Friday, March 8, 2013

Buffett on Berkshire's Float

A follow up to this post.

As I mentioned in the prior post, a part of Berkshire Hathaway's (BRKa) advantage is the $ 73.1 billion of "float" -- essentially free money if they break even on underwriting -- that comes from their various insurance businesses.

Well, the fact is that Berkshire has actually had underwriting profits for ten straight years. So they've done a whole lot better than breakeven.

Having cost-less and enduring float (and, at times, even better-than-cost-less) is not a minor strength.

From Warren Buffett's 2012 Berkshire Hathaway shareholder letter:

"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That's like your taking out a loan and having the bank pay you interest."

It's not just the quantity of the float, it's the quality. Buffett then added:

"...we have now operated at an underwriting profit for ten consecutive years, our pre-tax gain for the period having totaled $18.6 billion. Looking ahead, I believe we will continue to underwrite profitably in most years. If we do, our float will be better than free money."

The quality of Berkshire's float is a big source of the gap between Berkshire's book value and intrinsic value.

"So how does our attractive float affect the calculations of intrinsic value? When Berkshire's book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and were unable to replenish it. But that's an incorrect way to look at float..."


"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value."

Berkshire's float being free -- never mind getting paid to hold it -- is far from an industry norm. Property-casualty ("P/C") insurers, of course, receive their premiums upfront then pay the claims at a later time. Well, in the letter, Buffett makes the point that P/C industry premiums have not covered claims plus expenses in 37 of the 45 years.*

So, for the industry as a whole, underwriting losses are the norm. As a result, industry returns for decades have been subpar. In fact, the industry's returns are worse than the average return of American industry more generally. It gets worse:

"A further unpleasant reality adds to the industry's dim prospects: Insurance earnings are now benefitting from 'legacy' bond portfolios that deliver much higher yields than will be available when funds are reinvested during the next few years – and perhaps for many years beyond that. Today's bond portfolios are, in effect, wasting assets. Earnings of insurers will be hurt in a significant way as bonds mature and are rolled over."

Consider what they've accomplished in a bit more than four decades in terms of float. In 1970, Berkshire's float was just $ 39 million.


Long position in BRKb established at much lower than recent prices

* Ending in 2011.
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