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October 18, 2005

Finances are not the main concern in a natural disaster, but if you are considering investing in an insurance company, you'll want to know whether it will survive a mega-catastrophe (i.e., huge disaster). For example: 21st Century Insurance used to underwrite homeowners' policies, and the 1994 Northridge earthquake nearly drove the company into bankruptcy. This quake had a magnitude of 6.7, and far more powerful earthquakes can occur in California.

Basically, there are two ways to reduce this risk:

1) Invest in an insurance company you trust, or 2) Invest in an insurance company that is not particularly susceptible to mega-catastrophes.

For example: title insurance companies should be safe, while reinsurers and homeowners' insurance companies are particularly at risk. (note: many companies that sell title insurance also sell homeowners' insurance)

For me, Berkshire Hathaway is an example of item #1. Warren Buffett says that Berkshire Hathaway will survive a mega-catastrophe, and I fully trust Warren Buffett. Here's what he said about mega-catastrophes in his 2004 letter to shareholders: "Were a true mega-catastrophe to occur in the next decade or two - and that's a real possibility - some reinsurers would not survive. The largest insured loss to date is the World Trade Center disaster, which cost the insurance industry an estimated $35 billion. Hurricane Andrew cost insurers about $15.5 billion in 1992 (though that loss would be far higher in today's dollars). Both events rocked the insurance and reinsurance world. But a $100 billion event, or even a larger catastrophe, remains a possibility if either a particularly severe earthquake or hurricane hits just the wrong place....

"Many insurers regard a $100 billion industry loss as "unthinkable" and won't even plan for it. But at Berkshire, we are fully prepared. Our share of the loss would probably be 3% to 5%, and earnings from our investments and other businesses would comfortably exceed that cost. When "the day after" arrives, Berkshire's checks will clear."

Montpelier Re (NYSE: MRH) is an insurer that is unprepared for huge losses. In September, they announced that they expect to lose $450-$675 million from Hurricane Katrina, based on estimates that the hurricane will cost insurers $30 to $40 billion. The company's shareholder's equity is only $1.46 billion, meaning that Katrina may wipe out more than a third of Montpelier's net worth. If one year's hurricane season costs insurers $100 billion dollars, Montpelier might be driven out of business. Clearly, Montpelier Re is a far risker investment than Berkshire Hathaway.

After September 11, terrorism was excluded from most of Berkshire's insurance policies. Most other reinsurers have done the same thing, but Buffett has gone a step further. Berkshire no longer covers fires caused by terrorist acts. As a result, they have lost business. The company is sacrificing this income to ensure that it will remain solvent in the event of a mega-catastrophe.

If you are going to invest in a reinsurer, it should be one that you trust. That's why Berkshire Hathaway is the only reinsurance company I will invest in.