Berkshire's Free Money
The Hidden Power of Insurance Float in Warren Buffett's Berkshire Hathaway Success Story
Warren Buffett's prowess is often associated with his exceptional stock-picking abilities. However, beneath the spotlight of his market acumen lies a lesser-known yet crucial factor that has fueled Berkshire Hathaway's remarkable success over the years: the concept of insurance float. While Buffett's adeptness at identifying winning companies is unquestionable, it's the strategic utilization of insurance float – essentially the "free money" generated from Berkshire’s insurance businesses – that has consistently empowered Berkshire to not only weather market fluctuations but also to capitalize on lucrative investment opportunities, setting the stage for their unparalleled performance across decades.
In 2004 Warren Buffett told shareholders that if Berkshire hadn’t acquired National Indemnity for $8.6 million in 1967: “Berkshire would be lucky to be worth half of what it is today.” So how did this small insurer, at the time, end up creating so much value for Berkshire? The answer lies in the $19.4 million in float it possessed.
“Float has had greater value to Berkshire than an equal amount of equity”- Warren Buffett
Now lets explain the insurance business and float.
Individuals or companies purchase insurance policies primarily to manage risk and provide financial protection against unexpected events. The insurance business model is all about assuming and pooling risk. The insurer charges a premium (a regular payment made by an individual or entity to an insurance company in exchange for the coverage) to the policy holder and then promises to financially compensate the holder in the event of an unexpected loss/ event.
Thus an insurance company makes money in two ways:
Charging premiums in exchange for coverage
Investing the premiums
If the premiums charged are less than the claims paid out then the insurer is said to have an underwriting loss and if the premiums charged are more than the claims paid out the business is said to have an underwriting profit. This is however not as easy as it sounds. The insurance business is highly competitive and this can force insurers to charge very low premiums in order to gain market share; thus resulting in underwriting losses. To achieve an underwriting profit the insurer needs to exhibit maximal discipline as bad business is in excess in the insurance industry.
To evaluate the profitability and financial health of an insurance company we use the combined ratio. The combined ratio is calculated by dividing the incurred losses and expenses by the premiums earned. If the combined ratio is less than 100, the company has an underwriting profit. If the combined ratio is greater than 100, the company has an underwriting profit. Even though it would be unreasonable to expect an insurance company to produce an underwriting profit every year, you should seek insurers that have more underwriting profit years and than underwriting losses years.
An example of a great insurer is GEICO, which is also owned by Berkshire. GEICO’s business model is simple: it has cut out the middle man and sells auto insurance directly to government employees who statistically are the best drivers ( Hence Government Employees Insurance Company-GEICO). This allowed GEICO to undercut their competitors on price and also pay out fewer claims as they only sold to the “best drivers.”
Now onto the second revenue driver of insurance businesses; The investing of the premiums.
The insurance industry works on a collect now and pay later basis; the policy holder pays the premium upfront for a claim that the insurer may have to settle in the future. During the time when the premium has been paid but no claim has been settled the insurance company can invest that cash: this is what we call insurance float.
Float is basically money you have but do not own, it can be compared to an “interest free loan.” If the combined ratio is below 100, you are basically being paid to take other peoples money. This is why the insurance business is so attractive to Buffett. As of 2022, Berkshire Hathaway had $164 billion in float. This is money that doesn’t belong to Berkshire but that Berkshire can invest and gain profits from .
In Berkshire’s 2016 annual letter Warren Buffett explains the insurance business and the type of business characteristics that attracted him in the first place. Insurance float has provided Berkshire with “free” cash that it could invest thus playing a major role in the increase in Berkshire’s intrinsic value over long period of time .
The strategic utilization of insurance float has undeniably played a pivotal role in propelling Berkshire Hathaway's intrinsic value to new heights. Warren Buffett's masterful capital allocation, coupling insurance premiums received upfront with the judicious investment of these funds, has created a powerful mechanism for sustained growth.
Done.
Unlock the power of informed investing with Koyfin – your gateway to comprehensive financial research and analysis. Say goodbye to uncertainty and hello to data-driven decisions. Discover insights, track market trends, and make confident investment choices using Koyfin, your partner in financial success. Join now through my affiliate link and embark on a journey towards smarter investing. Your financial future starts here.
I wonder how the insurance float specifically enabled Berkshire to invest in companies like Coca-Cola or American Express, allowing them to compound returns over decades without relying solely on stock-picking.
Examples could have been given on how they were used over the years, perhaps including a great story, is there is one.