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Warren Buffett on Making Money in Credit Insurance

Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) insurance business is a fascinating beast. When you start exploring the ins and outs of the business and how it makes its money, it quickly becomes clear that there is much more to this division than just Geico and National Indemnity.

Berkshire's insurance operations stretch around the world, offering coverage for everything as long as the price is right. The group has even provided insurance for municipal bonds, which Warren Buffett (Trades, Portfolio) discussed at the 2010 Berkshire annual meeting of shareholders.


Berkshire and bond insurance

The Oracle of Omaha was originally responding to a question about the record $550 million fine the Securities and Exchange Commission hit Goldman Sachs (NYSE:GS) with after the Abacus case.

The regulator argued that Goldman had packaged up mortgages into Abacus and then sold the collateralized debt obligation to investors without telling them that one of its powerful clients, John Paulson's hedge fund, had been taking a trading position intended to profit from a fall in the value of U.S. house prices.

Buffett argued that it should not have been Goldman's responsibility to inform the buyers of the Abacus deal who was on the other side because it shouldn't have mattered.

"If they told me Ben Bernanke was on the other side of the trade, it wouldn't make any difference to me," he declared. "If I have to care about who's on the other side of the trade, I should not be insuring bonds. They could have told me Charlie [Munger] was on the other side of the trade."

In other words, Buffett believed the buyer was responsible for analyzing the investments they were purchasing, rather than the seller. In this case, they clearly didn't.

Berkshire, he went on to explain, is only happy to act as a bond insurer if it believes the price is right. As a result, when other credit insurers pulled out of the market in 2008-09, it was able to pick up a range of attractively priced deals:


"Berkshire Hathaway, when these other guys got into trouble, went into the municipal bond insurance business. And we insured things that were almost identical to what ACA or others had insured, the difference being that we thought we knew more about what we were doing. We got paid better than they got paid, and we stayed away from things we didn't understand.

...

We insured the bonds of the Nebraska -- of the Methodist Hospital, which is six or seven miles from here. We have told people that if the Nebraska Methodist Hospital does not pay its bonds, Berkshire Hathaway will pay them.

...

Now, a couple of years ago, somebody came to us, large investment bank, and they said, "Take a look at this portfolio."...And they said to us, "Will you insure these states, that these bonds of these states, will pay for the next 10 years?...And I looked at the list, Ajit Jain looked at the list, and we had to decide, A) whether we knew enough to insure them, and B) what premium we would charge, because that's what we're in the business for."



Buy what you understand

This gives us a deep insight into Buffett's insurance mentality and goes some way to explaining why his insurance business has been so successful over the past several decades as many other insurance companies have struggled.

Berkshire has only taken on risks it understands at the right price, using virtually the same mentality Buffett used to invest in the stock market since the early 1950s.

Other credit insurers got into trouble because they did not understand what was underneath the bonds they were guaranteeing, something Buffett and Ajit Jain would never agree to. Running a good insurance business is a lot like running a good investment business. You should only buy what you know and stay away from what you don't.

Disclosure: The author owns shares of Berkshire Hathaway.

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This article first appeared on GuruFocus.