David Merkel reviews Buffett’s 10k:
Buffett does very well, but I know of no other insurer that invests so much in equities funded by insurance liabilities. There is a real risk that if the markets fall hard, a la 1929-32, 1973-4, 2007-8. that BRK would be hard-pressed, particularly if there were some significant disaster like Katrina or Sandy, or set of disasters like 2004 or 2011.
He’s right that this philosophy adds risk to the business model. But riding equities isn’t as lonely a strategy for Buffett as it once was.
Consider Greenlight Re, an offshore reinsurance company linked to a hedge fund. Their strategy departed from the typical offshore startup model: write long tail, low-volatility, high-float insurance business and pump the cash into the hedge fund.
Taking big investment risks isn’t new for insurers. It’s just that doing it on purpose is unorthodox. Many insurers quietly took on more asset risk in the mid-00s and got crushed in 08. So did Greenlight for that matter. The difference is that Greenlight, fully expecting such a scenario, kept a hand steady at the till and rode the market back up.
Others tucked their tail between their legs and liquidated, in many cases locking in the losses.
If everyone (regulator, rating agency, management, investors) is on board with the risk, aggressive asset investment coupled with stable, high-float liabilities can work. Put another way, linking a hedge fund to an insurance company means the insurer can get by at lower combined ratios and grow.
But don’t take my word for it, look to the market and see the latest wave of offshore startups copying Greenlight/BRK: Third Point Re, SAC Re. And we see this convergence coming from the other side as AWAC, an established (re)insurer, bought into a hedge fund.
The key is to think of these insurers as more akin to banks: low-risk liabilities, high-risk assets. One can be skeptical of whether they are doing a good job of balancing these risks but in principle there is no reason to assume they will fail.