Berkshire reinsurance deals queried|
Agreements helped Gerling Global Re manipulate results
By Alistair Barr
April 26, 2005
SAN FRANCISCO (MarketWatch) -- Berkshire Hathaway, embroiled in widening investigations into so-called finite reinsurance, courted controversy surrounding the products at least a decade ago, according to reports by state regulators.
Finite transactions between some of Berkshire's (BRKA, BRKB) main insurance units and a top reinsurer helped that company distort its financial statements, according to a New York Insurance Department examination report written in September 1999.
The report was about Gerling Global Re, at one time the sixth-largest reinsurer in the world. Based in New York, but owned by the giant German firm Gerling, Gerling Global Re is no longer selling new policies after a string of heavy losses.
In 1994 and 1995, Berkshire units National Indemnity, National Fire and Marine, National Liability & Fire and Columbia Insurance entered into finite reinsurance agreements with Gerling Global Re that helped it distort underwriting results and artificially boost loss ratios, an important measure of underwriting profitability, the New York Insurance Department said.
The report said Gerling Global Re was unable to demonstrate that the deals actually transferred risk, and added that the company should have accounted for them as loans.
Finite reinsurance is currently at the center of investigations by regulators including New York Attorney General Eliot Spitzer and the Securities and Exchange Commission. They're concerned that companies such as insurance giant American International Group have used the products to manipulate their financial statements.
The probes precipitated the departure of longtime AIG CEO Maurice "Hank" Greenberg earlier this year and forced the insurer to admit to a series of accounting improprieties that could wipe $1.77 billion off its net worth.
AIG said a finite reinsurance agreement with General Re, another unit of Berkshire, in late 2000 and early 2001, was accounted for incorrectly and artificially bolstered its loss reserves.
Buffett was interviewed by regulators on April 11, but isn't a target of the investigations.
The Department of Justice is also investigating finite reinsurance that General Re sold to Reciprocal of America, a failed liability insurer.
Australian regulators are probing similar products sold by General Re that may have contributed to the collapse of HIH, a big insurance company in that country.
Buffett's involvement in these probes - even just as a witness - has led some to question his reputation as an advocate of ethics in business.
It's also knocked shares of Berkshire: The company's Class A shares touched five-month lows last week.
"There's no way to know for sure what Mr. Buffett actually knew about these reinsurance agreements, but because Berkshire's been a dominant player in this market, he may know a great deal," Andy Barile, an independent reinsurance consultant in Rancho Santa Fe, Calif., said.
"All we do know from the New York Insurance Department report is that the regulators were not happy with the transactions," added Barile, who's read a copy of the document. "There was very little risk transfer."
A copy of the report is available on the regulator's Web site.
A message left at Berkshire's Omaha, Nebraska headquarters on Friday seeking comment wasn't returned.
Phone calls made to Gerling spokesman Christoph Groffy in Germany on Friday and Monday weren't picked up. An email sent to Groffy seeking comment on Friday wasn't returned.
James Davis, the New York insurance examiner who wrote the 1999 report on Gerling Global Re, wasn't available for comment.Finite definition
Reinsurance is purchased by insurance companies looking to spread the risk of policies they've sold. Finite reinsurance is a form of this coverage that blends reinsurance and financing.
While there is no clear definition of finite products, generally insurers buy them to protect themselves against the financial risk of future liabilities. They've been used legally for decades and are often purchased by insurers that are weakened by lots of claims.
Berkshire Hathaway, and its National Indemnity division run by Ajit Jain, excels in this business.
The main problem with the products occurs when little or no risk is transferred from the buyer to the seller. In those cases, the transaction must be accounted for as a loan, not reinsurance.
That's important because reinsurance gets much more favorable accounting treatment than loans.
If finite deals that transfer little risk are still accounted for as reinsurance, that can distort financial statements. In the case of General Re's deal with AIG, it artificially boosted AIG's reserves for losses and loss expenses by $250 million.
Berkshire deals with Gerling
During 1994 and 1995, National Fire and Marine, National Liability & Fire and Columbia Insurance entered into three so-called supercat reinsurance agreements with Gerling Global Re, the New York Insurance Department said.
Gerling Global Re "was unable to demonstrate a transfer of risk for the agreements," the report stated.
Those three Berkshire units were at the time affiliated with National Indemnity.
"Supercat" reinsurance is a form of finite reinsurance that covers risks from huge catastrophes like earthquakes and hurricanes, according to Barile.
One deal between National Fire and Marine and Gerling Global Re stated that a reinsurance payment would only be triggered if insured market losses from a California earthquake occurring between April 1, 1994 and the end of 1995 exceeded $10 billion.
Another between National Liability & Fire and Gerling Global Re said payment would occur if insured market losses from windstorms in Florida, Georgia, North and South Carolina between April 1, 1994 and the end of 1995 topped $7 billion.
A third between Columbia Insurance and Gerling Global Re stated that payment would be triggered if Texas windstorm losses in the market exceeded $5 billion during the same period.
The New York Insurance Department said Gerling Global Re was unable to show evidence of any catastrophe losses in the U.S. in the previous 25 years that breached those limits.
"This report shows what can really go on in this industry," Barile said. "The trigger mechanisms for these policies were so high that no real risk was transferred."
National Indemnity and Gerling Global Re also struck another type of finite reinsurance deal on Dec. 15, 1994, the New York Insurance Department said.
The agreement covered losses occurring after Dec. 31, 1994, however, Gerling Global Re accounted for the transaction as reinsurance in its 1994 annual statement.
"It appears the accounting treatment... was incorrect and had the effect of distorting the financial statement," the report said.
The deal was also unwound on June 30, 1996, a short time after it took effect. That led the New York Insurance Department to "question whether or not such contract actually was for the purpose of transferring risk."
Gerling Global Re also forged two other finite reinsurance agreements with a New York unit of Centre Re, a Bermuda-based pioneer of the products which is now called Centre Solutions. The regulator questioned transactions too.
By accounting for these deals incorrectly Gerling Global Re distorted its results, preventing the New York Insurance Department from properly assessing the company's financial health.
According to the report, in 1994, Gerling Global Re reported an underwriting loss of $14.5 million, when its true loss was $50.7 million.
In 1995, the firm reported an underwriting loss of $14.4 million, when it actually lost $55.2 million, the report said.
It's not clear whether Buffett knew about the transactions with Gerling Global Re, or whether the Berkshire units involved knew Gerling Global Re would account for them incorrectly.
Late last month, the Berkshire chairman tried to distance himself from the finite reinsurance investigations by saying that he speaks infrequently with managers of Berkshire's main subsidiaries and leaves operating decisions to them.
However, Buffett did say that Ajit Jain, the head of National Indemnity, was an exception. In annual letters to shareholders, Buffett has described a close relationship with Jain.
At the time of the Gerling Global Re transactions, Jain was an executive vice president at National Indemnity, while Buffett was chairman of the board, according to reports by the Nebraska Department of Insurance.
The paths of Buffett and Gerling Global Re may also have crossed more recently.
In his 2002 letter to Berkshire shareholders, Buffett said one of the world's largest reinsurers had "all but ceased" paying valid claims.
While he didn't mention the company's name, many experts at the time said he was referring to Gerling Global Re.
A report issued by Fox-Pitt, Kelton analyst William Yankus said that Geico, an auto insurance unit of Berkshire, was owed an estimated $47 million by Gerling Global Re.
Later on in his 2002 letter, Buffett said Geico was owed more than $90 million by "deadbeat reinsurers."
The comments sparked controversy across the reinsurance industry and prompted Gerling to issue statements saying it was still paying claims.
National Indemnity's own accounting for finite reinsurance was questioned by its state regulator -- the Nebraska Department of Insurance - in a 1993 report.
The report, which covered a period ending Dec. 31, 1991, recommended that future finite reinsurance assumed by National Indemnity "which lacks significant insurance risk transfer" should be accounted for as a loan, rather than reinsurance.
The report listed 9 multi-million dollar finite agreements that National Indemnity forged in 1990 and 1991 with companies including American Re, SAIF Corporation and Employers Insurance of Wausau.
At the time those deals were done, they met reinsurance accounting rules laid out by the National Association of Insurance Commissioners, which oversees all state regulators, the report said.
However, the NAIC introduced new rules in the early 1990's requiring companies to account for finite reinsurance as loans if there wasn't enough risk transfer. While different states adopted them at different times, the regulations officially took effect across the U.S. on Jan. 1, 1995.
If National Indemnity had arranged the 9 transactions when the NAIC rules were in effect, at least some of them would have had to be accounted for differently, the Nebraska Department of Insurance said.
In a Feb. 4, 1994 letter to the Nebraska regulator, National Indemnity Treasurer Robert O'Connell agreed to follow its recommendations.
The Nebraska report isn't clear whether all the insurers on the other side of these National Indemnity deals accounted for them correctly.
The Wisconsin insurance regulator didn't "disapprove" of the two finite deals between National Indemnity and Wausau, a property and casualty insurer based in that state, the Nebraska report said.
However, the Wisconsin regulator didn't allow Wausau to account for the deal as reinsurance. That prevented the company from recording an increase in its surplus from the transactions, the Nebraska report added.
Surplus is an important measure of an insurer's financial strength. A low surplus often limits how much new business a company can take on.
Wausau, which struggled under the weight of asbestos claims from the 1980's, was acquired by Liberty Mutual in 1999.
Oregon's insurance regulator made SAIF, a workers' compensation insurer in that state, account for its finite transaction with National Indemnity as a loan, rather than reinsurance, the Nebraska report added.
In a later report by the Nebraska Department of Insurance - covering 1992 to 1994 - National Indemnity confirmed that it had been following the regulator's guidelines by accounting for finite reinsurance deals that lacked risk transfer as loans.
National Indemnity listed 8 finite deals that didn't transfer enough risk to be accounted for as reinsurance. The transactions were with firms including Gerling Global, Fortress Re and Nissan Fire and Marine and were worth more than $121 million, according to the Nebraska report.
Fortress Re, a closely held company specializing in reinsurance covering aviation risk, collapsed after the Sept. 11, 2001 terrorist attacks.
Fortress managed the reinsurance business for Japanese insurers including Nissan Fire and Marine and Aioi Insurance.
The Japanese companies claimed the tragedy uncovered years of deception by Fortress Re.
The insurers claimed that the way Fortress Re accounted for financial reinsurance it had purchase helped the firm conceal billions of dollars in losses.
Last year, an arbitration panel in New York ordered Fortress Re to pay $1.12 billion in damages to the Japanese companies, one of the biggest arbitration awards ever.