This is the first article in a series describing Berkshire Hathaway’s (BRK.A) business units. Part one describes Berkshire's insurance subsidiaries.
Investors seeking to judge Berkshire Hathaway's value as an investment have traditionally used its price to book ratio (P/B) as the primary metric. This is because the vast majority of Berkshire's businesses were insurance, and the primary metric to evaluate insurance company stocks are P/B. Today, however, only 27% of revenue comes from Berkshire's insurance businesses. Valuing the entire company of Berkshire Hathaway as an insurance company based on book value drastically underestimates the other three-quarters of the company. When Berkshire's various subsidiaries are valued by more appropriate metrics, Berkshire Hathaway clearly becomes a tremendously undervalued stock.
Warren Buffett is probably the world's greatest living investor. Investors look to his annual shareholder letter for guidance on stocks, the economy and general financial commentary. As chairman and CEO of Berkshire Hathaway, Buffett has overseen the growth of the company, known primarily as an insurance company, into a conglomerate with diversified revenue streams. While Berkshire Hathaway cannot be considered just an insurance company, insurance remains the flagship of the conglomerate.
Berkshire entered the insurance industry via its 1967 acquisition of National Indemnity. Insurance companies traditionally do not make money on the difference between what they charge in insurance premiums and what they have to pay out in claims. In fact, many leading insurance companies pay out more money than they collect in claims in any given year. Insurance companies actually make money by investing what they have received in premiums and not yet paid out in claims. In Berkshire's case, the skillful investment of this money – known as the float – by Warren Buffett is the major reason Berkshire Hathaway is such a successful company.
Of Berkshire Hathaway's three major insurance subsidiaries, the most well-known is GEICO: America’s third largest auto insurer boasting an 8.8% market share. GEICO collects $14.3 billion in premiums each year, and this amount has grown at an 11.5% annual clip since 1995. Its underwriting profit in the last three years has been 7.8% (2010), 4.8% (2009), and 7.3% (2008) while continuing to show premium growth.
Berkshire’s second major insurance subsidiary is Berkshire Hathaway Reinsurance Group (BHRG). Ajit Jain, considered by many investors one of the front-runners to succeed Warren Buffett as CEO, runs this unit. Jain is known for taking risks on insurance policies that other companies are unwilling or unable to take. In 2000, he wrote the permanent disability policy for then-Ranger (now Yankee) slugger Alex Rodriguez and his record-setting contract. Jain also wrote the policy for Pepsi's "Play for a Billion" promotion in 2003 where Pepsi insured against the 1 in 1,000 chance of a billion-dollar payout. Few if any other insurance companies would be willing to underwrite a disability policy on a $252 million baseball contract, or a $1 billion lottery drawing (and to my knowledge Berkshire didn't have to pay out on either policy). In addition to these one-time insurance policies, the Berkshire Hathaway Reinsurance Group has significantly expanded its life reinsurance business, with current annual premium volumes of about $2 billion.
The third major insurance subsidiary of Berkshire Hathaway is General Re, managed by Tad Montross. General Re is another reinsurance group, reinsuring property, casualty, life and healthcare policies. General Re and BHRG rank as two of the largest reinsurers in the world. General Re has shown more consistent underwriting profits than either GEICO or BHRG and stands between the two in current float. Its property/casualty premium volume has declined over the past two years due to pricing pressure and General Re's conservative underwriting standard (which is exactly what we, the shareholders want). Other sources suggest that reinsurance pricing might strengthen as a result of the earthquake that rocked Japan and other recent disasters. This would result in improved property/casualty premium growth. General Re's life and health reinsurance businesses have grown premiums in each of the last two years at a 4.7% and 4.8% currency-neutral rate.
Berkshire Hathaway also has a variety of smaller insurance operations, primarily providing property and casualty insurance for commercial accounts. Combined, these account for 7.8% of year-end 2010 float and 13% of 2010 underwriting profits.
Berkshire Hathaway's combined insurance businesses accounted for $35.9 billion in 2010 revenue, 27% of the company's total. This percentage is essentially unchanged from 2009 and up from 26.4% in 2008. Its insurance subsidiaries, however, account for 62.6% of its assets and 64.6% of its shareholder equity. To value the entire company of Berkshire Hathaway as an insurance company, and to do so based on book value, drastically underweights the rest of the company - nearly three-quarters by revenue - and therefore undervalues the company as a whole. Future articles in this series will analyze how best to value those portions of Berkshire Hathaway.
How much are Berkshire's insurance businesses worth?
Perhaps the easiest comparison is to other large similar reinsurance companies. To examine this, I looked several of the largest publicly traded reinsurance companies. Partner Re (PRE), Everest Re (RE), the Reinsurance Group of America (RGA), and Renaissance Re (RNR) are a good set of comparables. They trade in a relatively small range of price to book value with an average price to book of 0.87. Applying this average price/book ratio to the book value of Berkshire's insurance operations suggests that the market should value Berkshire's insurance subsidiaries around $92 billion, or about $37 per B share.
I should mention that this number subtracts from the book value of Berkshire's insurance subsidiaries a proportional (by assets) amount of Berkshire's deferred income taxes. If I don't subtract this number, the value of Berkshire's insurance businesses rises to about $111.6 billion or $45 per B share. If I completely subtract all of Berkshire Hathaway's income tax liabilities from its insurance subsidiaries combined book value, it would suggest a valuation of $80 billion or just over $32 per B share. Interestingly, applying the average price to sales of the four above companies of 1.32 to Berkshire's insurance revenues gives a value of just $41 billion to Berkshire's insurance operations, or about $16.40 per B share.
The disparity between the valuation on a price/sales ratio and a price/book ratio suggests that Berkshire's insurance operations are able to accumulate significantly more float than the average insurance company, or that the management (Buffett and others) is able to achieve higher returns on the float. Either way, Berkshire's insurance companies appear better run and should command a higher valuation than the average reinsurance company. I think the market would value these subsidiaries between $37 and $45 per share, and I personally think that it's worth significantly more. When Berkshire was more purely an insurance company, it was often valued at 1.5 times book value, suggesting that $50 per B share is a quite reasonable target for this portion of the company.
Part two of this series is in progress and will focus on Berkshire's MidAmerican Energy Subsidiary.