BUFFETT’S LETTERS 2001

[The September 11 attacks were a series of four coordinated terrorist attacks by the Islamic terrorist group al-Qaeda against the United States on the morning of Tuesday, September 11, 2001]

Though our corporate performance last year was satisfactory, my performance was anything but.

“I cannot promise results to partners.” But Charlie and I can promise that your economic result from Berkshire will parallel ours during the period of your ownership: We will not take cash compensation, restricted stock or option grants that would make our results superior to yours.

many of these people were urging investors to buy shares while concurrently dumping their own, sometimes using methods that hid their actions. To their shame, these business leaders view shareholders as patsies, not partners.

Though Enron has become the symbol for shareholder abuse, there is no shortage of egregious conduct elsewhere in corporate America. One story I’ve heard illustrates the all-too-common attitude of managers toward owners: A gorgeous woman slinks up to a CEO at a party and through moist lips purrs, “I’ll do anything ‘anything’  you want. Just tell me what you would like.” With no hesitation, he replies, “Reprice my options.

Some years back, a good $10 million idea could do wonders for us (witness our investment in Washington Post in 1973 or GEICO in 1976). Today, the combination of ten such ideas and a triple in the value of each would increase the net worth of Berkshire by only ¼ of 1%. We need “elephants” to make significant gains now ¾ and they are hard to find.

Robert P. Miles: The Warren Buffett CEO. The ability, energy and loyalty of these managers is simply extraordinary.

MiTek is the world’s leading producer of this thing I’d received, a “connector plate,” which is used in making roofing trusses. [isn’t it commodity business?]

we arranged for 55 members of the MiTek team to buy 10% of the company, with each putting up a minimum of $100,000 in cash. Many borrowed money so they could participate.

Throughout much of the 11th, Lew went through a particularly wrenching experience: First, he had a son-in-law working in the World Trade Center who couldn’t be located; and second, he knew we had the option of backing away from our purchase. The story ended happily: Lew’s son-in-law escaped serious harm, and Berkshire completed the transaction.

Trailer leasing is a cyclical business but one in which we should earn decent returns over time.

But the business eventually hit the skids and never recovered, and that resulted in our purchasing Acme’s remnants.

In the frontispiece to Security Analysis, Ben Graham and Dave Dodd quoted Horace: “Many shall be restored that now are fallen and many shall fall that are now in honor.” Fifty-two years after I first read those lines, my appreciation for what they say about business and investments continues to grow.

Bill Child, R.C. Willey’s chairman

more than $ 300 million of business (up, it should be noted, from $ 250,000 when Bill took over 48 years ago).

when I pontificate about retailing, Berkshire people just say, “What does Bill think?”

understand how to evaluate an insurance company. The key determinants are: (1) the amount of float that the business generates; (2) its cost; and (3) most critical of all, the long-term outlook for both of these factors.

we have calculated our float –which we generate in large amounts relative to our premium volume –by adding net loss reserves, loss adjustment reserves, funds held under reinsurance assumed and unearned premium reserves, and then subtracting insurance-related receivables, prepaid acquisition costs, prepaid taxes and deferred charges applicable to assumed reinsurance. (Got that?)

Last year I told you that, barring a mega-catastrophe, our cost of float would probably drop from its 2000 level of 6%. I had in mind natural catastrophes when I said that, but instead we were hit by a man-made catastrophe on September 11th —an event that delivered the insurance industry its largest loss in history. Our float cost therefore came in at a staggering 12.8%. It was our worst year in float cost since 1984,

When property/ casualty companies are judged by their cost of float, very few stack up as satisfactory businesses. And interestingly —unlike the situation prevailing in many other industries —neither size nor brand name determines an insurer’s profitability. Indeed, many of the biggest and best-known companies regularly deliver mediocre results. What counts in this business is underwriting discipline. The winners are those that unfailingly stick to three key principles:

1. They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.

2. They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.

3. They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.

In short, all of us in the industry made a fundamental underwriting mistake by focusing on experience, rather than exposure, thereby assuming a huge terrorism risk for which we received no premium.

Experience, of course, is a highly useful starting point in underwriting most coverages. …At certain times, however, using experience as a guide to pricing is not only useless, but actually dangerous.

Late in a bull market, for example, large losses from directors and officers liability insurance (“ D& O”) are likely to be relatively rare. When stocks are rising, there are a scarcity of targets to sue, and both questionable accounting and management chicanery often go undetected. At that juncture, experience on high-limit D& O may look great.

When stocks fall, these sins surface, hammering investors with losses that can run into the hundreds of billions.

The probability of such mind-boggling disasters, though likely very low at present, is not zero.

Fear may recede with time, but the danger won’t —the war against terrorism can never be won. The best the nation can achieve is a long succession of stalemates.

Until now, insurers and reinsurers have blithely assumed the financial consequences from the incalculable risks I have described.

Why, you might ask, didn’t I recognize the above facts before September 11th? The answer, sadly, is that I did —but I didn’t convert thought into action. I violated the Noah rule: Predicting rain doesn’t count; building arks does.

But we stumbled in a big way in 2001, largely because of underwriting losses at General Re. In the past I have assured you that General Re was underwriting with discipline —and I have been proven wrong. Though its managers’ intentions were good, the company broke each of the three underwriting rules I set forth in the last section and has paid a huge price for doing so. One obvious cause for its failure is that it did not reserve correctly —more about this in the next section —and therefore severely miscalculated the cost of the product it was selling. Not knowing your costs will cause problems in any business. In long-tail reinsurance, where years of unawareness will promote and prolong severe underpricing, ignorance of true costs is dynamite.

If “winning,” however, is equated with market share rather than profits, trouble awaits. “No” must be an important part of any underwriter’s vocabulary.

Jack Welch’s terrific book, Jack, Straight from the Gut (get a copy!).

[Ajit Jain]His extraordinary discipline, of course, does not eliminate losses; it does, however, prevent foolish losses. And that’s the key: Just as is the case in investing, insurers produce outstanding long-term results primarily by avoiding dumb decisions, rather than by making brilliant ones.

Loss reserves at an insurer are not funds tucked away for a rainy day, but rather a liability account.

It’s clearly difficult for an insurer to put a figure on the ultimate cost of all such reported and unreported events. But the ability to do so with reasonable accuracy is vital. Otherwise the insurer’s managers won’t know what its actual loss costs are and how these compare to the premiums being charged. GEICO got into huge trouble in the early 1970s because for several years it severely underreserved, and therefore believed its product (insurance protection) was costing considerably less than was truly the case. Consequently, the company sailed blissfully along, underpricing its product and selling more and more policies at ever-larger losses.

“Loss development” suggests to investors that some natural, uncontrollable event has occurred in the current year, and “reserve strengthening” implies that adequate amounts have been further buttressed. The truth, however, is that management made an error in estimation that in turn produced an error in the earnings previously reported.

Underreserving, it should be noted, is a common —and serious —problem throughout the property/ casualty insurance industry.

Major underreserving is common in cases of companies struggling for survival. In effect, insurance accounting is a self-graded exam, in that the insurer gives some figures to its auditing firm and generally doesn’t get an argument.

Even when companies have the best of intentions, it’s not easy to reserve properly.

Sometimes the problems they signify lie dormant for decades, as was the case with asbestos liability, before virulently manifesting themselves.

Discounting would exacerbate this already-serious situation and, additionally, would provide a new tool for the companies that are inclined to fudge.

I’ve made three decisions relating to Dexter that have hurt you in a major way: (1) buying it in the first place; (2) paying for it with stock and (3) procrastinating when the need for changes in its operations was obvious.

December 10th Fortune article.

The Great Bubble ended on March 10, 2000 (though we didn’t realize that fact until some months later). On that day, the NASDAQ (recently 1,731) hit its all-time high of 5,132. That same day, Berkshire shares traded at $ 40,800, their lowest price since mid-1997.

Despite these dangers, we periodically find a few —a very few —junk securities that are interesting to us. And, so far, our 50-year experience in distressed debt has proven rewarding. In our 1984 annual report, we described our purchases of Washington Public Power System bonds when that issuer fell into disrepute. We’ve also, over the years, stepped into other apparent calamities such as Chrysler Financial, Texaco and RJR Nabisco —all of which returned to grace. Still, if we stay active in junk bonds, you can expect us to have losses from time to time. Occasionally, a purchase of distressed bonds leads us into something bigger. Early in the Fruit of the Loom bankruptcy, we purchased the company’s public and bank debt at about 50% of face value. This was an unusual bankruptcy in that interest payments on senior debt were continued without interruption, which meant we earned about a 15% current return. Our holdings grew to 10% of Fruit’s senior debt, which will probably end up returning us about 70% of face value. Through this investment, we indirectly reduced our purchase price for the whole company by a small amount.

It’s déjà vu time again: