By Ravi Nagarajan
Published on March 9, 2010 at 11:51 am

Rupert Murdoch is bullish on prospects for organizations offering differentiated news content to charge for access to online editions.  One interesting comment involved increasing the amount of content on The Wall Street Journal that resides behind the pay wall.  While much of the Wall Street Journal has always been behind a pay wall, the editorial content was available for no charge until recently.  Mr. Murdoch claims that placing that content behind the pay wall has actually increased circulation for the online edition.  Mr. Murdoch also comments on the notion that only specialized, or niche, content can attract a paying audience.  Those who prefer newsprint will be relieved to know that Mr. Murdoch believes that the Wall Street Journal will appear in print for “decades” to come.

To view the full interview, please click on this link for the video.

By Ravi Nagarajan
Published on March 8, 2010 at 6:00 am

Last week, we took a brief look at Berkshire Hathaway’s loss estimation accuracy over the past ten years.  As we noted in the article, the process of estimating the ultimate losses resulting from an insurance company’s business is one of the most important tasks facing management.  In the case of Berkshire Hathaway, many types of policies expose the company to liabilities that will develop over a very long period of time.  Therefore, the ultimate payout to policyholders can vary significantly from management’s original estimate and may not be known for decades.

Auto Insurance and Short Tails

One of Berkshire Hathaway’s insurance subsidiaries is GEICO, a company engaged primarily in providing private automobile insurance in the United States.  Auto insurance losses generally have a “short tail” which means that losses tend to be reported quickly and paid out to policyholders.  Berkshire Hathaway only reports loss estimate development for all of its insurance subsidiaries in aggregate.  Since many Berkshire reinsurance operations write policies with “long tails”, estimation error is more likely to be seen in a consolidated summary of loss development than if we were to look only at a company such as GEICO in isolation.

Progressive’s Loss Estimates:  1999 to 2009

It may be interesting to take a brief look at a “pure play” auto insurer to see how the loss triangle table would look for an insurance company focusing on “short tail” coverage.  In theory, the accuracy of initial estimates should be fairly high and could be expected to develop fully within a couple of years in contrast to the experience of a typical reinsurer.

Progressive’s 2009 annual report was filed last week and contains data on loss estimation accuracy for 1999 to 2009.  The table shown below provides a summary (figures in millions, click on the image for a larger view):

One interesting aspect of the earlier years is that even when we see that the variance between the original loss estimate and the ultimate figure is large, the amount of the error is mostly known within a few years.  For example, in 2004 the original loss estimate of $4,949 million turned out to be higher than necessary.  However, the discrepancy was recognized very quickly.  By the second year after the original estimate was made, the revised estimate was very close to the current estimate.

While we cannot see GEICO’s results presented in such a granular format within Berkshire Hathaway’s annual report, it is very likely than loss development follows a similar pattern.  Management may still make relatively large errors when the initial loss estimates are calculated, but any errors are likely to be corrected within a short period of time.  In contrast, management estimates for reinsurance covering claims associated with asbestos health damage may only develop over many decades.  In such cases, any estimation problems may remain undetected for very long periods of time.

The lesson to be drawn may be obvious for insurance industry veterans, but is nonetheless worth pointing out:  Loss estimates for very long tail insurance is inherently less accurate than for short tail insurance.  Furthermore, it may be years or even decades before you know whether a mistake has been made.  It is useful to keep this in mind when analyzing insurance companies.

Disclosure:  The author has no position in Progressive. The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

By Ravi Nagarajan
Published on March 6, 2010 at 6:00 am

AIG’s former CEO Maurice “Hank” Greenberg has indicated that he is ready to testify regarding AIG’s transaction with Berkshire Hathaway’s General Re group in 2000.  The transaction in question was orchestrated by General Re in a manner that allowed AIG to inflate its loss reserves by $500 million.  Mr. Greenberg was never charged with a crime but prosecutors identified him as an unindicted co-conspirator and he refused to testify citing his fifth amendment right against self incrimination.  Now that the statute of limitations has apparently expired, Mr. Greenberg is willing to provide testimony in the case.

The AIG situation has been a headache for General Re and Berkshire Hathaway over the past decade.  On January 20, General Re finally reached a settlement with the federal government which will allow the firm to avoid prosecution for its role in the accounting fraud. General Re paid $92 million in total fines as part of the settlement.  Several General Re executives were implicated in the sham transaction and the entire episode threatened to tarnish Berkshire Hathaway’s reputation.  (The AIG matter is not the only trouble Berkshire ran into after the 1998 General Re acquisition.  We provide extensive detail regarding Berkshire’s troubled history with General Re in the Berkshire Hathaway 2010 Briefing Book.)

Warren Buffett was never accused of any wrongdoing in the case and willingly spoke to prosecutors regarding his knowledge of the situation.  When the $92 million settlement was announced, Mr. Buffett made the following statement regarding the matter:

“We did something wrong and we paid the price,” Buffett said during an interview on the Fox Business Network. “It shouldn’t have been done, and there’s nothing inappropriate about the fine we paid, so I have no problem with it.”

So on one hand we have Mr. Buffett who willingly cooperated with prosecutors and has taken responsibility for the actions of one of his companies and on the other hand we have Mr. Greenberg who refused to testify years ago and is only coming forward now that the statute of limitations has expired.

Mr. Greenberg had every right to exercise his fifth amendment protection against self incrimination, but Mr. Buffett has clearly set the better example in this case.

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

By Ravi Nagarajan
Published on March 5, 2010 at 10:56 am

Earlier this week, we highlighted the power of compounding in an article on the rapid appreciation of the first Superman comic book.  An equally dramatic example was recently published regarding Grace Groner, a 100 year old woman who recently died and left $7 million to her alma matter.  The source of the funds?  A $180 investment in Abbott Laboratories made in 1935.

Ms. Groner lived a modest life (her home is pictured nearby) and had few material requirements.  This enabled her wealth to compound without interruption for seventy five years.  Her investment in three shares of Abbott Laboratories at $60 per share compounded at a rate of slightly over fifteen percent per year with all dividends reinvested.

The $7 million donation is expected to result in an endowment generating $300,000 per year which will enable dozens of students to travel and pursue internships.  Ms. Groner also donated her modest home to the university which will be converted into living quarters for women receiving scholarships.

This story is another example of the power of compound interest, but it is not necessary to have an investment horizon of 75 years in order to harness the benefits.  While Ms. Groner’s story is exceptional, it is likely that there are many other “silent millionaires” throughout America fitting the “millionaire next door” model.

To read a more complete account of Ms. Groner’s story, click on this link.

By Ravi Nagarajan
Published on March 4, 2010 at 1:50 pm

The process of estimating the ultimate losses resulting from an insurance company’s business is one of the most important tasks facing management.  Many types of policies expose an insurer to liabilities over a very long period of time where the ultimate payout to policyholders will not be certain for years or even decades.  Despite this uncertainty, management must estimate loss reserves for each financial reporting period.  The credibility of these estimates depends, in part, on management’s track record with prior estimates.

Loss Estimates:  1999 to 2009

Berkshire Hathaway’s 2009 Annual Report was released on Saturday, February 27 but the company’s 10-K Report was not filed with the SEC until Monday, March 1.  The 10-K includes certain information that was not released in the annual report including data related to loss estimation accuracy.

Each year, Berkshire’s Balance Sheet includes a liability line item named “Loss and loss adjustment expenses”.  This line item is management’s estimate of the ultimate liability that will have to be paid out to policyholders.  On page 7 of the 10-K report, we have a reconciliation between the loss estimate as it was stated for each year from 1999 to 2009 along with a summary of how the liability was re-estimated in later years.

The table below is an excerpt from the data presented in the 10-K (click on the image for a larger view):

We can see that from 1999 to 2003, the original estimates of losses were insufficient based on subsequent developments and re-estimation of liabilities.  For example, in 1999, the original estimate of Net Unpaid Losses was $22,751 million.  However, the actual liability ten years later based on actual payments to policyholders and estimated remaining payments turned out to be $29,054 million.

Since 2004, management has been more conservative in original loss estimates and the re-estimated values in later years showed lower loss estimates than the original.  For example, the original loss estimate for 2005 was $42,834 million.  Four years later (at the end of 2009), the estimate was revised to $41,676 million.

While the tables present consolidated figures and do not break out the loss estimates by insurance subsidiary, it is likely that much of the estimation error from 1999 to 2003 stems from the problems at General Re.  As Warren Buffett has stated several times, he was unaware of problems at General Re at the time Berkshire purchased the company in 1998.  Underwriting discipline had faltered and part of the reason may have been due to unrealistically rosy projections of future losses which led to inadequate premium pricing.

Goal is Accuracy – But Very Difficult to Accomplish

When an insurer revises prior loss estimates, prior financial statements are not retroactively modified to reflect these changes.  Instead, the re-estimated amount are reported in earnings over time as components of loss and loss adjustment expenses.  This means that each year, the underwriting loss figure reported to shareholders may include revisions to prior estimates as well as current year developments.

Shareholders should not want to see either overly optimistic assumptions leading to a cumulative deficiency or overly conservative assumptions leading to a cumulative redundancy.  The goal should be to estimate losses as accurately as possible.  Given the uncertainty involved in estimating ultimate losses, particularly in reinsurance lines where ultimate payouts will not be known for decades, it is unrealistic to expect perfection.

The question of loss estimation accuracy is particularly important when one evaluates an insurance company based on the value of the float it generates.  The float based model is the primary method used in the recently released Berkshire Hathaway Briefing Book.  The cost of float is a critical variable that is directly impacted by estimation error.  It is good to see that estimation accuracy has improved in recent years which adds to the level of confidence in the float based valuation model.

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.