10/28/13

Flirting with Floats: Part I | Fundoo Professor

Fundoo Professor ~ Thoughts of a teacher &

practitioner of value investing and behavioral
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Flirting with Floats: Part I

09 Monday Jul 2012
POSTED BY FUNDOOPROFESSOR IN ABSTRACT IDEAS IN FINANCE, SECURITY & BUSINESS ANALYSIS
15 COMMENTS
There is a company which has the worlds strangest bond outstanding. Strange, because this
bond has no maturity date. Stranger, because the bond issuer pays no interest on it. Strangest,
because year after year, the issuer gets paid to have this bond on its balance sheet.
What better source of financing is there than one in which neither do you have to return the
borrowed money, nor are you charged any interest to use it? In fact, you are paid to use it!
This is not a small bond issue in some obscure little country. As of end December 2011, this
bond had a book value of about $71 billion and the issuer is an American company having a
current market cap of $205 billion.
I am, of course, referring to the float enjoyed by the insurance businesses of Warren Buffetts
Berkshire Hathaway. Float in the insurance business, says Buffett, arises because most
policies require that premiums be prepaid and, more importantly, because it usually takes
time for an insurer to hear about and resolve loss claims.
This float, which has grown from $17 million in 1967 to an astounding $71 billion by the end of
2011, is a key reason behind Warren Buffetts fame and fortune.

OPM: As Addictive As Opium

Float, as he explains is money we hold but dont own, which, by the way, is how one would
describe other peoples money or OPM, of which debt is the most common form.
The problem with plain-vanilla debt, however, is that its quite onerous for borrowers. When
you borrow money conventionally you have to: (1) pay back the loan by some definite date; (2)
pay the lender interest on the money borrowed over the course of the loan period; and (3) put
up adequate collateral until full repayment of loan has been made. How very onerous!
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Over the last 45 years, Berkshires insurance float enabled the company to effectively borrow
huge amounts of cash, with no set repayment date, and with no tangible collateral put up.
Even more astonishing is the fact that this money cost Berkshire less than nothing.
How did this happen?
For a typical insurer, the premiums it takes in do not cover the losses and expenses it must
pay. That leaves it running an underwriting loss the cost of float which is the functional
equivalent of interest on conventional debt. An insurance business is profitable over time if the
cost of its float is less than the cost the company would otherwise incur to borrow funds. The
business will have a negative value if the cost of its float turns out to be higher than market
rates for money.
For Berkshire, the cost of its float, over the long term, has been less than zero. The net result of
all this is that Berkshire has not only been able to borrow funds at a cost which is less than that
of the U.S Treasury, it has been been paid to borrow that money.
Its already well-known that the value of this large float with a negative cost has been huge for
Berkshires owners. After all, access to tens of billions of dollars of less-than-free capital in the
hands of one of the worlds greatest allocators-of-capital, has to be winning combination, isnt
it?
However, no matter how good an allocator-of-capital Warren Buffett is, that has little to do
with the value of Berkshires insurance float to its owners. Thats because of a principle of
finance (MM on Capital Structure) according to which the value of a firms assets have little to
do with how they are financed. So, we mustnt let Buffetts brilliant track record in capital
allocation influence us on how we should think about Berkshires insurance float. But we do
need to understand just how does that float create value for Berkshires owners. Thats
because, once we have understood how to evaluate Berkshires float, we will use that
knowledge to understand other types of floats in a variety of business models.
Berkshires cost-less float can be best understood by comparing it with other forms of
financing. When compared with plain-vanilla debt, it is obvious that borrowed funds which
cost money, require posting of collateral, and which have to be repaid by a definite date are
vastly inferior to Berkshires float which suffer from none of these disadvantages.

Warren Buffett on Insurance Floats

Its when we compare Berkshires insurance float with equity, things gets really interesting.
Buffett explained this point in his 1995 letter:
Since our float has cost us virtually nothing over the years, it has in effect served as equity. Of course, it
differs from true equity in that it doesnt belong to us. Nevertheless, lets assume that instead of our having
$3.4 billion of float at the end of 1994, we had replaced it with $3.4 billion of equity. Under this scenario,
we would have owned no more assets than we did during 1995. We would, however, have had somewhat
lower earnings because the cost of float was negative last year. That is, our float threw off profits. And, of
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course, to obtain the replacement equity, we would have needed to sell many new shares of Berkshire. The
net result more shares, equal assets and lower earnings would have materially reduced the value of our
stock. So you can understand why float wonderfully benefits a business if it is obtained at a low cost.
He explained it again in his 1997 letter:
Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate
of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting
irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater
than an equal amount of net worth would have had.
And again in his 2007 letter:
Insurance float money we temporarily hold in our insurance operations that does not belong to us
funds $59 billion of our investments. This float is free as long as insurance underwriting breaks even,
meaning that the premiums we receive equal the losses and expenses we incur. Of course, insurance
underwriting is volatile, swinging erratically between profits and losses. Over our entire history, however,
weve been profitable, and I expect we will average break-even results or better in the future. If we do that,
our investments can be viewed as an unencumbered source of value for Berkshire shareholders.
And finally in his 2011 letter:
So how does this attractive float affect intrinsic value calculations? Our float is deducted in full as a
liability in calculating Berkshires book value, just as if we had to pay it out tomorrow and were unable to
replenish it. But thats an incorrect way to view float, which should instead be viewed as a revolving fund.
If float is both costless and long-enduring, the true value of this liability is far lower than the accounting
liability.

General Principles
The lessons in these four excerpts from Buffetts letters are just about all we need to know to
evaluate not just quality of Berkshires float, but that of just about any other float. Here, then,
are a few general principles:
1. Floats are wonderful if they cost less than nothing. They are also wonderful if they are free;
2. Perpetual floats are better than non-perpetual ones;
3. Funds provided by free, or less-than-free floats, are more attractive than those raised
through conventional debt or even equity; and
4. The true value of a liability represented by an attractive float is far lower than its
accounting value.

Invert, Always Invert

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One way to see how the true value of an attractive float is far lower than its accounting value is
to use the inversion trick often used by Charlie Munger by looking at the problem from the
float providers viewpoint.
Imagine that you subscribe to a bond issued by a company at Rs 100. Imagine further that this
bond carries no interest, and has no definite repayment date. For the moment, suspend your
disbelief and ignore the question Why the hell would I ever buy subscribe to such bond?
Just assume that you did.
How would you value this perpetual, zero coupon bond? What price would any rational
person pay you for your bond? Almost nothing, isnt it?
Now lets invert the situation again and at look at this example from the viewpoint of the
bonds issuer. The bond appears as a liability on the issuers balance sheet at Rs 100. Now, if
the corresponding asset on your balance sheet is almost worthless, should not the true value of
this liability also be almost worthless from the issuers viewpoint? Of course it should!
Now lets add a twist. Imagine that for some reason the company must pay back Rs 100 it owes
you, but that it can find someone else to give money to it on identical terms so that even if you get
paid, the companys overall liability on account of the float remains unchanged. In effect, the
company gets to use OPM to retire a liability represented by OPM. Even if some of the older
providers of OPM have to be made whole, they are paid through refinancing on identical
terms by newer providers of OPM. If this sounds like a ponzi scheme (without its derogatory
connotation), then youre right on spot!

A Revolving Fund
Thats precisely what Buffett meant when he wrote the above-mentioned extract in his 2011
letter, which I am reproducing here with emphasis on key words:
Our float is deducted in full as a liability in calculating Berkshires book value, just as if we had to pay it
out tomorrow and were unable to replenish it. But thats an incorrect way to view float, which should
instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this
liability is far lower than the accounting liability.

Unencumbered Source of Value

So long as one is certain that the size of a free float will not diminish over time because it
resembles a revolving fund, one should value such a book liability at virtually nothing.
And when that happens, then assets financed by such a float become unencumbered. This is
what Buffett meant in his above-mentioned 2007 quote which I reproduce again with emphasis
on key words:
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Insurance float money we temporarily hold in our insurance operations that does not belong to us
funds $59 billion of our investments. This float is free as long as insurance underwriting breaks even,
meaning that the premiums we receive equal the losses and expenses we incur. Of course, insurance
underwriting is volatile, swinging erratically between profits and losses. Over our entire history, however,
weve been profitable, and I expect we will average break-even results or better in the future. If we do that,
our investments can be viewed as an unencumbered source of value for Berkshire shareholders.
This insight as to how do assets, when financed with cost-less floats become unencumbered,
will be instrumental in our understanding the role of floats in evaluating the economics of
businesses outside of the insurance industry.
Thats the subject matter of a subsequent post.
To be continued

thoughts on Flirting with Floats: Part I

1. said:harishbihani
July 9, 2012 at 22:20
Thanks sir. Eagerly awaiting the next post.
REPLY
2. said:Ramachandra Gupta (@guptarcv)
July 9, 2012 at 22:20
Sir, looking from Talebs point of view..Isnt insurance business exposed to negative
black swans?..Like take for example AIG.For a number of years, this float can be a
cheap source of fund, infact cheaper than equitybut one fine day, the unexpected might
happen.
REPLY
3. said:rohitc99
July 10, 2012 at 07:29
ramachandra AIG did not get hurt by insurance claims. they had (almost closed now) unit
called AIGFP which sold cheap CDS on RMBS which turned out worthless. thats like
insuring a warehouse full of dynamite where the owner then throws a match in
the cost of float for AIG also has been a few hundred basis points ofcourse not as cheap
as berkshire

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prof dont want to spoil the surprise but i am guessing you are planning to cover
companies which work with minimal AR and large accounts payables or take large
customer advances ?
REPLY
said:fundooprofessor
July 17, 2012 at 21:45
REPLY
4. said:rronak1234
July 10, 2012 at 10:30
Hello Sir,
Excellent Post. I guess you would be talking about companies with negative working
capital, where they receive advances from customers (int. free), which they can park to
create assets. In case the order gets cancelled and they have to repay advance, this could be
funded from other advances received from other customers, as they would receive
advances from several customers as a part of their business operations.
Its brilliant.
REPLY
said:fundooprofessor
July 17, 2012 at 21:44
Yes, that will be covered in part III.
Thanks.
REPLY
5. said:Arpit Ranka
July 12, 2012 at 13:57
Great article, Sir!
Being ever skeptical, when it comes to banking and insurance industry about projecting
past performance into future (even with BRK given that half of its float is in super
catastrophe/reinsurance), whereby the yearly under-writing profits enjoyed so far could
look like peanuts and reverse the economics of float from costing them less than nothing
to a lot, I was going through the annual report to understand it better..
Here is an excerpt, which highlighted Buffetts worst-case scenario evaluation.. Its Buffetts
credibility more than anything else which makes one trust this evaluation and conclude
that the skepticism could be misplaced.. but not sure how many people are out there
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whose judgments we can trust when its a matter of do or die for the enterprise as a whole..
Also, using Buffett metaphor of a great business being one which any fool can run (without
jeopardizing its franchise).. I am not sure if BRKs insurance arm can be clubbed as a great
business as eventually Mr. Buffett and Mr. Jain will not be looking after the two critical
aspects of making this float work for them beyond a decade or two..
From Annual Report 2011: First by float size is the Berkshire Hathaway Reinsurance
Group, run by Ajit Jain. Ajit insures risks that no one else has the desire or the capital to
take on. His operation combines capacity, speed, decisiveness and, most importantly,
brains in a manner that is unique in the insurance business. Yet he never exposes Berkshire
to risks that are inappropriate in relation to our resources. Indeed, we are far more
conservative in that respect than most large insurers. For example, if the insurance industry
should experience a $250 billion loss from some mega-catastrophe a loss about triple
anything it has ever faced Berkshire as a whole would likely record a moderate profit for
the year because of its many streams of earnings. Concurrently, all other major insurers and
reinsurers would be far in the red, and some would face insolvency.
From a standing start in 1985, Ajit has created an insurance business with float of $34
billion and significant underwriting profits, a feat that no CEO of any other insurer has
come close to matching. By these accomplishments, he has added a great many billions of
dollars to the value of Berkshire. Charlie would gladly trade me for a second Ajit. Alas,
there is none.
REPLY
said:fundooprofessor
July 17, 2012 at 21:52
Yes Arpit, I think it would be very hard to replicate the skills of Mr. Buffett and Ajit
Jain. I am not suggesting it would be easy. All I am saying is that Mr. Buffett has been
extremely creative in producing floats of many kinds (covered in parts I & II), and those
floats have played a very major role in the success of Berkshire. I am also using this
series to give my thoughts on whats the right way to think about floats for passive
investors in the stock market, and the relationship between floats and moats which will
be covered in part III.
Thanks for your inputs.
REPLY
6. said:rohitc99
July 14, 2012 at 04:31
arpit
insurance is definitely a business which cannot be run by a monkey ..on contrary if a
monkey does run it, like in case of AIG, the company can go bankrupt very easily, without
an investor realising it
case in point gen re which warren buffett bought and then realised that they had been
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under-reserving and it took him 6-8 years to fix the culture.

however if you have a the right person like warren buffet in berkshire then insurance is a
very profitable business as prof bakshi has pointed out. also buffett has indicated that they
are constantly looking at total loss exposure (max loss) in any event as in long tail
insurance one cannot estimate the probabilties with any certainty
you may want to look at FFH (fairfax holdings) in canada which is headed by prem watsa
and he is called the warren buffett of canada (for good reasons). very similar in operations
and this company is a partner in icici lombard.
so you are right in the sense, that insurance is truly a management driven business. good
management can do wonders, whereas the wrong one can bankrupt it much like banks
isnt it ?
REPLY
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8. said:manishmns
July 19, 2012 at 18:19
Sir , I understand that understanding Floats is good as an Investor and How Floats helped
WB to amass such a great fortune ( of course not denying the capital-allocating skills of
Mr.Buffett). As an Indian Investor all Insurance companies are non-listed . I have two
queries :
1) which business have the float ?
2) How can a business person create floats ?
REPLY
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10. said:svetlanakoslov
August 6, 2012 at 20:53
Very interesting as I am a bond investor
REPLY
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12. Pingback: Presentation on Floats & Moats Fundoo Professor

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