How Warren Buffett Used Insurance Float To Become The Second Richest Person In The World

Berkshire Hathaway B shares Warren BuffettBy Mark Hirschey (Work of Mark Hirschey) [CC BY-SA 2.0], via Wikimedia Commons

Article by Vintage Value Investing

Most people know about insurance industry terms such as premiums (the money a policyholder pays every month or every year for an insurance policy) and claims (the money an insurer must payout when the policyholder gets in a car accident, has a medical operation, etc.).

But do you know what happens to your paid premiums once they’re actually sent to the insurance company?

Insurers don’t pay out all the money they collect right away. Rather, an insurance company will collect money in the form of premiums, invest that money, and then pay out claims as needed at some future date. The difference between premiums collected and claims paid out is called insurance float.

It’s a lot like how a bank will collect deposits, invest that money (through loans to other people or companies), and then will repay your money at some future date when you eventually make a withdrawal.

Insurance float has been a huge contributor behind Warren Buffett’s success with Berkshire Hathaway. Because premiums received are essentially like loans from policyholders (that only need to be paid back when a claim is made sometime in the future), Buffett has been able to use insurance float as leverage when investing in stocks and private companies, which has a significant (positive) impact on the company’s return for its shareholders.

It’s part of the reason why Berkshire Hathaway’s book value and market value have grown at ~20% per year since 1965 compared to just 10% per year for the S&P 500 (including dividends)!

So, let’s dive a little deeper into what insurance float exactly is and how Warren Buffett uses it to his advantage.

Warren Buffett and Berkshire Hathaway’s Insurance Float

As mentioned above, insurance float represents the available reserve, or the amount of funds available for investment once the insurer has collected premiums, but is not yet obligated to pay out in claims.

In his 2002 Berkshire Hathaway Shareholder Letter, Warren Buffett explains:

To begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.”

So insurance float is the difference between premiums received today over claims that must be paid many years in the future. During that time, the insurer invests the money. Insurance float is so valuable that insurance companies often operate at an underwriting loss – that is, the premiums received are not enough to cover the eventual losses (hurricanes, car accidents, etc.) that must be paid and the expenses required to resolve those claims, operate the business, etc.

Why would an insurer operate at a loss? Again, because the insurer can invest the insurance float and make even more money. In this sense, insurance float is like a loan and the underwriting loss is like the interest rate on that loan (i.e. cost of capital).

Now, for most insurers the cost of float is usually a few percentage points. Berkshire Hathaway’s insurance operations, however, are so well run that the company’s historical cost of float has actually been positive… meaning Berkshire Hathaway is actually being paid to take other people’s money!

Here’s an even more in depth explanation of insurance float from Warren Buffett’s 2016 Berkshire Hathaway Shareholder Letter:

“One reason we were attracted to the P/C business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float…Warren Buffett Insurance Float We may in time experience a decline in float. If so, the decline will be very gradual – at the outside no more than 3% in any year. The nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources. This structure is by design and is a key component in the unequaled financial strength of our insurance companies. It will never be compromised.

If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it.

Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous indeed that it sometimes causes the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continue its dismal record of earning subnormal returns on tangible net worth as compared to other American businesses.

Nevertheless, I very much like our own prospects… Moreover, our P/C companies have an excellent underwriting record. Berkshire has now operated at an underwriting profit for 14 consecutive years, our pre-tax gain for the period having totaled $28 billion. That record is no accident: Disciplined risk evaluation is the daily focus of all of our insurance managers, who know that while float is valuable, its benefits can be drowned by poor underwriting results. All insurers give that message lip service. At Berkshire it is a religion, Old Testament style.”

At the end of 2016, Berkshire Hathaway’s insurance float totaled $91.6 billion! And because Berkshire Hathaway’s insurance operations are run at an underwriting profit, the company’s insurance float is essentially like a $91.6 billion interest-free loan that Berkshire is actually being paid to take (Buffett says Berkshire earned $28 billion of pre-tax income over 14 years – in other words, the Company was basically paid $2 billion a year to borrow $91.6 billion, which it could then use to invest).

Now, compare this investing model to that of private equity firms or hedge funds, who also use leverage to invest… but instead of cost-free insurance float, these PE funds and hedge funds usually use high yield loans with interest rates of 7%+ per year.

Moreover, Berkshire Hathaway’s insurance contracts are structured in such a way that it will never have to pay back more than 3% in any one year – while a high yield loan might have to be paid back in full if a private equity company or hedge fund’s performance falls below a certain level.

Viewed in this light, the Berkshire Hathaway insurance float model is clearly genius.

It’s really no wonder that Warren Buffett is the second richest person in the world.

 



About the Author

VintageValueinvesting
Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…