2001: How do “pain today, gain tomorrow” insurance deals work?

AUDIENCE MEMBER: Steve Bloomberg, from Chicago. I have two questions regarding the insurance operations.

With regard to the reinsurance contracts, which were written at what some consider and call “good losses,” you’ve discussed those insurance contracts in your report, indicating that it’s generated 482 million of losses in the year 2000.

Do we need an annual schedule disclosing the aggregate amortized charges of all current and past such deals, to make our adjustments, to reflect economic reality?

WARREN BUFFETT: Well, there are two unusual-type deals, and you referred to one type, what I call the “pain today, gain tomorrow,” or good losses-type deals.

And under the deals you’re describing, we record a usually quite significant loss in the current year, and then we have the use of float for many years to come, and there are no subsequent charges against that.

So in respect to those contracts, the important thing is that we tell you — and we should tell you — really, every quarter if they’re significant, and certainly yearly, any significant items that fall in that category.

And as you mentioned, you know, we had over 400 million last year. We had a significant amount the year before.

We have not had a significant amount this year. I think, in the first quarter, there may have been a 12 million charge for one of those.

If they’re significant, we’re going to tell you about them.

It’s a one-time adjustment in your mind that, in effect, should — you should regard as different than any other type of underwriting loss that we experience, because we willingly enter into these.

We take the hit the first year, and accounting calls for that. And over the life of the contract, we expect to make money. And our experience would be that we do make money.

But we’ll tell you about any significant item of that sort, so that you will be able to make an adjusted cost to float. I reported our cost to float last year at 6 percent, which is high. It’s not unbearable, but it’s high, very high.

And included in that 6 percent cost was — about a quarter of it came from these transactions that distorted the current year figure. And therefore, our cost of float, if we hadn’t willingly engaged in those transactions, would’ve been about 4 1/2 percent.

I should mention to you that I expect that our cost of float — I said in the annual report — that absent a mega-catastrophe — and I might define a mega-catastrophe as insured losses, we’ll say, of 20 billion or more, or something on that order — absent a mega-catastrophe, we expected our cost of float to come down this year, and I said perhaps substantially.

In the first quarter, our cost of float will probably run just a touch under 3 percent, and — on an annualized basis.

And I think that — I think the trend is in that direction, absent a mega-catastrophe. I would expect the cost of float, actually, to come down substantially this year.

But if we were to take on some of these “pain today, gain tomorrow” transactions — and we don’t have any in the works at the moment — but if we were to take those on, then it would be reflected in our cost of float, and we would lay out the impact of that sort of transaction.

Charlie?

CHARLIE MUNGER: Yeah, I think almost all good businesses have occasions where they’re making today look a little worse than today would otherwise be, to help tomorrow. So I regard these transactions as very much the friends of the shareholders.

WARREN BUFFETT: We have a second type of transaction, just to complete, which we also described in the report, which also creates a large amount of float, but where accounting rules spread the cost of that transaction over the life of the float.

And those do not distort the current-year figures, but they do create an annual charge that exists throughout the life of float. And that charge with us is running something over $300 million a year.

But there again, it’s a transaction that we willingly and enthusiastically engaged in. And that has this annual cost attached to it.

So when you see our cost to float at 3 percent, annualized, in the first quarter, it includes, probably, a $80 million charge or so, relative to those retroactive insurance contracts, which were the second kind described in the report.

I recognize this accounting is, you know — and even the transactions — are somewhat Greek to some of you. But they are important, in respect to Berkshire, so we do want to lay them out in the annual report for those who want to do their own calculations of intrinsic value.