From Luke Armstrong of Coburg Consultants

 

This weekend was an absolute bloodbath for March Madness brackets everywhere. I got hit hard – I had Duke going to the Final Four and Kansas taking it all.

For the uninitiated, NCAA March Madness is the three-week national championship tournament for men’s college basketball in the States. People enjoy the tournament because of its do-or-die nature. A champion is chosen from a pool of 64 teams through a one-game sudden death, arcade-style bracket.

You probably know someone who has a “bracket” for this year’s March Madness tournament. Essentially, filling out a bracket is a process of guessing who will advance through each round of the tournament, and picking a national champion. The goal is to guess a more correct bracket than your friends. March Madness brackets have become an annual obsession – even President Obama fills out a bracket every year.

Winning $200 from your office buddies is cool, but this year Quicken Loans and Warren Buffet tabled a $1 billion dollar bet that no one would pick a perfect bracket.  That’s right – Quicken Loans agreed to pay out $25 million every year for 40 years to any individual that could correctly pick every winner in the tournament. Warren Buffet’s Berkshire Hathaway insured the prize.

Admittedly, Warren Buffet could lose $1 billion cash today and with relatively little consequence. But he didn’t get that wealthy by making reckless business decisions. How does a $1 billion dollar insurance policy work, and what makes Warren Buffet the ideal insurer?

Insurers are masters of risk management and statistics. Essentially, their business is the packaging and holding of risk to indemnify the insured against a negative outcome in return for a paid premium. Insurance companies employ a lot of very smart statisticians in their underwriting department, called actuaries. How would an actuary price the billion-dollar policy? Details of the transaction are private, but best guess is somewhere north of $15 million, about 1.5% of the insured event.

Berkshire Hathaway is technically called a multinational conglomerate because it owns large stakes in companies in many industries. However, the key business activities of Berkshire Hathaway are investing, insurance, and other finance-related activities. The company is uniquely positioned to insure extreme risks as the largest finance company in the world, with assets of $484 billion including $48 billion in cash. Berkshire has the expertise to evaluate these kinds of opportunities, and the financial muscle to carry the risk safely. This isn’t the first time the company has insured a $1 billion prize – it insured the Pepsi Billion Dollar Sweepstakes in 2003 for a $10 million premium.

If you were to pick the winners of the March Madness tourney at random, your odds of picking a perfect bracket are 148 pentillion-to-one. But top analysts and attentive basketball fans have a much better chance (albeit still virtually impossible) of picking the winners correctly. A professor of mathematics at Duke estimates the odds of a perfect bracket for someone with expertise in college ball to be about one billion-to-one. And the observed probability? Of course, there has never been a confirmed perfect bracket in tournament history.

 

Good luck with your picks!