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The most important shift in Wesco’s capital allocation came about in 1985. It established Wesco-Financial Insurance Company (“Wes-FIC”). This insurance and reinsurance company (insuring insurers) was to have an intimate relationship with National Indemnity, the lead Berkshire Hathaway insurance operation.
It started with a deal with Fireman’s Fund. This former subsidiary of American Express floated on the stock exchange under the leadership of insurance company veteran, Jack Byrne in 1985.
Byrne had earned Buffett’s undying admiration and gratitude for turning-around GEICO, an insurance company on the verge of bankruptcy when Berkshire Hathaway took a major stake in the early 1970s.
Buffett respected him to such an extent that he signed up National Indemnity for 7% of all the insurance business in force at Fireman’s Fund (with a few exceptions) for four years. This type of deal in the insurance world is called a quota-share contract. It means that Berkshire Hathaway’s losses and costs on insurance companies were proportionate to the Fireman’s Fund throughout the contract period.
In return, Fireman’s Fund sent premiums to National Indemnity more or less as they came in. Thus the premium funds generated by accepting 7% of the risks were held within BH. This money adds to its float, and can be invested.
At that time Fireman’s Fund was bringing in about $3bn a year (expected to rise over the years). Thus around 0.07 x $3,000m = $210 would flow to BH. Of course, as insurance claims arose money would flow the other way. But that would still have left a substantial float for Buffett to invest, given the often lengthy time delays between a policyholder paying a premium and claiming for an event.
In the Chairman’s letter to Berkshire Hathaway’s shareholders, 1985, Buffett laid out the initial sums:
“The company’s [Fireman’s Fund] September 1, 1985 unearned premium reserve was $1.324 billion, and it therefore transferred 7% of this, or $92.7 million, to us at initiation of the contract. We concurrently paid them $29.4 million representing the underwriting expenses that they had incurred on the transferred premium.”
So where does Wesco fit in?
While all the Fireman’s Fund insurance was written by National Indemnity, two-sevenths of it was passed along to Wesco-Financial Insurance Company (“Wes-FIC”), a newly created subsidiary.
While the agreement with Fireman’s Fund to take premiums into Wesco came to an end in August 1989 the benefit to Wesco continued. Tens of millions of dollars were left in Wes-FIC as a float to cover future claims for the premium paid in the 1985-89 period. Even as late as 1997 $27.5m was retained in Wes-FIC as a reserve.
Charlie Munger knew very well the benefit of the money being held in reserve. As he said in his 1997 letter to Wesco shareholders: “ it will take a long time before all claims are settled, and, meanwhile, Wes-FIC is being helped over many years by proceeds from investing “float.”
Wes-FIC continued to take other reinsurance business, including……….To read the rest of this article, and more like it, subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
