Buffett Says Low Rates Means Insurers’ Bonds Are Wasting Assets
Warren Buffett, who built Berkshire Hathaway Inc. (BRK/A) into a $250 billion company with funds from insurance units, said low interest rates create “dim prospects” for the industry that fueled his firm’s growth.
The billionaire chairman and chief executive officer praised managers of Berkshire’s insurance businesses for posting their 10th straight year of underwriting profit in his annual letter to shareholders on March 1. He then struck a cautionary note about competitors with worse records.
“A further unpleasant reality adds to the industry’s dim prospects,” he wrote. “Insurance earnings are now benefiting from ‘legacy’ bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years, and perhaps for many years beyond that. Today’s bond portfolios are, in effect, wasting assets.”
Buffett, 82, has been adding capital-intensive businesses like railroad Burlington Northern Santa Fe, acquired in 2010. That deal, and growth of utility MidAmerican Energy Holdings Co., lessened Berkshire’s reliance on insurance as the CEO prepares the company for an eventual leadership transition. The shift also reduced his challenge of investing ever more float, the insurance premiums held until claims are paid.
Berkshire spent a record $9.8 billion last year on plant and equipment as it bolstered the railroad and energy units, Buffett wrote in the letter. His Omaha, Nebraska-based company spent about $2.3 billion more on 26 deals that expanded the operations of existing businesses.
“Those bolt-on acquisitions and those expansions at Burlington and MidAmerican, those would have happened with or without Buffett,” said James Armstrong, president of Henry H. Armstrong Associates, a Pittsburgh-based investment manager that oversees about $375 million, including Berkshire shares. “That shows us that the company has come a long way in its ability to soak up the cash it generates.”
Such investments are repeatable, lessening the burden on Buffett and Vice Chairman Charles Munger to find large acquisitions and securities bets, like the deal they struck last month to take ketchup maker HJ Heinz Co. private, Armstrong said. Berkshire will probably set a record again for capital spending in 2013, Buffett wrote.
Other CEOs who held back investment last year because of doubts about the economy missed an opportunity, the billionaire said. The future of the U.S. has been uncertain since the country’s Declaration of Independence in 1776, he wrote.
“American business will do fine over time. And stocks will do well just as certainly,” Buffett said. “Since the basic game is so favorable, Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of ‘experts,’ or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.”
Buffett said Berkshire’s insurance units including Geico and General Re “shot the lights out” last year as float climbed about $2.5 billion to $73.1 billion. That gave Berkshire cost-free money to invest, he said.
Buffett has favored stocks over bonds, shielding Berkshire from some of the pressure of low interest rates. Insurers including American International Group Inc. (AIG) and Travelers Cos. have more of their portfolios in fixed-income holdings.
Berkshire had more than $87 billion in equities at the end of 2012, including the biggest stakes in Wells Fargo & Co., International Business Machines Corp. and Coca-Cola Co, and $32.3 billion in fixed-income assets, such as corporate debt, sovereign bonds and municipal securities.
Treasury yields have tumbled over the last three decades, causing bond prices to rally and putting pressure on savers who rely on income from the assets. Ten-year notes hit a record low yield of 1.38 percent in July.
Insurance investment income contributed $3.4 billion, or 23 percent, of Berkshire’s $14.8 billion profit last year, according to a regulatory filing. That compares with $4.1 billion, or 51 percent, of earnings in 2009 when Berkshire still had preferred shares of Goldman Sachs Group Inc. and General Electric Co.
Buffett began the letter by telling shareholders his performance was “subpar” in 2012. The growth in Berkshire’s per-share book value, a measure of assets minus liabilities, trailed the Standard & Poor’s 500 Index by 1.6 percentage points last year, including dividends. The billionaire failed to exceed that yardstick only nine times since he took control of the company in 1965.
Buffett told investors that insurance units would underwrite conservatively. That reiterated a commitment he made eight years ago when he showed how National Indemnity Co. policy sales fell to $54.5 million in 1999 from $366.2 million in 1986 because managers felt the industry was charging too little for the risk it was taking. Sales climbed to $605.6 million in 2004.
Buffett’s latest letter may have been “signaling to the industry that we need to be rational about our pricing, because as the long-term debt rolls off returns are going to shrink,” said Richard Cook, co-founder of Cook & Bynum Capital Management LLC, which oversees Berkshire shares.
This year’s letter also included a section on dividends to address questions about why Berkshire doesn’t pay one. Buffett reiterated a policy he outlined in a 1985 letter, saying that shareholders have benefited because he retained the money in the business. Under some scenarios, he wrote in the latest letter, investors would be better off selling some of their shares to meet their needs rather than get a dividend.
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