is a unique business, and reflects the character of its founders (including Munger here).? No other large firm that I know of offers as much latitude to its operating units.

One final note: Buffett has also had a very good nose for sniffing out good insurance enterprises.? That’s the backbone of BRK.? It’s interesting to see over the years how he assembled the various pieces.? It would be interesting to see pre-1977 data on the insurance side, to look at how Buffett initially entered the insurance business, and transisted out of running a textile firm.

Tomorrow should have my final installment on BRK.? I will review the 10-K and provide commentary.