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US P&C industry escaped Q3 net loss on Berkshire's BofA warrant exercise

Realized gains on the surrender of Bank of America Corp. preferred stock and the exercise of warrants to purchase common stock during the third quarter by the property and casualty units of Berkshire Hathaway Inc. kept the U.S. property and casualty insurance industry from posting its first statutory net loss since the second quarter of 2011.

The U.S. P&C industry, excluding entities under coverage as state funds and residual markets, generated net income of $6.92 billion in the third quarter, down from $10.88 billion in the year-earlier period. The combination of net investment income earned and a record level of net realized capital gains that largely reflected the impact of the Bank of America-related transactions offset a net underwriting loss of $15.96 billion during a period in which hurricanes Harvey, Irma and Maria made landfall.

Net investment income increased to $11.89 billion in the third quarter from $11.03 billion in the year-earlier period, though the resulting net yield on invested assets remained near historic lows. Net realized capital gains of $9.99 billion in the third quarter, including $8.86 billion from Berkshire subsidiaries, marked an increase from $1.75 billion in the year-earlier period. The previous quarterly high in the more than 16 years in which S&P Global Market Intelligence has been collecting quarterly statutory data had been $8.06 billion in the first quarter of 2013. Only two other times since the start of 2001 had net realized capital gains equaled or exceeded $5 billion in a single quarter.

When excluding the Berkshire group entirely from the P&C industry aggregates, the third-quarter result swings to a net loss of $2.57 billion. When subtracting only the $9.10 billion in realized gains that Berkshire P&C subsidiaries attributed to August transactions involving Bank of America stock, the industry's net loss would total $2.18 billion. It has been since the second quarter of 2011, a record period for tornadic activity in which P&C companies sustained an aggregate net underwriting loss of $19.13 billion, that the industry last had a net loss in a reporting period.

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S&P Global Market Intelligence calculates a third-quarter combined ratio of 110.7%, excluding state funds and residual markets. Including state funds and residual markets, the quarter's combined ratio totaled 112.3%, reflecting the extent to which Hurricane Irma impacted the results of the Florida state-run Citizens Property Insurance Corp. and Hurricane Harvey hit the results of Texas Windstorm Insurance Association, which is the wind and hail insurer of last resort along the Lone Star State's Gulf Coast. The industry's third-quarter net income when including state funds and residual markets, including Citizens and Texas Windstorm Insurance Association, totaled $5.32 billion. Net realized capital gains were negligibly higher when including the state funds and residual markets.

Berkshire P&C units reported $8.31 billion in realized gains pertaining to the Bank of America warrants, including $3.44 billion for Government Employees Insurance Co., $1.72 billion at National Indemnity Co. and $1.22 billion at GEICO Indemnity Co. Their realized gains on the disposal of Bank of America's 6% noncumulative perpetual preferred stock totaled $786.4 million. National Indemnity noted in its quarterly statement that the realized gains would be deferred for federal income tax purposes until the time of disposal of the Bank of America common shares.

The acquisition of the Bank of America preferreds and the warrants to acquire Bank of America common shares at a price of approximately $7.14 apiece occurred in 2011. Berkshire surrendered most of the preferreds along with accrued dividends in August to cover the $5 billion aggregate cost to exercise the warrants, leading to its acquisition of 700 million shares of the bank's common stock.

A total 22 Berkshire P&C units reported the acquisition of 554.4 million Bank of America common shares in the closing days of August. The reported actual cost of those shares in the aggregate implies a value of $23.56 per share.

It is not the first time an unusual Berkshire investment transaction or series of transactions were significant enough to dramatically impact industry results.

National Indemnity and its affiliated insurers reported $7.77 billion in net realized capital gains in 2005, for example, during a year in which the industry's result in that income statement line item totaled $12 billion. A review of annual statements indicates that six Berkshire P&C companies generated a combined $4.94 billion in realized gains in October 2005 as a result of their accounting for the conversion of shares of Gillette Co. common stock into Procter & Gamble Co. common stock.

In 2014, National Indemnity and its affiliated insurers posted investment income of $15.05 billion, of which approximately $7.05 billion resulted from the accounting for the distribution and contribution of certain affiliated common stock. The group's net investment income has ranged from $8.41 billion to $8.70 billion in each of the other calendar years from 2011 through 2016. Though there was an offsetting entry to the unusual investment income in the group's capital and surplus account, the line item provided a boost to the industry's net income for 2014.

Berkshire Chairman Warren Buffett in his 2011 annual letter to shareholders accurately predicted that his company's investment in the Bank of America warrants that year "will likely be of great value before they expire."