How Warren Buffett used

insurance float - Business Insider

Most people know about insurance industry terms such as (the
money a policyholder pays every month or every year for an
insurance policy)and (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

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…"
Berkshire Hathaway
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.

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