Insurance Australia Group (IAG) and Berkshire Hathaway

There’s been some staggeringly misinformed comment regarding Berkshire Hathaway’s partnership and equity stake with IAG (announced on 16 June 2015). 

Commonwealth Bank analyst, Ross Curran asked Mike Wilkins (IAG’s Chief Executive) and Nick Hawkins (IAG’s CFO) one of the most naively stupid questions I’ve ever heard. He asked whether IAG had given Berkshire 20 percent of its business in exchange for the 3.7 percent equity stake that Berkshire made in IAG!

Let’s get a few things straight.

Firstly, the equity stake that Berkshire took in IAG is completely incidental to the much more important partnership arrangement that the two companies have entered into (they just happen to have been announced at the same time which somehow managed to confuse both analysts and media alike). They could have entered into the latter agreement without Berkshire taking any equity interest in IAG, it doesn’t matter because that has nothing to do with their arrangement. It just so happens that Buffett believes that IAG is a well-run, cheap company with a strong franchise that he was happy to pay $5.57 per share for (and don’t think for one minute that he would buy a stake in any company that he didn’t believe in, no matter what the size of that stake was).

For someone like Ross Curran to confuse this side equity deal with the fee-based partnership arrangement suggests to me that Ross isn’t the brightest analyst we’ve ever seen.  Hey Ross, a couple of billionaires called earlier, they want to buy 3.7% of the Commonwealth Bank and get your Board to give them 20 percent of your profits for the next 10 years– sound like a good deal for the bank Ross? No? Then how stupid do you think IAG are?

For some media outlets like the Australian Financial Review (James Thomson) to pick it up as if it was some great insight is laughable. On the other hand, one of the few analysts who does seem to have had a much sounder understanding of the implications of the deal was Jan van der Schalk at CLSA.

The really important deal was the ceding of 20 percent of IAG’s insurance premium to Berkshire in return for Berkshire paying 20 percent of the claims and also insurance operating costs plus what Buffett described as a large annual payment. In Buffett’s own words describing the payment: “substantial – a payment of a size that virtually no other insurance company in the world would pay, and that we have never paid before.”

Buffett is a person of great integrity, so I would accept his statement. However, because we do not know what the size of that payment will be, we simply don’t know who got the better deal and whether it is earnings dilutive etc. This is actually something that should have been mandatory for both parties to disclose.

The main points are as follows:

·        The equity deal that Berkshire did was completely incidental to the partnership agreement with IAG, anyone confusing the two is displaying their ignorance;

·        Notwithstanding the above point, the equity deal is a huge endorsement of IAG’s management and business model (make no mistake, Buffett wouldn’t touch 99 percent of ASX listed entities with a barge pole and nor should you);

·        IAG is not entering into this deal with Berkshire under distressed conditions (unlike for example Goldman Sachs did during the GFC), so there is no requirement to give Berkshire a great deal;

·        We do not know the details of the payments that Berkshire will make to IAG over the life of the agreement, so any earnings dilution calculations etc. undertaken by pseudo analysts are purely guesswork;

·        Buffett has basically put a floor under the IAG share price at $5.57, if it does go lower, you can buy at less than Berkshire (and personally, I’m happy to);

·        The benefits for IAG are the freeing up of significant capital and greater earnings stability (IAG has made underwriting losses in two of the past five years); and

·        Contrary to what some pundits have written, unless Berkshire never intends on repatriating its Australian dollar investments, it is going to be subject to currency risk.