1998: What is the long-term impact of catastrophe bonds and catastrophe derivatives on Berkshire's float?

AUDIENCE MEMBER: Good morning. Good morning, gentlemen. I’m Hugh Stevenson (PH), a shareholder from Atlanta.

My question involves the company’s super-cat reinsurance business. You’ve addressed some of this, but I would like for you to expound on it, please.

You’ve indicated that you think this is the most important business of the company. And my question is, what do you think the long-term impact of catastrophe bonds and catastrophe derivatives will be on the float and the growth in float of the company?

And I understand that the mispricing of risk in these instruments doesn’t really affect the way you price your business, but I’m wondering how you think it can affect the volume of the business.

And I remember several years ago, Mr. Buffett, you talked about, you can never be smarter than your dumbest competitor.

WARREN BUFFETT: Right.

AUDIENCE MEMBER: And these are some potentially dumb competitors.

WARREN BUFFETT: You’ve got it. (Laughter)

I just want to put an asterisk on one thing. We say insurance will be our most important business. We’ve not said the super-cat business will be our most important.

Super-cat has been a significant part of our business, and may well over the years remain a significant part, but it is far less significant than GEICO. And I’ll mention a word or two about that.

But the super-cat business, you can price wrong, as I illustrated in my report. You can be pricing it at half what it should be priced at.

I used an illustration in the report of how you could misprice a policy that you should be getting, say, a million and a half for, namely a $50 million policy on writing — on something that had one chance in 36 of happening, so you should get almost a million and a half for it.

I said if you price it at a million a year, you know, you would think you were making money after ten years 70-odd percent of the time. The interesting thing about that is if you price it for a dollar a year you would have thought you made money 70-odd percent of the time, because when you are selling insurance against very infrequent events, you can totally misprice them but not know about it for a long time.

Super-cat bonds open up that field wide open. I mean you’ve always had the problem of dumb competitors, but you have a much more chance of having dumb competitors when you have a whole bunch of people who, in the case of hedge funds who have bought some of these, where the manager gets 20 percent of the profits in a year when there are profits and there is no hurricane, and when there happens to be a hurricane or an earthquake he doesn’t take the loss. His limited partners do.

So it’s very likely to be a competitive factor that brings our volume down a lot. It won’t change our prices.

You know, the thing to remember is the earthquake does not know the premium that you receive. (Laughter)

I mean the earthquake happens regardless.

So it doesn’t say — you know, you don’t have somebody out there on the San Andreas Fault that says, “Well, he only charged a 1 percent premium so we’re only going to do this once every 100 years.” (Laughter)

Doesn’t work that way.

So we will probably do a whole lot less volume in the next few years in the super-cat business. We have these two policies that run for a couple more years. But in terms of new business, we will do a whole lot less.

GEICO is by far the most important part of our insurance business, though. GEICO in the 12 months ended April 30th had a 16.9 percent increase in policies in force. Year-end, I told you it was 16.0. A year ago, I told you it was 10. Year before that, I think it was six and a fraction.

So its growth is accelerating and it should be in a whole lot more homes around the country than it is now, you know, by a big factor. And it will be, in my view. So that will be the big part of our insurance business.

But we may be in the insurance business in some other ways too as time goes along. It’s a business that if you exercise discipline you should find some ways to make money, but it won’t always be the same way.

Charlie?

CHARLIE MUNGER: I’ve got nothing to add.