Many P&C insurance companies are still dealing with legacy losses from asbestos, although policies issued since 1985 exclude coverage. On July 13, The Hartford Financial Services Group (HIG) announced substantial increases to its reserves for losses from that cause. The ads are back on TV: "If you or a loved one died from Mesothelioma, don't wait, call now."
Is the industry heading for another round of bleeding from long-tailed asbestos claims? Or is Warren Buffett's Berkshire Hathaway (BRK.A) going to earn outsize profits by relieving other insurers of their exposure? The Oracle of Omaha once said: "I can go into an emergency room and write life insurance if you let me charge enough of a premium." In April this year Berkshire assumed AIG's (AIG) asbestos risk for $1.65 billion, after receiving $2 billion in 2010 to take on CNA's asbestos and environmental risks.
In 4Q 2010 AIG took a reserve charge of $1.3 billion for asbestos, offering the following explanation:
During the 2010 year end loss reserve review, the third-party actuary's standard account-specific asbestos model was updated for 2010 information and was calibrated to actual AIG experience, including that in the second and third quarters of 2010. AIG also modified certain of its loss-reserve-related assumptions to better reflect both industry-wide and AIG-specific expectations and experience for IBNR claims, taking into consideration recent, higher industry-wide trends regarding expanding coverage theories for liability.
HIG, pre-announcing 2Q 2011 results, noted an increase in asbestos reserves:
A reserve increase of $290 million, pre-tax, or $189 million, after tax, resulting from the company's annual review of its legacy asbestos liabilities. The increase was primarily driven by higher frequency and severity of mesothelioma claims, particularly against certain smaller, more peripheral insureds.
AIG presumably had to update its reserves prior to the transaction with Berkshire. Berkshire would perform due diligence. David Merkel has lovingly chronicled AIG's reserving practices, which at times have been egregiously slack. Given a very long history of under-reserving, the size of AIG's increase should not be taken as indicative of the industry as a whole.
What is Buffett Thinking?
Reviewing the most recent 10-K, the following excerpts provide a fairly clear explanation of the nature of the the transactions and the reasoning behind them:
In 2010, BHRG (Berkshire Hathaway Reinsurance Group) entered into a reinsurance agreement with Continental Casualty Company, a subsidiary of CNA Financial Corporation (“CNA”), and several of CNA’s other insurance subsidiaries (collectively the “CNA Companies”) under which BHRG assumed the asbestos and environmental pollution liabilities of the CNA Companies subject to a limit of indemnification of $4 billion.
In BHRG’s retroactive reinsurance business, the concept of time-value-of-money is an important element in establishing prices and contract terms, since the payment of losses under the insurance contracts are often expected to occur over lengthy periods of time. Losses payable under the contracts are normally expected to exceed premiums and therefore, produce underwriting losses. This business is accepted, in part, because of the large amounts of policyholder funds (“float”) generated for investment, the economic benefit of which will be reflected through investment income in future periods.
Earlier in the 10-K, is the kicker:
For many years, the insurance industry has been subject to personal injury claims arising from exposure to asbestos. The magnitude of such losses has caused many manufacturers to file for protection under the U.S. Bankruptcy Code. Over the years, large numbers of asbestos related claims have been filed, including claims based upon exposure to asbestos, even though no related illness has been identified. Consequently, the U.S. Congress has periodically introduced legislation to assure that resources are available to indemnify claimants suffering from asbestos-related illnesses and to manage the overall cost of those claims. To date, no legislation has passed. It is highly uncertain as to whether or not any legislation will be enacted and, if enacted, how the provisions of such laws will affect Berkshire.
Companies like CNA or AIG have difficulty maintaining their financial strength ratings due to the expected volatility of asbestos liabilities. They evidently prefer to take their losses and move on, leaving AAA rated Berkshire to bear the risk, and enjoy the profits. If at some point Congress does something to rein in the excesses of plaintiff lawyers on asbestos claims, so much the better.
Even though no related illness has been identified? There may be some need for corrective action.
Buffet's approach to investing has been marked by an extremely long term view, a willingness to be greedy when others are fearful, and an appreciation for the value of float. The asbestos transactions sit at the intersection of these three lines of thinking, and are likely to be a source of long term earnings strength for Berkshire.
From the 2010 10-K:
The recorded net reserves as of December 31, 2010 of $2.14 billion ($1.80 billion and $339 for asbestos and environmental, respectively) is within an estimated range, unadjusted for covariance, of $1.67 billion to $2.44 billion. The process of estimating asbestos and environmental reserves remains subject to a wide variety of uncertainties, which are detailed in Note 12 of Notes to Consolidated Financial Statements. The Company believes that its current asbestos and environmental reserves are appropriate. However, analyses of future developments could cause the Company to change its estimates and ranges of its asbestos and environmental reserves, and the effect of these changes could be material to the Company’s consolidated operating results, financial condition and liquidity. Consistent with the Company’s long-standing reserving practices, the Company will continue to review and monitor its reserves in Other Operations regularly and, where future developments indicate, make appropriate adjustments to the reserves.
The difference between the reserve as of 12/31/2010 and the high end of the range is $300 million, or $0.67 per share, representing about 1.5% of book value. The recently announced reserve increase, after tax, is $189 million; $0.42 per share, or 1% of book value. HIG currently trades at a P/B of 0.51, influenced in part by concerns for legacy liabilities. 1% or 1.5% is a rounding error under those circumstances.
Berkshire Hathaway has demonstrated the ability and willingness to bear exposures of this type. Management at The Hartford could improve market perceptions and share prices by retroactively reinsuring the companies asbestos exposure, perhaps with Berkshire. Rating agencies would also be appeased by the reduction in uncertainty, always a consideration.
CNA Financial Corp (CNA)
CNA is majority owned by Loews (L). The combined loss-expense ratio has been over 100 for 9 out of the past 10 years. With an S&P Credit Rating of BBB-, a reduction of uncertainty was in order. The retroactive reinsurance transaction with Berkshire makes sense for that reason, and eliminates a prospective reservation for investors who are willing to speculate on the possibility of a turn-around.
Trading at a P/B of 0.61, and with substantial uncertainty removed, shares of CNA may be of interest to value investors. Loews is of equal interest, as an indirect play on CNA.
American International Group (AIG)
Given AIG's long history of under-reserving, as well as inordinate risk-taking, not to mention the presence of the government as a majority owner, any investment in the company should be regarded as speculative, and inappropriate for investors who cannot tolerate volatility and potential loss of capital.
That having been said, offloading the exposure onto Berkshire makes AIG a more attractive investment. Questions about reserve adequacy, at least for asbestos and environmental, have been answered.
Examining the company's 2010 10-K, information on asbestos reserves is available, as shown:
click on images to enlarge
Allstate has decreased its Asbestos reserves in recent years. A 20% increase to asbestos reserves would be $220 million, $0.32 per share after tax, 0.9% of book value.
After many years of patiently holding this perennial value candidate, I gave up on it and deployed the funds elsewhere, but asbestos was not a consideration.
From the 10-K:
Chubb's annual reviews have not indicated any need to add to reserves. The company has a history of prudent and conservative reserving practices and current reserves appear adequate. A 20% increase would be $132 million, $0.30 per share after tax, 0.6% of book value.
A review of the 10-K shows that the company increased asbestos reserves by an average of $132 million over the past three years, or $0.24 per share after taxes. That amounts to 0.4% of book value. A 20% increase in asbestos reserves would be $510 million, $0.91 per share after tax, 1.8% of book value.
Social Inflation and Legislative Relief
The phenomenon of increased litigiousness may be described as social inflation. Attorneys become very adept at securing increasing settlements, devising new theories of liability, and identifying new classes of claimants. Always idealistic, Americans strive to do the right thing for themselves and their loved ones. Often that means calling a lawyer.
Ideology becomes involved, with the right wing eager to restrain litigation, and the left more willing to let the plaintiff's bar have its way.
From time to time, Congress considers Tort Reform, but has not enacted any legislation to date. As the US becomes more polarized, the possibilities of well thought out reform diminish. There is no reason to look for legislative relief on asbestos liability.
Legacy losses from asbestos related loss exposures are in the process of putting on another growth ring. A complex set of considerations involving access to equity capital, rating agency opinions, and regulatory capital requirements makes these legacy exposures difficult for insurers that do not enjoy extremely strong credit and insurance financial strength ratings. AIG and CNA sought relief from Berkshire for that reason, paying prices that should be profitable to their rescuer.
The recent developments on asbestos do not make the insurance industry as a whole unattractive. Many companies have little or no exposure, and others have arranged to offload the risk onto Berkshire Hathaway. It's best to make the analysis for each company separately. In the cases reviewed, a hypothetical 20% increase to asbestos reserves reduced book value by 0.6% to 1.8%, very manageable for companies that are trading below historical P/B multiples.
From an analytical point of view, simply doing a word search for "asbestos" on the most recent 10-K will lead the investor to numerical data that can be quantified against book value or earnings in order to get a handle on the risk involved.