Berkshire Annual Letter 1997 (Part 5)
Continuing on from Warren Buffett’s discussion on insurance float, we now move on to the most volatile form of insurance, the super-cat (or super-catastrophy) insurance.
Insurance companies and reinsurance companies purchase insurance themselves to limit their losses in the event of a major disaster. A company that is willing to underwrite such policies must have a very strong financial strength.
Berkshire, being in such a position, underwrites super-cats heavily and has a huge involvement in this form of insurance.
Since major catastrophes are very rare, a company underwriting super-cat insurance can be expected to show large profits in most years with a occassional huge loss when there is a disaster.
As there is no exact way of calculating the probability of a disaster striking, thus it is difficult to really guage the performance of a company underwriting super-cat insurance over the short term.
A disaster is bound to strike, it is only a matter of when it will come.
A kind of financial instrument that came onto the market were “catastrophe bonds”. These were contracts which by means of their structure actually allowed their buyers to underwrite super-cat insurance indirectly.
Unsophisticated buyers run the risk of underestimating their risks. Let’s look at this example given by Warren Buffett.
Consider the odds of throwing two ‘6’s on two dices. That is a 1 in 36 chance. Assume you get paid $1 million whenever it doesn’t happen but you have to pay $50 million when it happens.
This is a case of badly under-pricing the premiums.
As with the sale of any product, there will always be salesmen around to convince you that the investment is a sound one. Perhaps they might (mistakenly) think that the odds of throwing a 36 is 1 in 100.
You would be happily collecting $1 million year after year for many, many years thinking you were making money. Eventually, you will go broke.
With the influx of people into the super-cat business (through castrophe bonds), the premiums of super-cat insurance has dropped badly. Berkshire is always mindful of the prices they write their policies. If the odds are not in their favour, they won’t do it.