“Our Main Business Is Insurance” 35loss exposure of approximately $275 million for two years running
(1998 and 1999).
The problem, it later became apparent, was that GenRe was under-
pricing its product. Premiums coming in, remember, will ultimately be
paid to policyholders who have claims. When more is paid out than
comes in, the result is an underwriting loss. The ratio of that loss to the
premiums received in any given year is known as the cost of f loat for that
year. When the two parts of the formula are even, the cost of f loat is
zero—which is a good thing. Even better is less than zero, or negative
f loat cost, which is what happens when premiums outstrip loss payments,
producing an underwriting prof it. This is referred to as negative cost of
f loat, but it is actually a positive: The insurer is literally being paid to
hold the capital.
Float is a wonderful thing, Buffett has often commented, unless it
comes at too high a cost. Premiums that are too low or losses that are un-
expectedly high adversely affect the cost of f loat; when both occur si-
multaneously, the cost of f loat skyrockets.
And that is just what happened with GenRe, although it wasn’t
completely obvious at f irst. Buffett had realized as early as 1999 that
the policies were underpriced, and he began working to correct it. The
effects of such changes are not felt overnight, however, and in 2000,
General Re experienced an underwriting loss of $1.6 billion, produc-
ing a f loat cost of 6 percent. Still, Buffett felt able to report in his 2000
letter to shareholders that the situation was improving and he expected
the upward trend to continue. Then, in a moment of terrible, uninten-
tional foreshadowing, he added, “Absent a mega-catastrophe, we expect
our f loat cost to fall in 2001.”^6 Some six months later, on September
11, the nation had an enormous hole torn in its soul by a mega-
catastrophe we had never imagined possible.
In a letter to shareholders that was sent out with the third quarter
2001 report, Buffett wrote, “A mega-catastrophe is no surprise. One
will occur from time to time, and this will not be our last. We did
not, however, pr ice for manmademega-cats, and we were foolish in
not doing so.”^7
Buffett estimated that Berkshire’s underwriting losses from the ter-
rorist attacks on September 11 totaled $2.275 billion, of which $1.7 bil-
lion fell to General Re. That level of loss galvanized a change at GenRe.
More aggressive steps were taken to make sure the policies were priced
correctly, and that suff icient reserves were in place to pay claims. These