A letter a day!

A letter a day!

Letter #59 2005

Key learnings:

1. The more uncertain the future of a business, the more possibility there is that the calculation of rations will be wildly off-base. (Hence it is always written “estimate”)

2. In the insurance industry, it is difficult to predict what amounts will be required to pay the claims the insurance company has inherited.

Medical malpractice insurance is a “long-tail” line, meaning that claims often take many years to settle. In addition, there are other losses that have occurred, but that we won’t even hear about for some time. One thing, though, we have learned – the hard way – after many years in the business: Surprises in insurance are far from symmetrical. You are lucky if you get one that is pleasant for every ten that go the other way.
Too often, however, insurers react to looming loss problems with optimism. They behave like the fellow in a switchblade fight who, after his opponent has taken a mighty swipe at his throat, exclaimed, “You never touched me.” His adversary’s reply: “Just wait until you try to shake your head.”

3. Closure of Gen Re derivative operations with a loss of $104 million.

This division was started keeping in mind the needs of insurance clients. Buffett writes on the same:

I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.
So I failed in my attempt to exit painlessly, and in the meantime, more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.
The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors, and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continue to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

4. When the long-term competitive position improves as a result of unnoticeable actions, the phenomenon is known as “widening the moat.”

“We always, of course, hope to earn more money in the short term. But when short-term and long-term conflict, widening the moat must take precedence. If management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction, or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted. Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed to them by their predecessors. Charlie is fond of quoting Ben Franklin’s “An ounce of prevention is worth a pound of cure.” But sometimes no amount of cure will overcome the mistakes of the past. “

5. Three reasons for which Berkshire will borrow debt:

1. occasionally use repos as a part of certain short-term investing strategies that incorporate ownership of U.S. government (or agency) securities.

2. borrow money against portfolios of interest-bearing receivables whose risk characteristics the company understands.

3. At MidAmerican, there is a substantial debt, but it is that company’s obligation only. Though it will appear on its consolidated balance sheet, Berkshire does not guarantee it.