Credit Suisse weighs up implications of deal between Berkshire Hathaway and AIG

Berkshire Hathaway’s $9.8 billion retroactive reinsurance deal with American International Group’s (AIG), revealed last week, is big enough to potentially jeopardize an underwriting profit in Warren Buffett’s reinsurer’s P&C operations for the first time.

That is one of the findings of a research report written by analysts at Credit Suisse examining in the implications for the deal for both Berkshire Hathaway and AIG.

The  $9.8 billion reinsurance deal between AIG and National Indemnity Company (NICO), a subsidiary of Berkshire Hathaway, sees the latter cover US commercial long-tail exposures for accident years 2015 and prior.

Credit Suisse examined Berkshire's past retroactive reinsurance deals to assess the relative cost of the deal for AIG and better understand the company’s rationale for these deals.

The report noted that the AIG deal is the biggest retro contract Berkshire Hathaway has done, both in terms of maximum potential loss payable ($20 billion versus $14 billion on second largest deal), and upfront premium paid ($10.2 billion versus $7.0 billion on second largest deal), and maximum losses above upfront premium ($9.6 billion versus $7.0 billion).

The report noted that while Berkshire Hathaway has at times indicated that it is happy to write business at breakeven – in exchange for generating float that it then invests – in fact in clearly prefers to make money on its underwriting, noting in its 2015 letter to shareholders: "Berkshire's huge and growing insurance operation again operated at an underwriting profit in 2015 – that makes 13 years in a row."

“This deal the first big enough to risk that,” the analysts note. “While there's a clear appreciation for the volatility of the insurance business, it's also clear that Berkshire prefers to make money underwriting,” they wrote.

“What's interesting to us is that this deal is the first deal in BHRG (Berkshire Hathaway Reinsurance Group) large enough to potentially jeopardize an underwriting profit in Berkshire's P&C operations. Across Berkshire's P&C platforms, total underwriting profits at Berkshire since 2010 have averaged $1.9 billion ranging from $248 million to $3.1 million,” the report noted.

“So even though the risk reward of this deal looks similar to past deals in that Berkshire stands to lose very little in the worst case scenario – which doesn't give comfort about the worst case scenario – we are less certain that Berkshire would want this deal to generate material adverse underwriting results.”

That said, the analysts also stress that AIG would have to take almost $10 billion of charges for Berkshire to "lose money" on the deal over its lifetime, though they note that this gives little confidence to investors on AIG's reserve situation.

“We also estimate that the projected benefit to Berkshire from the deal is about 65 percent of the total limit for further losses, a number not out of line with past deals,” they wrote. “On the surface this indicates that Berkshire economically views the stability of AIG's casualty book as similar to A&E blocks, otherwise we would expect a greater expected reward per unit of risk.”

They define the "total projected benefit to Berkshire" to be the lifetime investment income from investing the float less the cost of maintaining the float which is dictated by what premium was paid up front and further adverse development. “We assume day one benefit from the deal ends up being $1.5 billion after an estimated $1.5 billion 4Q reserve charge at AIG,” they wrote.

They also note that statutory data shows that investment returns in NICO (NII + realized gains) have averaged about 6 percent since 2005. “Because of the long tail nature of the reserves combined with the fact that Berkshire doesn't have to start paying until after the first $25 billion of losses are paid, we estimate the average duration of Berkshire's reserves are 10 years even though the average duration of AIG's casualty book is probably half of that.

“Based on these assumptions, we estimate that AIG would have to take almost $8b of charges for the total cost of the deal to outweigh the projected benefit,” they wrote.

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