Berkshire Hathaway Letters to Shareholders: 1965-2024

by Warren Buffett

Truly outsized risks will exist in these contracts if they are not properly priced. A pernicious aspect of catastrophe insurance, however, makes it likely that mispricing, even of a severe variety, will not be discovered for a very long time. Consider, for example, the odds of throwing a 12 with a pair of dice—1 out of 36. Now assume that the dice will be thrown once a year; that you, the “bond-buyer,” agree to pay $50 million if a 12 appears; and that for “insuring” this risk you take in an annual “premium” of $1 million. That would mean you had significantly underpriced the risk. Nevertheless, you could go along for years thinking you were making money—indeed, easy money. There is actually a 75.4% probability that you would go for a decade without paying out a dime. Eventually, however, you would go broke. In this dice example, the odds are easy to figure. Calculations involving monster hurricanes and earthquakes are necessarily much fuzzier, and the best we can do at Berkshire is to estimate a range of probabilities for such events. The lack of precise data, coupled with the rarity of such catastrophes, plays into the hands of promoters, who typically employ an “expert” to advise the potential bond-buyer about the probability of losses. The expert puts no money on the table. Instead, he receives an up-front payment that is forever his no matter how inaccurate his predictions. Surprise: When the stakes are high, an expert can invariably be found who will affirm—to return...