Buffett Jumps in Where Others Fear to Tread

Berkshire Hathaway starts underwriting terrorism policies--and investors approve

Warren E. Buffett has seen the future of America's security, and it is a scary sight indeed. Buffett, chairman and CEO of Berkshire Hathaway Inc. (BRK ), made headlines at his company's annual meeting in May by predicting that terrorists one day will detonate a nuclear bomb on American soil. "It will happen," he said.

Despite his dire prophecy, Buffett was in exceptionally good cheer throughout his shareholder weekend. So extreme a disconnect between message and mood would be unseemly in a government official. But Buffett is a businessman, and he believes that his company is well-positioned to profit from the chaotic post-September 11 market in terrorism insurance. "We're selling more terrorism coverage than anybody," he told his investors, "but it does not endanger Berkshire Hathaway."

Since the World Trade Center was destroyed, Berkshire has written a series of large policies extending terrorism coverage to some of the highest-profile potential targets around. The 2002 World Cup, the world's biggest sporting event, might have ended before it started had not the Sage of Omaha agreed to insure its sponsor against losses resulting from cancellation. Berkshire replaced French insurer AXA Group (AXA ), which terminated its cancellation policy after September 11. Buffett's company even wrote a $500 million policy on the 110-story Sears Tower, North America's tallest skyscraper.

With most reinsurers running scared, terrorism coverage is hugely expensive, with companies paying 5% to 30% of a policy's face value. Thanks in part to Buffett's willingness to go where most of his competitors fear to tread, Berkshire's reinsurance business posted much improved results during the first quarter of 2002, with its disappointing General Reinsurance subsidiary turning its first quarterly underwriting profit since 1998. Analysts predict that rising reinsurance earnings will continue to buoy Berkshire Hathaway, but only if it can dodge the colossal land mine that lurks somewhere just under the surface of the global insurance industry: the next terrorist catastrophe.

Investors seem to be giving Buffett the benefit of the doubt. Since bottoming on Sept. 19 at $61,400, Berkshire's A shares have risen to $66,700--a gain of nearly 9%, compared with a 5% decline in the Standard & Poor's 500-stock index during this period. Berkshire made huge profits over the years insuring against damage caused by hurricanes, earthquakes, and other "super-catastrophes." But as Buffett acknowledges, the well-honed science of predicting natural disasters is of little use when it comes to terrorism, with its abbreviated history and human X factor. "It is not quantifiable," Buffett says flatly. How then can he be so certain that Berkshire is safe in a world shadowed by terrorism?

Buffett's confidence is rooted in a mighty balance sheet. Even after booking a pretax underwriting loss of $2.4 billion on the WTC disaster, Berkshire still boasts a robust shareholder's equity of $60.5 billion. "Can Buffett handle it?" asks Standard & Poor's analyst Frederick Loeloff, responding to a question about Berkshire's terrorism exposure. "If a BB company was writing terrorism insurance, I'd have some concerns. But Berkshire is AAA"--S&P's highest credit rating.

What's more, September 11 did indeed prompt Buffett and the top execs at his two reinsurance subsidiaries--National Indemnity Co. and General Reinsurance--to think much more carefully about how to define the risks they insure. It actually occurred to Buffett in the months leading up to September 11 that large-scale terrorism losses were a growing threat, but he did not factor this realization into Berkshire's underwriting decisions. "I violated the Noah principle: Predicting rain doesn't count, building arks does," Buffett admitted in his annual shareholder's letter. "I consequently let Berkshire operate with a dangerous level of risk."

This failing was hardly Berkshire's alone. It will take years to tote up the damages from September 11, but insurers already have booked losses of $26 billion and the final tab easily could double. In the typical natural disaster, property damage accounts for almost all insurance loss. However, the claims from the WTC attacks come from many different types of coverage, with property accounting for 27% to 30% of total losses, and business interruption and worker's compensation for most of the balance.

Before September 11, terrorism insurance per se did not exist in the U.S. Berkshire and its rivals unwittingly provided coverage at no extra charge by not excluding losses caused by terrorist attack from conventional property-casualty policies. At the same time, they failed to realize that by insuring companies in the same building, they were concentrating underwriting risk dangerously even though they were writing various kinds of coverage. "On September 11, people woke up and realized that instead of having diversification, you actually have aggregation because of the possibility of losses happening all at the same time," says Ajit Jain, a Buffett confidante who runs National Indemnity's reinsurance business.

Since September 11, Berkshire's basic underwriting strategy has been to limit its generic exposure to terrorism by excluding losses due to nuclear, biological, or chemical attack from standard policies while avoiding worker's comp and many kinds of property coverage altogether. Meanwhile, the company is writing new, carefully crafted terrorism policies at high prices (table). As Buffett puts it: "We will write some coverage for terrorist-related losses, including a few noncorrelated policies with very large limits. But we will not knowingly expose Berkshire to losses beyond what we can comfortably handle."

The key word here is "knowingly." Alice Schroeder, who follows Berkshire for Morgan Stanley, estimates that as much as 60% of the company's $2.4 billion loss on the World Trade Center was a product of unwitting aggregation. Obviously, insurers now know that a hijacked airliner can be made into a bomb that creates horrendous business interruption and worker's comp losses. But what previously unimaginable aggregations will surface in the next catastrophe? "Everyone is thinking through these issues," Jain says. "But there are no easy answers."

Buffett and crew generally find a way to hedge the new terrorism risks they take on. With the Sears Tower, Berkshire is not on the hook until total losses exceed $500 million. Similarly, the $578 million worth of property coverage that Berkshire extended to a South American refinery does not kick in until damages exceed $1 billion. Berkshire apparently bore the risk of World Cup cancellation alone, but Buffett no doubt took comfort in knowing that this liability expired when the soccer tournament ended.

In April, Berkshire joined with Allianz (AZ ) and 10 other insurers to offer terrorism insurance to airlines. The Allianz-administered pool will cover a plane for as much as $1 billion or an airline up to $2 billion a year, but the policy automatically terminates after "four major events resulting in losses." Berkshire also is participating in Extremus, a new terrorism insurer in Germany. Berkshire will be liable for $380 million, but the company is part of a $1.4 billion pool that will be tapped only if the $1.4 billion contributed by the German government is exhausted first.

In the U.S., Congress is now considering legislation that would limit the insurance industry's exposure to terrorism losses by shifting most of the potential liability to the government. Like most insurance executives, Buffett strongly favors federal intervention. Berkshire's CEO has said that he is "perfectly willing" to again lose $2 billion to $2.5 billion on a single catastrophe. But under the "close-to-worst case" that Buffett envisions, a large-scale terrorist attack on America could inflict $1 trillion in damage. "Only the U. S. government has the resources to absorb such a blow," Buffett warns.

By Anthony Bianco in New York

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