Andrew Main | November 10, 2008 THE nearest you can get to committing lese majeste in the financial world is to question the actions of Warren Buffett, the Oracle of Omaha.
But his new biography omits an important episode that involves Australia and has still not been resolved
The Snowball, by investment analyst Alice Schroeder, is a doorstopping 837 pages but it doesn't cover the time in 2005 when Buffett fronted the press at his annual Omaha love-in carrying one document: a copy of a reinsurance policy issued in 1998 by Berkshire Hathaway subsidiary National Indemnity to FAI Insurance of Sydney.
You don't need all the background but in summary, Rodney Adler's FAI Insurance had such big holes in its reserves in mid-1998 that it had to rent the balance sheet of Berkshire's reinsurance arm, using some very imaginative engineering called financial reinsurance to paper over the cracks.
FAI took out two such policies to make its annual result move up from a $50 million loss to an $8.6 million pre-tax profit. The result was good enough for HIH Insurance to buy the company for almost $300 million, sight unseen.
The provider of one of the two policies, National Indemnity, didn't approach FAI -- that was done by FAI execs through intermediary broker Guy Carpenter.
This is where we get to the "say it ain't so, Superman" moment.
The document Buffett was carrying, issued by National Indemnity chief and reinsurance whiz Ajit Jain, involved a specific artifice to make it look as though the reinsurer was taking more risk than it was. So concluded the HIH Royal Commission in 2003.
The contract included the clause that the reinsurer would pay out more money if Australia had an earthquake with a damage bill of $5 billion or more in any one year.
Two points: one is that the worst-ever earthquake in Australia, in Newcastle in the late 1980s, cost only $1.7 billion. The other is that the risk of such a payout was between 2.2 and 3 per cent when the minimum risk it would need to take, to qualify as real reinsurance, was 10 per cent.
Unfortunately, no reporter put Buffett through serious hoops that day, even though he provided what can only be described as an unimpressive defence of the deal.
"I knew about the contract, yes," he said after the meeting. He had not looked at the contract but had looked at FAI and decided there was nothing unusual about the company.
He said there were 100 or 200 contracts a year and "contracts are not getting mailed to Omaha".
He read out a bit of the contract that demanded it be shown to insurance regulators and that if they disapproved of it, the contract would be considered null and void. It was never shown to the regulators.
Sorry, Warren, that's not a proper explanation. It's down there with dogs and homework.
There's no suggestion he was party to the dodgy earthquake clause to make the contract look more realistic, but he missed an opportunity to say his company had done the wrong thing and wouldn't do it again.
Instead, he tiptoed around the issue on which he had clearly been well briefed, explaining all the things the contract didn't do wrong. National Indemnity had not backdated the contract as it had been asked to do (another surefire way to make it look as though the insurer was taking more risk than it actually was) and there was no "side letter", a feature of many such financial reinsurance policies.
Side letters were and are a device whereby a reinsurer can offer all sorts of generous-looking cover to a cash-strapped insurer, according to documents shown to the latter's auditors.
The side letter is signed by the buyer and says in fact there won't actually be a claim at all. That sits in someone's bottom drawer and is never shown to the auditors because its real effect is to convert an insurance policy into a disguised loan. Just because the National Indemnity contract didn't do half a dozen bad things doesn't mean it wasn't a bad contract, and Buffett never got around to admitting that.
He had a problem in that it was Jain who thought of the earthquake clause, and Jain is one of his possible successors when he eventually retires. "There's nobody at Berkshire I would have more confidence in than Ajit," he told reporters, reprising a comment he'd previously made to investors in one of his very readable annual statements, that if they met Jain they should bow deeply, as Jain's reinsurance operation made more money for Berkshire than any other part of the business.
That 2005 episode in Omaha is old now, but it happened and Buffett's performance came up short. It's not go-to-jail stuff, or even close, but it was wrong. The contract was a stinkeroo. In 2004, National Indemnity paid FAI liquidator Tony McGrath $55 million, the amount it had received in premiums, thus closing off any further legal argument. But it's worth knowing about.
Andrew Main published Other People's Money in 2003, about the HIH collapse.
