Andrew Holt takes a look at Berkshire Hathaway's success in the insurance market, and how it has made its chairman a multi-billionaire.

Churchill once described Russia as "a riddle wrapped in a mystery inside an enigma". Such a description could apply to financial company Berkshire Hathaway, the brainchild of Warren Buffett, which has made him the second-richest man in the world.

Hidden away in deepest Omaha in the US, is the centre of Buffett's empire that stretches across the world. This reach has propelled Berkshire Hathaway to number 35 in our top 50 list - a rise of seven places from last year. But what is the secret of its success?

Warren Buffett, chairman of Berkshire, has become a billionaire by buying and investing in undervalued companies. This has made him into something of investment guru. But Berkshire Hathaway's core business is insurance, including property and casualty insurance and reinsurance and specialty nonstandard insurance.

The company averaged an impressive 25%+ annual return to its shareholders for the last 25 years while employing large amounts of capital and minimal debt. Buffett has used the finance provided by Berkshire Hathaway's insurance operations to finance his investments.

Floating investments

This is what Buffett calls the company's "float". The "float" is a system most financial service companies use for investment, particularly banks, in that they exploit this money that doesn't belong to them but temporarily hold. Most of Berkshire Hathaway's float arises because first, premiums are paid upfront, though the service it provides - insurance protection - is delivered over a period that usually covers a year; and second, loss events that occur today do not always result in Berkshire immediately paying claims, because it sometimes takes many years for losses to be reported, negotiated and settled.

The $20m of float that came with Berkshire Hathaway's 1967 entry into insurance has now increased - both by way of internal growth and acquisitions - to $49bn.

For Buffett, "float is wonderful" - if it doesn't come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses it will ultimately pay compare with the premiums Berkshire has received.

When an insurer earns an underwriting profit - as has been the case at Berkshire in about half of the 39 years it has been in the insurance business - float is better than free. In such years, Berkshire is actually paid for holding other people's money. For most insurers, however, life has been far more difficult: in aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so.

In 2004, Berkshire Hathaway's float cost less than nothing, and the company had a chance - in the absence of a megacatastrophe - of a no-cost float in 2005. But of course there was a "mega-cat", and as a specialist in that coverage, Berkshire suffered hurricane losses of $3.4bn.

Nevertheless, Berkshire Hathaway's float was cost less in 2005 because of the results it had in our other insurance activities, particularly at auto insurance company Geico.

Auto policies in force grew by 12.1% at Geico, in 2004, again increasing its market share of US private passenger auto business from about 5.6% to about 6.1%.

An insight into Buffett's approach was also given in the Berkshire Hathaway's latest annual report. In this, Buffett made the observation that insurers have generally earned poor returns for a simple reason: they sell a commodity-like product, with little scope for brand differentiation. In fact the trend towards affinity sales and white labelling only accelerates this commoditisation as in most cases the insured has no visibility of the insurer prior to contract.

His recommendations to succeed under economic pressures are attributed to managerial success and being a low-cost operator (for example Berkshire Hathaway's auto insurance company Geico).

Berkshire Hathaway's desire to take on new risks was revealed recently when its subsidiary National Indemnity was in the spotlight by coming to the rescue of 34,000 Lloyd's Names through a unique deal. On October 20, National Indemnity said that it had agreed to take on the liabilities of Equitas, which was set up to handle mainly asbestos-related claims against the Lloyd's of London market from 1992 and earlier. In return, National Indemnity will get most of Equitas' assets, plus some premium payments.

Equitas deal

As part of the deal, Berkshire Hathaway group of insurance companies will: reinsure all Equitas' liabilities; provide up to a further $7bn of reinsurance cover to Equitas; take on the staff and operations of Equitas and conduct the run-off of Equitas' liabilities.

The transaction will occur over two phases. In Phase I, Berkshire will provide $5.7bn in reinsurance protection to Equitas, and take on the staff, operations and management of the run-off of Equitas. Phase II will result in the transfer of Lloyd's members' pre-1993 liabilities into a UK-based subsidiary of Berkshire and the provision of additional reinsurance protection of up to $1.3bn. Lloyd's will make a contribution of £90m towards the premium paid to Berkshire for the reinsurance protection under Phase I and Phase II of the transaction.

National Indemnity specialises in this type of transaction with many of the liabilities that the Berkshire firm has taken on are "long-tailed," meaning claims and losses from policies take many years to appear and be settled.

"National Indemnity assumes that the nominal value of those liabilities will grow over that time, but they hope that they will earn enough of a return on the assets to cover those liabilities and also make a profit too," says Donald Thorpe, senior director at Fitch Ratings.

Berkshire Hathaway reported net earnings of $2.3bn in the first quarter of this year, compared to $1.4bn for the same quarter in 2005. The company said insurance underwriting operations accounted for some $330m of the net earnings, up from $319m.

And Berkshire Hathaway's owned Syndicate 1919, through subsidiary Marlborough Underwriting, received approval from Lloyd's to write aviation, energy and marine business recently. The syndicate is wholly capitalised by CV Starr (25%) and Starr International Investments (75%). It has a capacity of £50m for 2007.

It looks like Buffett's golden touch will keep Berkshire Hathaway growing for some time.