Last Saturday Warren Buffett, the Sage from Omaha, delivered his Annual Letter to Bershire Hathaway shareholders. What is so special about it? Tens of thousands of companies are operating around the world. Each one produces an annual report with a letter to shareholders to give investors an account of how their corporation performed in the previous year and what is in the pipe for the forthcoming year.
Of all those letters, the one that excites the most interest is indeed the annual missive from the Sage of Omaha, Warren Buffett, whose iconoclastic approach to running a company has made Berkshire Hathaway Inc.'s class A shares the most expensive stock in America. The 2003 Letter is pure Buffett. No need to say that Buffett is still disappointed with Corporate America: "In judging whether Corporate America is serious about reforming itself, CEO pays remains the acid test. To date, the results are not encouraging." In a coming post we'll cover Buffett's criticisms and suggestions for an improved corporate governance.
For the moment being, we'll look at a thought provoking piece of business information related to the insurance side of Bershire Hathaway. Buffett tells his shareholders that Ajit Jain, who runs Berkshire reinsurance operations, had decided to write a rather unsual insurance policy. Indeed, in 2003 PepsiCo promoted a drawing that offered participants a chance to win a $1 billion prize. The drawing was to be made by a chimp named Kendall. Pepsi management was obviously worried that somebody might hit the jackpot. Hence, it decided to find somebody to lay off the risk. And, guess what, Berkshire issued a policy for the whole risk (as a matter of fact, the risk was less than $1 billion as the prize was to be paid over yearly instalments, namely a present value of $250 million). The drawing was held on September 14th, 2003 and you can imagine that Jain and Buffett were holding their breadth while Kendall the chimp was carrying its duty. Fortunately for Berkshire, nobody won!
This story is not only interesting per se but also because it raises the question of whether you can trade away any type of risks. Kenneth Arrow and Gérard Debreu, two Economics Nobel laureates, came up with the so-called complete markets model where any event can be spanned by a security yielding a payoff upon the occurrence of the event and none in case of no-occurrence. The model is also nicknamed the Arrow-Debreu model. Real life is obviously far from this abstraction. But, as Buffet's example shows, market creativity reduces the gap between the ideal Arrow-Debreu world and reality.
This reminds me of the late Karl Borch story about the Loch Ness monster. Karl was a first-class economist and a true gentleman. He dedicated his entire life to the study of insurance and the economics of uncertainty. One of his pet example of a market initiative that was in the vein of an Arrow-Debreu world was that of the Scottish whisky distillery that had promissed a significant prize to the individual who would capture the monster of Loch Ness. The distillery was fearing that, despite the odds, somebody may succeed. Well, Lloyd's of London did not shy away and issued a policy to cover the risk!
What is the lesson, if any, to be drawn from this? The lesson is that, in my point of view, contrarily to received wisdom, we do not suffer from an excess of markets. As a matter of fact, a simple look at daily life strongly suggests that we suffer from not having enough markets to fine-tune our exposures to daily contingencies. Think of your home: Real estate prices are volatile. Still, you have to live (to survive?) with them. If you're not convinced please read Yale University Robert Shiller's book entitled "The New Financial Order".
You'll look at the world differently for sure!
P.S.: By the way, Berkshire Hathaway is Coca Cola's largest shareholder!
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