Berkshire Hathaway, the Warren Buffett-controlled US conglomerate with enormous re/insurance investments, has concluded yet another deal that gives it even greater involvement in the Lloyd's of London insurance market.
The $212m deal with Trenwick Managing Agents, agreed in mid-September, means that Berkshire could now be the largest capital provider to the Lloyd's market in 2002.
The deal, Berkshire's fifth in Lloyd's this year, suggests that Mr Buffett, one of the world's most respected investors, has a certain level of confidence in not only the outlook for the insurance sector but also the future of Lloyd's, as the market drives through the reforms initiated by outgoing chairman Sax Riley. However, a closer look at Berkshire's arrangements reveals that it is not overly enthusiastic about Lloyd's and that its commitments to the market almost pale into insignificance when compared to its overall size.
Lure of Lloyd's
In the aftermath of September 11, the prospect of significant rate increases in Lloyd's traditional lines of business attracted millions of dollars of extra capacity to the market. The money mainly came from re/insurers, old and new, that were trying to take advantage of what may prove to be the most profitable underwriting environment in living memory. Berkshire is no exception, but it has focused strongly on a short- to medium-term reinsurance strategy that has, to a large extent, avoided the rigmarole of a direct investment in Lloyd's. That strategy is quota shares.
A quota share is a type of proportional reinsurance where the reinsurer accepts a fixed percentage of every risk written by the ceding company. However, in exchange for that risk, the reinsurer is paid a proportion of the original premium which is the same as the proportion of the risk it assumes. Where these deals are arranged at Lloyd's, they are called qualifying quota shares (QQSs) because they have to meet certain criteria that are specific to Lloyd's.
Generally, quota shares are 12-month agreements. This means that where Berkshire has provided capacity to a syndicate, it can review its arrangements on an annual basis and withdraw that capacity relatively quickly if it is not happy about the state of the underwriting environment.
The hard market is generally expected to last at least until the beginning of 2004. Most of Berkshire's QQSs have been negotiated since July 2002 and some analysts expect them to run until the end of 2003.
"At the end of 2003, they're quite within their rights to say, `No, we're no longer providing that capacity'," said David Wharrier, director of insurance at Fitch Ratings in the UK. "They've got the balance sheet - they can do that sort of thing. They can move in and out quite quickly and take advantage of what people are saying is an excellent 2002, and likely to be a good 2003, without having to go through all the legal ramifications of buying into the market or buying an entity and managing it - they're simply using their capital to get the best short-term returns."
Mr Wharrier added that quota shares were an effective short-term solution for companies or Lloyd's syndicates that needed additional capital quickly to take advantage of rising rates - particularly where the company or syndicate involved was struggling to attract investment. For example, UK-based insurer Royal & SunAlliance, which has been trying to raise capital since 2001, revealed a one-year, 10% quota share with Munich Re when it reported its results for the first quarter of 2002.
However, another analyst, who asked not to be named, took a slightly more cynical view of Berkshire's dealings at Lloyd's. He speculated that Berkshire's QQSs had been written retroactively to
1 January 2002 and that Berkshire would capitalise fully on this year's high premiums and then withdraw from the market before any hint of a softening. This appears to be the case with the QQS that Berkshire's subsidiary, National Indemnity, agreed with Lloyd's operator Euclidian in early July. That deal was agreed for the 2002 year of account only.
"As I read it, in many cases they are receiving a year's worth of premium for substantially less than a year's worth of risk, so the economics are swayed very favourably towards them..." he said. "Generally speaking, Berkshire expects to earn very high returns on its capital in the reinsurance business, especially when it's providing capital to others to underwrite."
Backing the right horses
Berkshire is now involved with several different Lloyd's entities and its biggest concern will be whether or not it has backed the right operators.
Berkshire's involvement at Lloyd's is not exclusively through quota shares. When it acquired the US reinsurer General Re Corp, it inherited Faraday Underwriting Ltd (previously DP Mann), General Re's Lloyd's operations. General Re had acquired DP Mann's holding company in December 1998. Faraday's capacity stands at £400m ($620m) for 2002.
In late 2000, Berkshire bought Marlborough Underwriting Agency Ltd from UK insurer CGNU (now Aviva) as part of a reinsurance deal to end CGNU's involvement in the London insurance market. Marlborough's surviving syndicate, 1861, has a capacity of £205m ($310m) for 2002.
Then, in April this year, Berkshire agreed to provide listed Lloyd's insurer Wellington plc with the funds to establish a £150m ($232.5m) syndicate to write in parallel with its existing syndicate 2020. However, the Wellington deal also involved a 30% QQS for syndicate 2020. That provided £187.5m ($291m) in extra capacity, and took the company's total Lloyd's capacity to £963m ($1.5bn).
In addition, Berkshire writes part of Catlin Underwriting Agencies' quota share, alongside the agency's Bermuda company, CICL.
The beginning of July saw Berkshire sign up to a £50m ($77.5m) QQS for Lloyd's operator Euclidian's syndicate 1243, while on 9 July, a £15m ($23.3m) QQS was agreed for syndicate 2147, part of another quoted Lloyd's insurer, SVB.
In August, Heritage Underwriting Agency established syndicate 1200. Heritage said the new syndicate would have £33.7m ($52.2m) of capacity, "including qualifying quota share arrangements". Berkshire is believed to have some involvement here too.
And then came the Trenwick deal. Like Wellington, this involved a combination of additional funding and a QQS: Berkshire provided $93m for syndicate 839 as well as an extra QQS of $119m. This took the syndicate's 2002 capacity to $512m.
This means that the funds that Berkshire has tied up in the Lloyd's market stand at around $1.3bn, while the money it has committed to more short-term QQS arrangements is $560m or more.
Small additional risks
In doing the Wellington and Trenwick deals, Berkshire has upped its investment - its longer-term commitment - at Lloyd's by about $250m this year. However, this is less than half the value of its 2002 QQS arrangements. One could argue that in doing the QQS deals, Berkshire has still committed those funds to at least three years within the Lloyd's environment, because of Lloyd's three-year accounting rules. Theoretically, Berkshire will not be able to extricate itself from the business that is written in 2002 until the syndicate years are closed at the end of 2004.
But the analyst who preferred not to be named said that although Berkshire could be taking a three-year bet - because it had to wait for the reinsurance-to-close point - he suspected that Berkshire had indemnified itself against the failure to close.
"I don't know what special terms and conditions are in these quota shares. It's possible there might be indemnification for Berkshire against the failure to close.... It may be that the syndicate manager would be liable in that case," he said. "So, it's very possible they're carrying no tail risk past 31 December."
Cautious but smart capital
Berkshire is notorious for guarding its capital, assessing its risks carefully and avoiding unnecessary aggregation of risk. As a result, it has capital to take advantage of opportunities within the insurance sector at a time when other large operators are trying to recover underwriting losses, fighting downgrades, raising capital through rights offerings and/or rearranging their senior management structures.
The analyst said: "They're very prudent in their approach to risk and they tend to think that just because something might have a very low probability of happening, they don't care, they still won't do it if they can't live with the consequences - no matter how remote they are. Most insurers don't think that way."
Despite the extra QQS deals that Berkshire has done this year, its total commitment to Lloyd's in 2002 is still only around $2bn. At the end of 2001, the company's shareholder equity stood at $58bn. That means it has committed just over 3% of its shareholders' equity to Lloyd's - an amount that would make little difference to Berkshire if its Lloyd's investment was completely destroyed. The probability of that happening is not high.
Mr Wharrier from Fitch said: "Obviously it could go wrong if you back five or six Lloyd's syndicates and Lloyd's has a horrendous year - if there are ten catastrophes in the last two or three months, you've got some significant exposure. But the numbers involved for Berkshire are very small compared to their overall size. If they lost it all, it wouldn't hurt them. But it might make a very nice return for them. They've seen an opportunity and they've gone for it."