Berkshire Weathers the Storms

Given the storm damage and flooding created by hurricanes Harvey, Irma, and Maria during the third quarter, we find it unlikely that wide-moat

With estimates of total insured damages from Harvey and Irma running at $50 billion-$70 billion and Maria looking to be a $40 billion-$85 billion event, 2017 is expected to be as one of the worst years for natural disasters since 2005, when hurricanes Katrina, Rita, and Wilma racked up more than $50 billion in total insured losses.

There are some mitigating factors that should limit the exposure for property-casualty insurers and reinsurers, and our own valuation models already account for the possibility of large natural catastrophe losses, even with the exact timing of these events being impossible to predict. This keeps us from doing anything too drastic during times like this, especially with a company that is as diversified as Berkshire is--not only in its insurance operations but overall.

While we expect the company to experience material losses, it is more than adequately reserved to deal with this year’s hurricane season. CEO Warren Buffett likes to keep at least $20 billion in cash on hand as a backstop for Berkshire’s insurance operations, primarily for scenarios like this.

Given the nature of the insurance business and the fact that we’re still relatively close to the events that will ultimately drive the insurance claims from this year’s hurricane season, we may have to wait weeks--if not months--to get a good sense of the full impact that the storms will have on the loss ratios for Berkshire’s property-casualty and reinsurance operations. In the meantime, we expect to gradually work in details as they become clearer and we can ascribe a dollar value to the impact.

We’ve got some sense of the damage from Harvey, which was largely a flooding event, which limited the impact on property-casualty insurers, especially those providing homeowners insurance, as most national carriers tend to cover just wind damage (flood damage is largely covered under government programs). For instance, while the insurance industry incurred substantial losses in 2012 because of Hurricane Sandy, the government covered roughly 75% of insured losses, as the storm stayed offshore and most of the damage was related to flooding. Commercial carriers could see meaningful losses, though, as commercial and industrial properties (like the oil industry in the Houston region) are more likely to have coverage for flooding. Much of this gets backed by reinsurance. Through Berkshire Hathaway Primary, as well as the company’s two reinsurance arms (Berkshire Hathaway Reinsurance Group and General Re), there will probably be some exposure, but Buffett has noted recently that the company’s retreat from reinsurance underwriting in the past several years (given the poor pricing environment) should limit Berkshire’s exposure.

Where the company could get hit is on the auto insurance front. Some of the early estimates we’ve seen for insured auto losses are in the $4 billion-$6 billion range, relative to an expectation of $20 billion-$30 billion in total insured losses for Hurricane Harvey overall. While Geico holds 12% market share nationally, it has about a 10% share in Texas, so the auto insurer’s losses are expected to be $400 million-$600 million. Buffett recently noted that he expects 50,000 of the roughly 500,000 vehicles that Geico insures in the area to be total losses, which at an average payout of $10,000 per vehicle would lead to $500 million in losses--similar to the $490 million of incurred pretax losses (net of estimated salvage) Geico recorded in the fourth quarter of 2012 for Hurricane Sandy. The company’s insurance operations overall recorded $1.1 billion in pretax losses from Sandy, with most of that coming from its reinsurance operations.

As for Hurricane Irma, which was a more typical hurricane with heavier wind and surge damage, initial estimates have total insured damages in the United States at $30 billion-$40 billion, expanding to $50 billion when considering losses in the Caribbean. However, some mitigating factors in Florida should limit the exposure for larger national property-casualty insurers and reinsurers. In the wake of Hurricane Andrew in 1992, Florida’s insurance regulators made several changes that were designed to support a healthy homeowners’ insurance market and maintain affordable rates. In practice, though, these changes achieved the latter goal at the expense of the former. Given the constraints on pricing, national carriers largely exited the state, with the market becoming more dependent upon smaller local insurers and government-backed entities.

This meaningfully limits the potential for homeowner-related losses from Hurricane Irma within the insurers we cover, although the potential for losses still exists in commercial and other personal lines, much as they do with Hurricane Harvey. We think the biggest industry impact of large privately insured losses would probably be in reinsurance, especially on many of the Caribbean islands that were big tourist destinations (where there are higher insured values), which were devastated by the storm. As we said earlier, Buffett believes Berkshire’s reinsurance exposure should be limited, given the company’s retreat from underwriting reinsurance the past several years as pricing weakened due to an overabundance of capital and the rise of the catastrophe bond market. While we have long believed that a string of major catastrophe losses could serve as a catalyst for some of this nontraditional capital to leave the market and for pricing to return to more normalized levels, Buffett doesn’t expect pricing to improve materially in the aftermath of the hurricanes and other natural disasters (like the Mexican earthquakes) we’ve seen this year.

Much like with Hurricane Harvey, Berkshire’s biggest exposure to Hurricane Irma will be through its auto insurance operations, with Geico being the top provider of auto insurance in Florida with an estimated 26% share of the market. While the total losses in Florida are likely to be much lower than with Hurricane Harvey, given the massive flooding that accompanied the latter storm (and the fact that water tends to do greater damage to cars than wind), they will not be immaterial. However, Buffett has noted that the total insured auto losses from Hurricane Irma will be less than those from Hurricane Harvey. Some of the earliest estimates we’ve seen so far about total vehicles losses from Harvey and Irma have come from Cox Automotive, the parent company of Kelley Blue Book and Autotrader.com. That company has total vehicle losses from Hurricane Harvey of 300,000-500,000, which would put Geico’s share of the losses at 30,000-50,000, similar to Buffett’s own projections for the auto insurer. As for Irma, the number of vehicles affected is lower, but not meaningfully, with total losses projected to be 200,000-400,000. Applying Berkshire’s market share to the midrange of that estimate would put Geico’s total insured auto losses from Hurricane Irma at $300 million.

Hurricane Maria is believed to have caused an estimated $40 billion-$85 billion in insured losses, with most looking to be concentrated in Puerto Rico, an area that has traditionally been underserved when it comes to hurricane-related insurance. For example, recent estimates from AIR Worldwide (a subsidiary of Verisk Analytics that provides catastrophe risk modeling software and consulting services) point to just 50% of the homes in Puerto Rico having insurance policies that protect against wind damage, much lower than what is typically seen in hurricane-prone regions in the U.S. That’s not to say that there won’t be losses--it’s just that the impact for our traditional property-casualty coverage is likely to be muted, given the insurance dynamics on the island. We envision the biggest impact on the reinsurance side of the business, which is likely to absorb much of the insured losses in the region. Chubb CB, one of Berkshire’s competitors in the reinsurance market, which is believed to have a similar level of exposure to the region as BHRG and General Re have, has already announced that its maximum net insurance and net reinsurance losses related to Hurricane Maria will be around $200 million aftertax for the third quarter, which equates to around $250 million pretax; we think this is probably a good base for Berkshire’s own insured losses in the region.

All in, we’re probably looking at $1.5 billion-$3.0 billion in total insured losses for Berkshire’s insurance operations from hurricanes Harvey, Irma, and Maria (based on the dispersion of insured losses from other periods of heavier hurricane activity), with our expectations being somewhere in the middle of that range. For some perspective, Berkshire recorded $3.4 billion in hurricane-related losses in 2005 when hurricanes Katrina ($2.5 billion), Rita, and Wilma ($900 million) struck the Gulf Coast, with Geico reporting $200 million in pretax losses, General Re posting $685 million in insured losses, and BHRG seeing $2.5 billion in pretax losses. With Hurricane Sandy in 2012, Berkshire’s total insured losses were $1.1 billion on a pretax basis, with $490 million coming from Geico, another $266 million tied to General Re, and $364 million from BHRG.

Given the changing nature of Berkshire’s insurance operations, with the company becoming a much larger player in the auto insurance market while stepping away from a lot of catastrophe and supercatastrophe underwriting in the reinsurance market, we expect the company will see near-equal losses from those parts of its business, which is how $800 million in expected auto insurance losses from hurricanes Harvey and Irma translates into $1.5 billion in total insured losses (the lower end of our range). Believing it pays to be prudent in times like this, we’ve multiplied that figure by 2 to arrive at the upper end of our range of expected total insured losses from this year’s hurricane season.

Our best guess at this point is that total insured losses are likely to end up around $2.25 billion, which works out to about a 1% reduction in our fair value estimate for Berkshire Hathaway after adjusting for the timing and dispersion of large natural catastrophe losses that we already had built into our model as well as the potential for price increases in the auto insurance and reinsurance markets following hurricanes Harvey, Irma, and Maria. We expect to gradually work these estimates, along with changes to the investment portfolio (including Berkshire’s recently announced 38.6% investment in the company behind the Pilot and Flying J travel centers in the U.S.), into our valuation in the near term.