Why Warren Buffett Sold Munich Re

The company doesn't meet at least one of his requirements for investing

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Oct 06, 2015
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Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), itself a dealer of reinsurance, reduced its shareholding of Munich Re (XTER:MUV2, Financial), the largest reinsurer in the world, last week after commenting that he and his associates saw trouble ahead for the industry. The sell represents a large shift of focus for an investor for whom insurance is a forte.

Buffett cut back the stake from around 12% to 9.7% of the company, below the 10% threshold for voting rights, on Sept. 28, the company announced. Formerly, he was the company’s largest private shareholder and owned the third largest percentage of capital. Munich Re was also Buffett’s largest international holding, above Sanofi (XPAR:SAN, Financial) and Tesco (LSE:TSCO, Financial), which he sold out last year.

“What was a very lucrative business is no longer a very lucrative business going forward,”Ajit Jain, who oversees Berkshire's reinsurance businesses, told the Wall Street Journal in July. “… Since the reinsurance business isn’t going to offer as many opportunities for the foreseeable future, we feel like we should go down the food chain.”

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This idea matches what Buffett has said previously – that when purchasing investments he thinks about not only the quality and price of the current business but the state of its business five or 10 years into the future. At one time, those prospects for the reinsurance industry looked good to him.

Buffett began showing greater interest in reinsurance when he merged Berkshire and the largest U.S. property-casualty reinsurer, General Re Corp., in June 1998 for $22 billion.

“... We believe that Berkshire’s ownership will benefit General Re in important ways and that its earnings a decade from now will materially exceed those that would have been attainable absent the merger,” he said at the time.

For reinsurance Buffett was primarily looking to international markets, “where the preponderance of industry growth will almost certainly occur,” he said in his 1998 shareholder letter. He also outlined the key points for evaluating an insurance company, which were the amount of float the company generated, its cost and, “most important of all, the long-term outlook for both of these factors.”

But the once-bright outlook for reinsurance has begun to gray. The $540 billion global reinsurance industry reached record capitalization in 2014, according to the Treasury, which has put pressure on premium rates. Catastrophe reinsurance global renewal premiums fell 11% year over year as of January 2014, and U.S. catastrophe reinsurance premiums declined 15%, with the trend continuing in April, June and July of that year. The trend is likely continue, the report said:

“In addition to a period of below-average catastrophe losses,136 market capacity expansion, including the increased importance of alternative reinsurance options (addressed below in section VI.C) and accompanying competition for deployment of reinsurance capital partially explain this trend of decreasing reinsurance premiums.137 Analysts have suggested that some industry consolidation might occur due to the sector’s current competitive climate.138 Over the course of 2014, all of the major rating agencies announced negative outlooks for the reinsurance industry.139”

Fellow value investors Third Avenue Management (Trades, Portfolio) echoed those sentiments, announcing in its third quarter letter this year that it exited its long-held position in Munich Re, which it purchased prior to the financial crisis of 2008:

“As a well-capitalized historically prudent underwriter and manager of its enormous investment portfolio, the company survived the Global Financial Crisis as well as the subsequent European Sovereign Crisis relatively unscathed. With those experiences behind us, a long stretch of low levels of catastrophe-related losses in the industry has led to an oversupply of capital in the industry. Meanwhile capital continues to flood into the industry from financial investors and reinsurance pricing remains under pressure. Low pricing means low returns for the assumption of certain risks. In total we realized an IRR of 5.5% beginning in early 2008. We would like to return to quality companies in the insurance industry when some of the excess capital has been cleared out, premiums reflect a 'harder' market and prices of equities are available at cheaper prices.”

Munich Re described the circumstances in which it found its business in its first-half 2015 financial letter:

“In property-casualty reinsurance, we are currently experiencing unrelenting competition. Given their good capitalisation, primary insurers are ceding fewer risks to reinsurance, which tends to result in falling demand for cover. At the same time, reinsurers are able to provide ample capacity, since their capital base has also steadily improved thanks to the good results posted over the last few years. There is also the ongoing availability of alternative capital in the US market: institutional investors, such as pension funds, increasingly favour insurance securitisation and other forms of reinsurance-like transactions. This means there is currently appreciable surplus capacity on the supply side. The prices, terms and conditions for reinsurance cover are therefore under pressure across the board, albeit with decreasing intensity.”

Munich Re estimated in an investor presentation that $50 billion in alternative capital was available in 2013, the highest in five years, compared to $22 billion in 2009, driven by “scarcity of investment opportunities in a low-interest rate environment.”

Though lack of disasters in the past several years has led to a surplus of capital, the industry may see increased catastrophes due to climate change in upcoming years. In his 2015 half-year letter to shareholder, Munich Re CEO Dr. Nikolaus von Bomhard discussed in detail the need for increased insurance against the negative results of climate change, calling it “a compelling idea whose time appears to finally have come.” Bomhard also cited a G7 summit in Germanyin which leaders estimated an addition 400 million people would need related insurance.

From 2005 through 2012, severe weather and climate-related events represented 85% to 90% of natural hazards leading to insurance claims globally, Munich Re said in 2012. 2011 saw a record $380 billion of economic losses from natural disasters, surpassing the previous record of $220 billion set in 2005. In 2012 Munich Re presented a case for a continuing trend of such disasters that started around the 1980s.

Swiss Re AG (XSWX:SREN), the second largest reinsurance company in the world, said in its 2014 financial report it still expected the trend to continue, though the effects did not readily appear in its recent premium reports yet:

“While the effect of climate change will increase over the coming decades, most of our business is renewed annually and our risk models are refined every few years. Risks are essentially covered for 12 months, for cat bonds up to five years. Thus, reinsurance premiums do not reflect expected loss trends over the next decades,” the report said.

Reinsurance has dampened for Berkshire’s owned businesses as well, although the impact on the behemoth may be slight. Berkshire reported a $411 million underwriting loss at its Berkshire Hathaway Reinsurance Group for the second quarter of 2015 versus a $9 million loss the same quarter last year. General Re saw a gain of $107 million, up from $116 million the corresponding period a year ago.

At General Re, property and casualty premiums declined 22% to $361 million, while premiums earned decreased 12% from 2014. Berkshire Hathaway Reinsurance Group saw property and casualty premiums written fall 40% compared to 2014, and pre-tax underwriting losses were $137 million in the second quarter of 2015.

“Insurance industry capacity remains high and price competition in most property/casualty reinsurance markets persists. We continue to decline business when we believe prices are inadequate. However, we remain prepared to write more business when more appropriate prices can be attained relative to the risks assumed,” Berkshire Hathaway said in its quarterly report.

Reinsurance generated revenue of $3.47 billion for Berkshire in the second quarter, accounting for about 30% of its total insurance revenue and 6.8% of its total revenue of $51.4 billion.

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Financial services stocks also represent about 44% of Berkshire’s U.S. investment portfolio with nine total holdings, only one of which is an insurance company. Berkshire owns 6,353,727 shares of Torchmark Corp. (TMK), a life insurance company, representing 5.1% of its shares outstanding and only 0.3% of Buffett’s portfolio.

Other international gurus followed by GuruFocus did not pull out of Munich Re in the second quarter, with Tweedy Browne (Trades, Portfolio) holding 699,000 shares and Bernard Horn (Trades, Portfolio) retaining 14,900 shares.

The company had five-year average annual revenue growth of 1.2%, EBITDA growth of 8.3% and book value growth of 8.3%. With a P/E ratio of 9.45, it has a P/B ratio near a three-year low at 0.79 and P/S ratio near a one-year low at 0.49.

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Munich Re shares have declined 0.4% since Buffett disclosed his reduction a week ago. They are up 63% over the past five years, closing at $167.60 per share Tuesday. Swiss Re shares also gained 2.4% in the past week and 100% over the past five years. The S&P 500 Insurance Industry lost 3.65% year to date and gained 66.7% in the past five years.

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Buffett started a Munich Re position in January 2010, when shares were about $108 per share, giving him an approximate 57% gain on the holding as of Tuesday.

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