Why Berkshire’s cutting back on reinsurance

By Felix Salmon
July 13, 2009

Scott Patterson reports that Berkshire Hathaway wrote less than half the amount of reinsurance in 2008 as it did in 2006, and that 2009 will be substantially lower still. He relates this development to Berkshire’s credit rating, which was downgraded from triple-A by Moody’s in April:

In its credit opinion, Moody’s also cited the potential volatility of Berkshire’s “catastrophe-exposed business.” Berkshire is a major investor in Moody’s Corp., parent of the ratings group…

A higher book value and a rising cash stockpile could eventually lead to a reinstatement of Berkshire’s Aaa rating, though Moody’s isn’t likely to reverse itself soon.

If and when Berkshire wins back a higher rating, that could pave the way for the company to move aggressively back into the property catastrophe market.

It strikes me that the really important thing here isn’t Berkshire’s credit rating, so much as its CDS spreads. Reinsurers used to feel that they needed a triple-A rating because that connoted utter safety: you could reinsure your catastrophe risk with Berkshire safe in the knowledge that the risk of Berkshire being unable to meet its obligations was significantly lower than the risk of, say, a hurricane hitting New York.

Now that the value of a triple-A rating has plunged, however, in the wake of many formerly triple-A-rated securities defaulting over the past year or two, insurers are going to feel much more need to hedge their counterparty risk when it comes to their reinsurance contracts. As a result, the cost of reinsurance isn’t just the cost of the premiums any more: it’s the cost of the premiums plus the cost of buying credit protection on the reinsurer.

Conversely, from Berkshire’s point of view, every dollar that Berkshire reinsures is another dollar of demand for Berkshire credit protection, and the upward pressure on Berkshire’s CDS spreads will remain. And thanks to delta hedging and capital-structure arbitrage, sellers of Berkshire credit protection will ultimately end up depressing the Berkshire share price.

Berkshire’s shares are looking pretty cheap these days: at $85,000 apiece, they’re lower than they were five years ago. But five years ago, the idea that Berkshire’s insurance products would have to be discounted by its counterparty risk would have been unthinkable. Without its triple-A moat, Berkshire looks much less special than it did back then.

Update: My commenters are saying that insurers don’t hedge their counterparty risk to reinsurers. Either you trust a reinsurer or you don’t; if you do, you don’t hedge counterparty risk, and if you don’t, you don’t do any business with them at all. Maybe insurance regulators should be looking into this.

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