by
Justin McCarthy | Apr 10, 2013
In 2012, Berkshire Hathaway made a claim of between US$0.5bn and US$1.0bn against Swiss Re regarding a disputed retrocession (or re-insurance) contract from pre-2004. Swiss Re has maintained that the claim was without merit, however warned that a loss of up to US$1.0bn was possible. While such a loss would be considered very manageable we viewed the main concern as a potential souring of a strong relationship with Berkshire Hathaway/Warren Buffett who has been an important financial backer of Swiss Re in the past, including a CHF3bn injection at the depths of the GFC.
Last week Swiss Re reported that this dispute has been resolved and expects to post a 1Q13 gain of about US$100m on the settlement.
As part of the settlement Swiss Re will assume some of the risks covered by the disputed US life insurance retrocession contract and in return will receive a payment of US$610m from Berkshire Hathaway. Berkshire Hathaway will reduce the reinsurance protection it provides to Swiss Re for the retrocession deal to $1.05bn from $1.5bn.
It is expected that the contract will results in losses on a longer term basis for Swiss Re (depending on future mortality rates in the USA) but the US$610m up-front payment will offset those losses.
While the financial side of the retrocession contract is important, and the settlement outcome is viewed as credit positive for Swiss Re, the bigger picture relates to the relationship between the two parties.
Both parties appear to be pleased with the relatively quick settlement of the dispute and Berkshire Hathaway continues to have a number of other reinsurance and retrocession contracts in place with Swiss Re. It appears that no permanent damage has been done to the relationship and this is considered a very important outcome with Berkshire Hathaway/Warren Buffett viewed as a potential supporter (or even saviour) in the unlikely event Swiss Re faces financial difficulty.
Conclusion
As reported back in February when the company released their full year 2012 results,
“We continue to marvel at the outperformance in of Swiss Re since the GFC. The profit and loss and balance sheet is back to pre-GFC strength and the market outlook remains positive.
With respect to the Swiss Re Tier 1 hybrid securities we continue to believe they represent amongst the most compelling risk-return investments in the market despite the very strong rally over recent years. The Tier 1 securities of Swiss Re are rated two to three notches above listed Tier 1 hybrid securities issued by the major banks, however they continue to trade wider due to the market’s perception of call risk and exposure to Europe, both of which we believe are overstated. Moreover, we prefer the structure of the “old style” Swiss Re Tier 1 hybrid securities to the more equity like “new style” listed bank hybrids.
We also view Swiss Re as a far superior credit than AXA SA and at the time of writing believe Swiss Re should trade at least 150bps tighter than the equivalent AXA SA Tier 1 securities (which are now rated four notches lower than Swiss Re). The differential is currently circa 50bps [now circa 65bp] for the fixed rate securities and circa 75bps [now circa 70bp] for the floating securities. Given the current differential we would recommend that clients reduce weighting to AXA SA and consider an overweight position in Swiss Re, subject to the level of other financial and callable exposure in their overall portfolio.
This dispute settlement further strengthens the creditworthiness of Swiss Re and whilst we have seen some client selling of AXA SA and buying of Swiss Re, the credit spread differential continues to remain insufficient. We reiterate that any new or existing wholesale clients should strongly consider an overweight position to Swiss Re and existing wholesale clients holding AXA SA should consider selling down some of that exposure and increasing their weighting to Swiss Re given the strong credit position and superior relative value of the latter.