Warren Buffett (Trades, Portfolio) could be facing one of the biggest threats to Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) in its history.
Berkshire is one of the world's largest insurance businesses. This has been an enormous advantage for the company over the past few decades. Berkshire has been able to take on risks other insurers cannot, and this has helped it win business. Other companies have also flocked to the ground for coverage, as it's the only insurance company that has so much capital.
With more than $120 billion of cash on its balance sheet at the end of 2019, Berkshire had the financial capacity to withstand significant losses. Or, to put it another way, Berkshire had enough capital to withstand significant foreseeable losses. However, the Covid-19 pandemic has thrown the financial position of the whole insurance industry into doubt.
Insurance lawsuits
The industry's problems revolve around business interruption insurance. Most of these policies are sold, guaranteeing a business's income if its premises are damaged. The exact wording and exclusions will vary from contract to contract.
However, most insurers specifically excluded pandemics or infectious diseases from policies—the reason why is simple. The insurance industry pools risk, spreading risk across numerous policies. This works because the chances of every policyholder registering a claim at once are low. That's not the case in a pandemic. In a pandemic, as we've seen over the past few weeks, almost every business suffers.
Lawmakers and policyholders are not satisfied with this. They believe the insurance industry should pay. To that end, parties are suing insurance businesses, and some states have introduced legislation to change insurance policies retroactively.
For example, in New Jersey, lawmakers are trying to push a bill through that would require insurers to pay out to businesses with fewer than 100 employees. If these efforts succeed, they will not only undermine the entire principal of the insurance industry, but they will also threaten the solvency of the sector.
Huge cost
The ultimate cost of such changes would be huge. According to David Sampson, chief executive of the American Property Casualty Insurance Association, the cost to cover small businesses with 100 or fewer employees across the U.S. would run to $110 billion to $290 billion a month. If the threshold is raised to 500 employees, the cost would be $900 billion a month. The insurance industry, as a whole, only holds $800 billion in surplus capital.
It is challenging to quantify Berkshire's direct exposure to this threat, but if lawsuits do succeed, then it is clear that the business might have to make some substantial payouts. Its reinsurance exposure could also hurt the company.
On top of this, Buffett's equity portfolio would undoubtedly take a battering. Insurance companies are some of the largest equity owners in the world. If these businesses are forced to pay out hundreds of billions of dollars every month to other companies, they'll have to eat into reserves and sell stock to cover payouts.
The insurance industry has been here before. From Hurricane Sandy to 9/11, the industry has warned that it's survival is under threat. In every case, it has managed to negotiate a favorable outcome. It is highly likely that the industry will find a way around this threat as well.
Nevertheless, its something to consider when considering an investment in Berkshire or its peers right now. Insurance can be a highly profitable business, but as the Oracle of Omaha has made it clear many times before, you can also lose a lot of money very quickly if you don't get it right.
Berkshire has been on the right side of this line most of the time, but there's no guarantee the business will always make money from insurance, especially if laws change.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- How to Identify Good Businesses, According to Warren Buffett
- 3 Deep-Value Stocks for the Bear Market
- Lessons on Investing From Warren Buffett's 1962 Partnership Letter
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