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.