2005: How do GenRe and National Indemnity prevent catastrophic losses?

AUDIENCE MEMBER: David Winters, Mountain Lakes, New Jersey.

How do you try to manage risk at GenRe and National Indemnity to be comfortable and maximize returns? Especially, how do you prevent a catastrophic loss or unexpected correlation? Thank you.

WARREN BUFFETT: Yeah, well, that’s a very good question because we are doing things in different parts of our insurance operation where there is correlation.

And there’s not only correlation among the insurance risks.

I mean, just, you know, take a major, really major, earthquake in California, in the wrong place. There have been about 25 6.0s or larger in the last hundred years, but most of them don’t occur where a lot of people are.

But if you get the wrong one in the wrong place, it would not only hit National Indemnity and General Re, as you mention, but it might very well have a severe effect on See’s Candy. It might very well have a severe effect on Wells Fargo.

We don’t own Freddie [Mac] or Fannie [Mae] now, but we owned Freddie at one time. It could have had a severe effect on Freddie. It can have all kinds of secondary and tertiary effects that you might not think of initially.

So, we find when there’s trouble, everything correlates. And it’s — part of my job is to have at least a general idea of the sort of risk that the various enterprises might be running operationally, and then integrate that into my own notion of the risk that we run, in terms of investments, in terms of all kinds of things. And, you know, that is my job.

The most likely mega-cat, at any time, is a hurricane. But we have more exposure to that.

On the other hand, if you’re talking 25 billion and up, maybe 100 billion and up, insured catastrophes, you know, a quake might be just as likely as some Force 5 hurricane that would come in at the wrong place.

But that — my job is to think absolutely in terms of worst case. And to know enough about what’s going on, in both investments and operations, to make sure that no matter what happens, you know, I don’t lose sleep that night, you know, over what can, you know, whether there’s a 9.0 quake someplace or whether there’s a Force 5 hurricane that actually goes up the East Coast and enters at places that very seldom does it enter.

Long Island, for example: huge amount of exposure. How often is Long Island going to, you know, really have a major hurricane? Not very often. I think there was one back in the ’30s, but there were potato fields there in the ’30s and now there’s all kinds of insured value.

Everything will — everything that can happen, will happen.

I mean, in terms of our — what we know of history in this country, last three or four-hundred years, and then with the most severe quake, by far, was at New Madrid, Missouri.

And who would have guessed, you know, that that quake would happen? And there were two subsequent quakes that were far enough apart so that didn’t exactly seem like aftershocks.

All three of those were higher than 8 on the Richter scale. Nobody thinks about that, but they’ve had them in Charleston, South Carolina.

They’ve had, I mean, it’s — you will see things, maybe not in your lifetime, but if you take the centuries, some extraordinary things can happen. And it’s Berkshire’s job to be prepared, absolutely, for the very worst.

And, by and large, I would think hurricanes and quakes are the biggest thing now, but a few years ago we did not have nuclear, chemical, and biological risks excluded in policies, and we had huge exposure, subsequently gotten rid of.

But we take on large risks. I’ll give you a couple of examples.

Just the other day — and nobody else will write this stuff, basically, because they would want to reinsure it with somebody else and they’re not set up to do it — but one large airport, one large international airport, came to us and we wrote a policy for $500 million, excess of 2 1/2 billion, from any action that was not caused by nuclear, chemical, or biological sources.

So, if that airport is taken out in some way, but not by nuclear, chemical, or biological activities, the first 2 1/2 billion, somebody else worries about, and we get the next half-billion. There’s a — sublimit is only a billion-six can be counted for business interruption. So you would need — and that airport would have to be out for a couple of years to have a billion-six of business interruption. So you need 900 million of physical damage on top of that.

But somebody is willing to buy that policy and there is a real risk.

We insured the NCAA Final Four down in St. Louis against being canceled, not postponed, or having the games, those final four games, moved to another city. But if it was canceled totally, and again, not through nuclear, chemical, or biological, we would have paid $75 million. Same thing at the Grammys.

I mean, we take on risks that very few people want to write. But in the end, we’re willing to lose a lot of money in one day, but we’re not willing to do anything that causes us any discomfort, in terms of writing checks the following morning.

Incidentally, while I’m on the nuclear — while we’re talking about the pleasant subjects — I recommended in the annual report that book, “Nuclear Terrorism.”

And if you go to lastbestchance.org, you can obtain, or will soon be able to obtain, a tape, free, that the Nuclear Threat Initiative has sponsored, which has a dramatization of something that is now fictional, but it’s not fanciful. It’s something that could happen, and which the Nuclear Threat Initiative is working to minimize the chances of.

And on that program, in addition to this dramatization of what could happen in that field, you have [former Senator] Sam Nunn and Senator [Richard] Lugar with [NBC News anchor] Tom Brokaw, discussing the subject.

It’s an important subject. It didn’t get a lot of attention, again, in this last campaign, although I think both candidates fully recognize the importance.

But we would regard ourselves as vulnerable to extinction, as a company, if we did not have nuclear, chemical, and biological risks excluded from virtually all of our policies, although we intentionally take on the risk periodically, but only in an amount that we feel we can handle.

We do not write it and give it away for free. And we do not want to write it promiscuously, because there could be events happen that would make it impossible for our checks to clear the next day, and we’re not going to get ourselves in that position.

Charlie?

CHARLIE MUNGER: Yeah. We’re likely to do better than most other people in dealing with what concerns you. We care more about it, that kind of correlation.

We just naturally have minds that think about tidal waves in California, where they’ve never had one in modern California civilization.

Can you imagine what a 60-foot tidal wave would do in California? There’s nothing physically impossible in having a 60-foot tidal wave in an earthquake zone, which California is in. But it’s never happened in modern history. But it’s the kind of thing that we do think about.

And you think any other company has as much, as rigorous, nuclear and so on, exclusion as we do?

WARREN BUFFETT: Well, nobody’s attacked it any more vigorously than we’ve attacked, I would say.

I mean, what you have here is, individually, we probably worry more about the downside than that just about any manager you can find. And collectively, you know, it’s Armageddon around here every day. (Laughs)

But that’s — you know, we care about that. We’ve never used a lot of borrowed money. Back when I started out, I mean, I had $10,000. But I just didn’t want to borrow any significant amount of money.

There’s no reason to. You know, we’re living fine. We were living fine when I had $10,000.

And the idea that you risk what you need and is important to you for something that you don’t need and it is unimportant, is just craziness. And we try to run Berkshire that way.

And you know, I had a 98- year-old aunt, my Aunt Katie [Buffett], that died last year. She had everything she had in Berkshire.

And the idea that I should be doing something to try and add a few dollars to my net worth, or a few percentage points to the record, and be risking the fact that she would go back to Social Security, is, you know — I just think that’s kind of crazy for a manager.

But, you know, maybe if I had a two-and-twenty percent arrangement with my Aunt Katie, I’d be — differently, but I hope not. (Laughs)