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Insurance Float Money

Insurance Float Money

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It’s actually incorrect to say the duration, lag, tail or time horizon of Berkshire Hathaway’s float is short/small. It varies depending on the type of risk that is being assumed.

Float is essentially calculated by the following, per Berkshire Hathaway’s 2002 Shareholder Letter:

“. [W]e have calculated our float — which we generate in large amounts relative to our premium volume — by [my formatting]:

  • [A]dding net loss reserves, loss adjustment reserves, funds held under reinsurance assumed and unearned premium reserves, and then
  • [S]ubtracting insurance-related receivables, prepaid acquisition costs, prepaid taxes and deferred charges applicable to assumed reinsurance.”
  • I would say the float at Berkshire Hathaway comes in generally 3 different durations:

    1) Short duration revolver, credit card-like “float” that funds its claims with incoming premiums in almost a controlled ponzi fashion (i.e. GEICO). For example, the combined ratio year after year for GEICO is around the 90-95% range. This means for every $100 coming in the door in premiums from policyholders, I am paying back policyholders for their auto insurance claims in aggregate $95. And premium volumes are stable and actually growing. What this means is that I can keep funding my liabilities/claims with incoming premiums without ever touching/selling/buying or doing anything with my invested assets. Furthermore, the time lag, duration even for this GEICO and personal auto insurance isn’t that quick either. It varies. The lag in claims payments for auto insurance claims is longer for BI or bodily injury coverage, meaning it takes T + 3, 4 years to pay off more than 80% of all the claims from T = 0, the date on which the coverage started. Whereas the lag for other collision and comp coverage claims payments is 0-2 years or so, with most of those claims (80% or so) being paid out more quickly in the same year of the policy coverage due to less litigation and time needed to adjust and settle the claims than for a bodily injury claim. Here is the lag for Progressive in the chart below. GEICO’s lag is actually longer (on purpose) but this is a good baseline chart for what auto insurance claims payment lag (i.e. duration of float before “maturity”):

    • 2) Short-duration insurance lines, with potentially fluctuating premium levels from year to year. Why would this fluctuation happen? For personal auto insurance above, it’s a mandatory coverage people must buy regardless of whether the economy is doing well or not, as long as you need to drive a car. Furthermore, GEICO is the lowest-cost provider by being able to sell directly (not using independent insurance agents who require 10-15% commission). Progressive is moving more and more to direct, as right now their distribution channel is half direct and half independent agencies and they’ve often been able to squeeze the commissions to below 10-15% from their independent agencies because they drive so much volume. So if you have a product line that’s not lowest-cost, you will need to drive the top-line up and down depending on how hard or soft the insurance market is in the current premium cycle to maintain underwriting profitability. Here, you can’t take as much volatility on the asset side. NICO, the first insurance carrier that Buffett bought in 1967 for $8.6 million, and the carrier to which he attributes as the baby that is responsible for starting it all and is responsible for at least HALF of Berkshire Hathaway’s $373 billion market-cap today, falls into this second bucket of float.

    3) Long-tailed primary insurance and long-tailed reinsurance float. Long-tailed reinsurance float has been the biggest creator of float for Berkshire Hathaway since the arrival of Ajit Jain in 1985. Buffett started getting serious with reinsurance in the early 80’s with loss portfolio transfers (LPTs) but really started in earnest when Ajit Jain arrived in 1985. Jain helped Berkshire become the reinsurer of last resort by reinsuring hairy stuff that many reinsurers would not touch. But given a long-enough tail, even an incremental, additional 4-5% that Buffett could return on the assets backing those liabilities compared to the base 2-4% that most reinsurers were getting from the same amount of assets backing the liabilities, compounded over 10-30 years, makes a massive difference. Compounding for so many years essentially made those liabilities much smaller on an NPV basis for Berkshire Hathaway than for any other reinsurer (even if Berkshire only got 200-300 bps of incremental return). A great example of such “float” liabilities are runoff portfolios like the acquisition of Equitas, a long-dated, seasoned book of asbestos claims from Lloyd’s that was in runoff. The February 2014 loss portfolio transfer (LPT) reinsurance transaction which essentially reinsured a runoff block of variable annuities (VA) policies belonging to Cigna, generated $2-$3 billion of float, with excess loss above a certain amount being backstopped by Cigna. No one talks about that – they pay attention to the Heinz deal that happened a few weeks later. Where do you think some of that money for the Heinz deal came from?

Below is a great analysis of the role of Berkshire’s float from Goldman Sachs in its research report on Berkshire Hathaway in 2010, on a page titled “The Power of Float: collect-now, pay-later”:

“Put simply, float is the amount of money held by insurers on behalf of other parties – the majority of which is typically funds held to pay future claims. With premiums often collected well before losses are paid, the insurer can invest these funds for its own account. Additionally, for longer-tail lines of business, the timing differential can be decades long. Thus, while any given year will see its share of claim payments go up or down, the amount of float held by an insurer will stay relatively steady to its premium in-take. Thus, for an insurer that is not shrinking, the float can take the form of permanent capital.

When valuing Berkshire, we believe it is important to ascribe a value to the float. We believe that the amount of investable capital held by an above-average investor has a tangible value. There are two important distinctions, however:

  • The cost of funds: Over time, there is only value to the float if the investment returns exceed the cost of funds – which for an insurer would be the underwriting profit or loss. As an industry, insurance companies have historically operated at an underwriting loss (i.e. the premiums were less than the combined expenses and claims). Thus, it is Berkshire’s proven ability and stated willingness to focus on profitability (as opposed to growth) in its insurance operations that has allowed the cost of its float to be essentially zero over its multi-decade history. This is also one of the reasons we do not ascribe a value to the float generated by the other insurance companies in our industry, where the track record to assess historical profitability is for most companies too short of a time frame.
  • The “callability” of funds: “borrowed funds” can only be truly invested if there is limited ability for the lender to call the funds. This is what distinguishes BRK’s model from that of a “levered” investment fund – i.e. the funds, for the most part, cannot be redeemed by the lenders (i.e. the policyholders). The one caveat to this however is a catastrophic insurance scenario in which some portion of the float would need to be returned to policyholders. However, as we noted in the section above, BRK’s billions of dollars of cash on hand helps to protect against this scenario.
  • THE VALUE OF FLOAT: If you were to invest a certain sum of borrowed
    capital – where the cost of such funds was zero, there was no “callability” to the funds by the lender, and the entirety of the investment returns accrued to your benefit – you would want to maximize the amount of borrowed capital. This is essentially the value proposition for being a shareholder in Berkshire Hathaway – where the float is the borrowed capital.”

This chart below is a nice graphical illustration from Goldman Sachs, as well, showing the consistent spread below the long-term gov’t bond rate. This spread of at least -5% or 500 bps below the 10-year treasury RISK-FREE rate is evidence of an amazingly cheap source of funding. Berkshire has been borrowing at a cost of capital or interest rate 5% BELOW THE 10-YEAR TREASURY RISK-FREE RATE. Think about that.

How Berkshire Hathaway thinks of reinsurance float: Warren Buffett

Today saw the publication of one of the most interesting shareholder letters of the year, high-profile investor Warren Buffett’s letter to shareholders in his diversified investments, insurance and reinsurance firm Berkshire Hathaway.

Buffett’s Berkshire Hathaway is perhaps the archetypal follower of the hedge fund style, or asset manager backed, reinsurance strategy that Artemis often writes about. Warren Buffett’s insurance and reinsurance businesses generate a significant amount of premium float which he puts to work investing and across his other businesses.

Being so diversified, and cash rich, Berkshire Hathaway’s insurance and reinsurance businesses continue to pay claims and liabilities while the insurance and reinsurance premium float builds and generates significant upside on the investment side of Buffett’s businesses.

This approach allows the Berkshire Hathaway insurance and reinsurance business to profit from its underwriting, something it does well enough alone, and then boost the overall company returns with outsize investment returns from its float investing. The insurance float strategy helps an asset manager, or hedge fund, to significantly increase its assets under management from sources that otherwise would not have invested in their funds and this is more permanent capital than typically raised through funds.

Of course, typically a hedge fund style reinsurance firm is not as large as Berkshire Hathaway, or as diverse, so they stick to lower-volatility underwriting business with longer duration liabilities so that the float can be invested more sustainably. Berkshire Hathaway is so big and diversified across insurance, reinsurance, annuities, health, property and casualty, that this is not so much of an issue.

So, in Warren Buffett’s letter he discusses his insurance and reinsurance businesses and gives away a little of his ideas about float and how it is thought of at Berkshire Hathaway. The insurance and reinsurance story at Berkshire Hathaway is pretty incredible in terms of the growth achieved and the way the float has increased over time.

Warren Buffet wrote; “Berkshire’s extensive insurance operation again operated at an underwriting profit in 2013 – that makes 11 years in a row – and increased its float. During that 11-year stretch, our float – money that doesn’t belong to us but that we can invest for Berkshire’s benefit – has grown from $41 billion to $77 billion. Concurrently, our underwriting profit has aggregated $22 billion pre-tax, including $3 billion realized in 2013. And all of this all began with our 1967 purchase of National Indemnity for $8.6 million.”

Back in 1970 Berkshire Hathaway’s insurance float was $39m, by 1990 it cleared one billion dollars for the first time, at $1.632 billion. Ten years later it had grown to $27.87 billion in the year 2000, by 2010 that was $65.83 billion and by the end of 2013 the Berkshire Hathaway float was a massive $77.24 billion.

Warren Buffett explains how the float works for Berkshire; “Property-casualty (“P/C”) insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over 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 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.”

Traditional insurers and reinsurers tend to invest conservatively, holding their float in assets which are considered very safe but that tend to have low returns. Berkshire Hathaway and the new breed of asset manager or hedge fund backed reinsurers follow more risky investment strategies and work hard to make sure the liabilities they take on are suitably long-duration to support this type of investing.

Float can go down as well as up, Warren Buffett notes, saying that; “Further gains in float will be tough to achieve. On the plus side, GEICO’s float will almost certainly grow. In National Indemnity’s reinsurance division, however, we have a number of run-off contracts whose float drifts downward. If we do experience a decline in float at some future time, it 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 demands for sums that are large compared to our cash resources.”

Here’s the rub though, underwriting profits become free money when what you really want is the float. Buffett explains; “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.”

On traditional insurers and reinsurers, Buffett is not that complementary of the traditional strategy of aiming for underwriting profit and income to drive the businesses returns.

He said; “Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous in most years that it 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. For example, State Farm, by far the country’s largest insurer and a well-managed company besides, incurred an underwriting loss in nine of the twelve years ending in 2012 (the latest year for which their financials are available, as I write this). Competitive dynamics almost guarantee that the insurance industry – despite the float income all companies enjoy – will continue its dismal record of earning subnormal returns as compared to other businesses.”

In essence, Warren Buffett aims for his float to be worth more than the total value of the liabilities that his insurance and reinsurance firms have to pay.

Buffett continued; “So how does our float affect 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 could not replenish it. But to think of float as strictly a liability is incorrect; it should instead be viewed as a revolving fund. Daily, we pay old claims – some $17 billion to more than five million claimants in 2013 – and that reduces float. Just as surely, we each day write new business and thereby generate new claims that add to float. If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability.”

On how Berkshire Hathaway benefits from this float, Buffett explained; “Charlie and I believe the true economic value of our insurance goodwill – what we would happily pay to purchase an insurance operation possessing float of similar quality to that we have – to be far in excess of its historic carrying value. The value of our float is one reason – a huge reason – why we believe Berkshire’s intrinsic business value substantially exceeds its book value.”

Warren Buffett then went on to discuss his reinsurance business, run by Ajit Jain, which is the largest float producing business in Berkshire Hathaway.

Buffett said; “First by float size is the Berkshire Hathaway Reinsurance Group, managed 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 important, brains in a manner 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 avoiding risk than most large insurers. For example, if the insurance industry should experience a $250 billion loss from some megacatastrophe – a loss about triple anything it has ever experienced – Berkshire as a whole would likely record a significant profit for the year because of its many streams of earnings. And we would remain awash in cash, looking for large opportunities if the catastrophe caused markets to go into shock. All other major insurers and reinsurers would meanwhile be far in the red, with some facing insolvency.”

It’s fascinating to get the insight into the Berkshire Hathaway insurance and reinsurance businesses and how Warren Buffett and his managers think about the investable float which is a key factor behind the firms success and growth. Buffett does not always give away so much insight into how his firm thinks about reinsurance business and the float it generates.

Buffett’s comments clearly show why the hedge fund and asset manager backed reinsurance strategy came into being and why it remains a very popular strategy for new launches. It also shows why third-party investors are attracted to reinsurers following this strategy, the opportunity to make market-beating returns can be so much higher with a premium float investment strategy that aims to achieve better-than-market returns.

We’ll leave you with some final thoughts on the insurance and reinsurance business from Warren Buffett, which perhaps give a glimpse into the powerhouse his business has become in the global re/insurance marketplace.

Simply put, insurance is the sale of promises. The “customer” pays money now; the insurer promises to pay money in the future if certain events occur.

Sometimes, the promise will not be tested for decades. (Think of life insurance bought by those in their 20s.) Therefore, both the ability and willingness of the insurer to pay – even if economic chaos prevails when payment time arrives – is all-important.

Berkshire’s promises have no equal, a fact affirmed in recent years by the actions of the world’s largest and most sophisticated insurers, some of which have wanted to shed themselves of huge and exceptionally long-lived liabilities, particularly those involving asbestos claims. That is, these insurers wished to “cede” their liabilities to a reinsurer. Choosing the wrong reinsurer, however – one that down the road proved to be financially strapped or a bad actor – would put the original insurer in danger of getting the liabilities right back in its lap.

Almost without exception, the largest insurers seeking aid came to Berkshire. Indeed, in the largest such transaction ever recorded, Lloyd’s in 2007 turned over to us both many thousands of known claims arising from policies written before 1993 and an unknown but huge number of claims from that same period sure to materialize in the future. (Yes, we will be receiving claims decades from now that apply to events taking place prior to 1993.) Berkshire’s ultimate payments arising from the Lloyd’s transaction are today unknowable. What is certain, however, is that Berkshire will pay all valid claims up to the $15 billion limit of our policy. No other insurer’s promise would have given Lloyd’s the comfort provided by its agreement with Berkshire. The CEO of the entity then handling Lloyd’s claims said it best: “Names [the original insurers at Lloyd’s] wanted to sleep easy at night,
and we think we’ve just bought them the world’s best mattress.”

You can read Warren Buffett’s full letter to the shareholders of Berkshire Hathaway here.

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