Understanding How Floats Work

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I’ve been reading your blog for quite sometime and I’ve always been astounded by your vast knowledge of just about everything in investments. I’m new to this game and I hope to learn from you, which brings me to the following:

I know we have to calculate “float”, “cost of float” and find the “combined ratio” for an insurance company to value it more accurately. However, I’ve spent hours googling around and I still can’t find what exactly in the balance sheet/P&L/CF statement (or even in the footnotes!) that constitutes as:

loss adjustment expense, unearned premiums, other policyholder liabilities, premium balance receivable, loss recoverable from reinsurance ceded, deferred policy acquisition costs, deferred charges on reinsurance, related deferred income tax, etc. 

In most insurance companies’ balance sheets, all I see are the usual suspects “cash & cash equivalents”, “goodwill”, “intangible assets”, “derivative financial instruments”, “PPE” and the likes. I’ve never seen any of those above-mentioned terms, are there substitute words for them? I’m obviously missing something out. Thank you for your time!

Let’s clear something up here — there is no GAAP financial statement item called float.  What is float?  Let me teach you something deeper.  How does a property & casualty insurer invest?

There is some wiggle room around this, but typically, the premium reserves are invested in high quality short-term debt.  Premium reserves represent the premiums paid in advance that have not yet been taken into income, because some insureds don’t pay month-by-month, but they have paid for many months in advance.  They are often called unearned premiums.

Claim reserves are typically invested in longer-term debt, where the term of the debt will approximately match the period over which the claim will be paid.  Much of the claim reserves fall into the category “Incurred but not Reported [IBNR].  Insurance claims are not always filed immediately.

Finally, the surplus of the insurance company is usually invested in risk assets — equities, private equity, real estate — whatever area the insurance company thinks they have expertise to make money.

The first two categories, premium and claim reserves, comprise float.  You can try to measure them by looking at the statutory statements of the insurer, where those are real line items on the liabilities page, or you can approximate it by looking at the current liabilities, and adding in the claim reserve, which is usually in one of the footnotes.

Reinsurance can mess this up a little, so try to work with numbers net of reinsurance.

Property & Casualty Insurers do not have to credit interest as they delay paying claims, or receive premiums in advance.  Thus the concept of float.  Few insurers use float to be as aggressive as Buffett.  They invest more conservatively, especially among insurers where claims get paid quickly (home & auto).  With long-tailed claims, like asbestos & environmental, the claims may take so long to emerge that the insurer can be investing in stocks, and that will be the optimal investing decision.

The so-called “cost of float” is net underwriting losses.  If there are no net underwriting losses, float is free, or more often, is a source of profit.

But float isn’t worth much unless you have a clever investor investing the cash that stems from the delay of paying claims.  Even with Buffett, that advantage is uncertain.

Tell you what, I never analyze float in insurance.  I analyze management teams.  Insurance is uncertain enough, that I want a margin of safety, and the best way that I can do that is find management teams that are conservative.  Do they consistently make money on underwriting?  Do they occasionally/frequently deliver negative surprises?

I wouldn’t spend time on float.  Any insurer can generate float.  Look at how they make money.  How do they underwrite?  How do they invest?  Are they conservative in their accounting?  That is what you should look for.

Next letter:

I hope you are doing well.  I have been reading your blog for the last few years and have found myself thoroughly educated and entertained.  My favorite series of posts has been your explanation on the holders’ hands, which is a unique and more useful way of classifying market participants, rather than just using timeframe.

A little bit about myself: I am currently a student at zzzzzzzzz studying Economics and before that I was in the Marine Corps Reserves where I served a tour in Iraq. 

I managed to save some money from that time and began investing, which dovetailed nicely with my burgeoning interest in macroeconomics (particularly through the Austrian and Post-Keynesian lens).

As I learned from my mistakes and improved, I recently felt confident enough to form my own LLC in the hopes of bringing on close family and friends as part owners (essentially limited partners) and manage our savings in a more productive and less expensive manner than the current meta of mutual funds or indexing.

This brings me to the the reason I am emailing you: suppose I would like to expand this type of business…How would I go about this? Am I reliant on word of mouth via friends and family?  I also plan to talk to the Small Business Administration for investors, but I don’t think anybody will even give me a chance until at least after a few years. 

Would it be feasible to talk to pension/asset management firms for interest in investing?  I would love to hear your opinion on the matter and please let me know if there is someone more appropriate for me to send this email to.

If I have this straight, you have started a firm that invests in other firms, not all that much different from Buffett in his days after ending his limited partnership.  In this case, you are limited by the number of people that can invest in your private firm, which in these days, I believe is 1000 people.  I could be wrong here, so consult competent legal counsel to guide you.  Not sure how the SBA would fit in here, though I know they aid funding small firms together with venture capitalists.

What you are doing is too small for pension and asset managers.  Given the JOBS Act, your best option is to recruit medium-sized investors, and invest wisely.  Given that you run a private firm, you might not want to limit yourself to public companies.  You might be able to compound capital faster by buying whole small companies, or large portions of medium-sized companies.

Of course, this all presumes that you have a real talent here.  If you’re not sure, give it up now, and give the capital back to your shareholders.

I wish you well, but if you are doing public assets, far better that you do what I do and manage separate accounts for investors.  It’s a lot cleaner.

By David Merkel, CFA of Aleph Blog

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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