According to reports the Bank of England has written to the U.S. Treasury to ask why the reinsurance business of Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has been left off the initial list of financial institutions that are deemed systemically important, or too big to fail.
It's a good question. At this stage a number of major primary insurance firms have been named as systemically important, or so large that their failure poses a risk to the wider financial market, but no reinsurance companies.
According to the report in the Financial Times, a number of primary insurers have fought back by claiming that it is actually the major global reinsurance firms that are systemically important, not the primary providers of insurance policies.
On that point it seems that insurers would be within their rights to claim this if they passed on the majority of their risks to the global reinsurance markets, but with retentions on the rise and reinsurance purchases rationalized, and in some cases shrunken, it seems primary players are retaining enough risk to be deemed too big to fail.
But what about reinsurers like Berkshire Hathaway? Yes Berkshire is certainly an extremely large reinsurer (and insurer), but is the business model it follows one that makes it particularly systemically important?
In order to be deemed systemically important, you'd imagine that a reinsurer (or insurer) must be so large, with its finances so interlinked with wider financial markets, that if an event caused it to fail it would cause ramifications so widely and deeply felt that it would damage the economy.
Questions that need to be asked include such topics as; does Berkshire have one major exposure that dwarf's all others, can the reinsurer access the float to pay its claims readily (liquidity), is the firm exposed to a large amount of derivative risk, or does it engage in significant amounts of non-traditional, non-insurance business?
Berkshire Hathaway has gathered around $84 billion of float, which Buffett terms as "money that doesn't belong to us but that we can invest for Berkshire's benefit." Having such a massive pool of capital and assets, which are invested across a truly diverse range of sectors and asset classes, provides Berkshire with capital that can be liquidated to pay claims.
Berkshire is also known for having a tight capital model, which looks to forecast claims expectations and ensure that float can always be freed up to meet any eventuality. A lot of Berkshire's float investments are in stocks which can be easily liquidated to cash.
So, due to Warren Buffett's float model, of investing the insurance and reinsurance premium float across an extremely diverse range of assets and investments, it seems the asset side may be more liquid than some other reinsurers that put everything into so-called 'safe assets'. Of course it is also a more risky investment strategy and is exposed to wider financial factors too, a more correlated investment strategy although diversified within it, if you will.
In terms of major exposures at Berkshire Hathaway, one that comes to mind is the asbestos liabilities that Berkshire Hathaway took on, including having assumed large amounts of asbestos risk from other global reinsurers over the years. Berkshire has often been found to be the only insurance or reinsurance market that would touch many of these risks.
However the reinsurer is so large that the asbestos exposure may be diversified away to a degree now that it is adding less of that risk, given we're passed the peak concern over rising claims for it (many believe). In fact Berkshire's underwriting business is so large and diversified that perhaps no single risk is a real concern from a systemic point of view?
That does leave the firm exposed should the claims experience start to increase significantly. Could that be enough to deem it systemically important though? Perhaps, but other major reinsurers also have significant exposures to single risks, sometimes major catastrophe exposures and sometimes large liabilities or life mortality risks. Berkshire is not alone in having major risk accumulations among the reinsurers.
Derivatives. Berkshire is said to have around $3.5 billion of derivatives, according to the FT's report, which seems a lot until you compare it to the float. At that point it becomes reasonably clear that Berkshire could probably afford these derivative positions turning sour. The $84 billion of float is a massive war chest that is also perhaps undervalued, given the valuations of each individual investment could be much higher at the time of liquidation.
The regulators have a tough job, both with assessing Berkshire Hathaway's systemic riskiness and also with the other major global reinsurance firms. These are extremely complex businesses, with differing asset, underwriting and reserving strategies, differing risk profiles, portfolios of risk and use of derivatives.
It's no surprise it is taking time for the regulators to offer a decision on whether to name any reinsurance firms as systemically important.
In the end it may come down to more simple analysis of 'what's the maximum possible loss' versus 'can it pay for those claims readily', simplistic perhaps, but the real systemic risk is the total failure of these firms.
Berkshire Hathaway, due to the float investment strategy, may actually be better placed than some other reinsurers to meet its claims for many of its worst case scenario losses. The fact that the float is already so large, continues to grow at such a rapid pace, is invested in a diversified manner and might be more readily liquidated, at least enough to pay many claims, could actually stand in its favor.
The other interesting angle of the systemically important reinsurers story is how the regulators would actually address applying rules to any deemed to be so. Would they insist on a certain matching of liabilities to their assets (something Berkshire already works hard to do), or require large players to downsize (seems unlikely given the importance of being diversified at such scale)?
It will be interesting to see how the FSB and other regulators treat reinsurers, versus primary insurers. The different business models deserve different treatment and careful examination of the factors that could cause systemic risk to rise should any fail, or get into trouble.
The promise to pay that insurers and reinsurers make is supposed to be written in stone. When things go wrong, it is this promise that the regulators want to see being lived up to. Any major, global reinsurers unable to live up to their promises, in certain scenarios, perhaps deserve to be deemed systemically important.
Will Berkshire Hathaway become one of them? Or will its diverse portfolio of risks and perhaps even more diverse portfolio of assets mean it can escape systemic designation?
And even if it is deemed systemically important, the resulting regulatory environment it may be subjected to might only involve greater scrutiny and checking of its liabilities and assets. Something that Berkshire Hathaway could surely adjust to, given its size, even if it needed to change some of its business practices to keep regulators happy.
The topic of systemic importance is an interesting one that promises to rumble on for months and perhaps years to come. Even after any reinsurers are designated there will no doubt be years of adjustment and changes to be made, which will also affect the wider market.
Of course all of this discussion does make the topic of fully-collateralized reinsurance come to mind, given the collateralized nature of ILS and capital markets backed reinsurance, which means the money is always there (held in trust) to pay the claims as required.
Could the issue of systemic importance create such pressures on large reinsurers, that ILS and collateralized players are left free to capitalize and focus on taking market share while traditional players are grappling with increased regulation? That's something that will be interesting to watch out for.
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