The Limitations of GEICO’s Liability Risk

The strong blue-chip stocks in the world are generally decentralized holding companies. For instance, when you buy Berkshire Hathaway stock, there are layers of separation between it and GEICO, its most famous insurance subsidiary.

Berkshire Hathaway has a 100% ownership interest in Government Employees Insurance Company, and in turn, this company owns (1) GEICO Indemnity Company; (2) GEICO Casualty Company; (3) GEICO Advantage Insurance Company; (4) GEICO Choice Insurance Company; (5) GEICO Secure Insurance Company; and GEICO County Mutual Insurance Company. That is just on the underwriting side. The sales of GEICO policies occur through GEICO Insurance Agency, Inc., which is 100% owned by Government Employees Insurance Company, which in turn is owned by Berkshire Hathaway, Inc.

Each of these individual smaller companies has its own capitalization structure (i.e. cash and debt with a unique balance sheet), its own management team, and follows its own set of corporate formalities.

For almost all of Berkshire’s existence, these distinctions have not mattered. In fact, Warren Buffett himself blurs these distinctions in annual letters to shareholders when he talks about Berkshire’s might in being able to absorb potential liabilities totaling tens of billions of dollars.

But they do matter. Although many GEICO insurance policies include an express provision that the parent Berkshire’s assets would be tapped in the event that the particular GEICO subsidiary was unable to make payment, this obligation only exists due to contract (rather than operation of law). Likewise, some state insurance commissioners contain regulations that obligate the parent insurance company to step in under certain situations.

So why the web of LLCs? Because in the event that some liability arises that is not the result of an express contract provision that obligates the parent company or does not require payment under state law, the parent company could declare bankruptcy for the subsidiary and dissolve it without having to fulfill the subsidiary’s obligations.

Imagine a lender provided $50 million in funding for a robust GEICO advertising company as non-recourse debt on the balance sheet of one of the GEICO subsidiaries. Now, imagine the advertising campaign is a complete failure and no additional policies are written as a result. So long as that particular GEICO subsidiary honored corporate formalities and was properly capitalized before the adverse events, it could be dissolved, with the parent Berkshire only being affected to the extent that the dissolved subsidiary’s assets would be sold off or liquidated to pay off the creditors.

It is fascinating to me. When Warren Buffett talks about Berkshire’s capabilities to handle an adverse mega-catastrophe that would result in enormous payouts, he is factually analyzing legal obligations. When he is talking about the ability for Berkshire to withstand other events, he is largely speaking theoretically. Several of Berkshire’s newspaper holdings have been dissolved without Berkshire stepping in to pay the debt and owing because the separate holding company structure provided that protection. Interestingly enough, in an old Fortune Magazine article written by Carol Loomis, Berkshire said he came to appreciate the benefits of using a web of corporations, limited partnerships, and limited liability companies after studying the legal holding structure for R.J. Reynolds Tobacco Co.