Warren Buffett’s much-anticipated 50th anniversary letter to Berkshire Hathaway investors was published on Saturday and the ‘Sage of Omaha’ explained that insurance and reinsurance has been “the engine” that propelled the firm’s expansion.
Buffett’s was the first to truly discover the value of insurance premium float, by building huge pools of capital that he could put to work across his diversified investment focused business. As such he is the inspiration of many of the hedge fund strategy reinsurers, and the envy of many traditional insurers and reinsurers.
Berkshire Hathaway has such a strong capital base, as a result of the Warren Buffett strategy, that the largest insurers and reinsurers turn to Berkshire when they need a counterparty who can put down the largest lines in the industry and who they trust to be there to pay claims in another 50 years time.
So, it’s always insightful to take a look at some of the sage’s comments and in the 50th anniversary investor letter Warren Buffett gives away some of more of his thinking behind the way Berkshire has leveraged insurance and reinsurance premium float, as well as how important re/insurance has been to enable Berkshire Hathaway to become a huge and profitable business empire
Buffett’s letter includes a history lesson on Berkshire Hathaway’s entry into the insurance and reinsurance world, explaining; “That industry has been the engine that has propelled our expansion since 1967, when we acquired National Indemnity and its sister company, National Fire & Marine, for $8.6 million.”
Just think about that for a moment. The largest re/insurance business empire in the world began from an $8.6 million acquisition. That small acquisition, which was still a significant sum in 1967, has now morphed into a re/insurance business that in 2014 generated $2.7 billion of underwriting profit and over the last twelve years which have all been profitable, $24 billion.
Buffett said that “insurance was in my sweet spot”, an industry that he understood and saw as a way to generate both huge profits as well as huge premium float for investment purposes.
During the twelve successive profitable years of underwriting at Berkshire Hathaway the firm has generated a massive amount of premium float. “During that 12-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 $84 billion,” Buffett explained.
The float is something Buffett always explains in his letters, because; “Though neither that gain nor the size of our float is reflected in Berkshire’s earnings, float generates significant investment income because of the assets it allows us to hold.”
This is the Buffett ‘secret sauce’, or at least it was until others discovered that float does not just have to be held in safe assets like treasuries and that if you have enough float, with sufficient and varied durations of liabilities and expected claims, you can put it to work much more aggressively and expansively.
Buffett said that float was a key reason for attracting him and Berkshire Hathaway to the property and casualty insurance and reinsurance industry.
“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 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 benefit,” he wrote.
And insurance premium float keeps growing as you keep underwriting, resulting in growth of the assets that can be used for investment purposes. Buffet continued; “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.”
The growth of Berkshire Hathaway’s premium float since it launched into the insurance business back in 1967 is quite stunning.
In 1970 the float was just $39m, which while small was actually generated pretty quickly from an industry the firm had only entered three years prior. By 1980 the premium float at Berkshire had expanded significantly to $237m. Then by 1990 the float hit $1.632 billion, in 2000 it reached $27.871 billion and the accumulation of float kept on accelerating to $65.832 billion by 2010.
Over just the last few years the growth of Berkshire Hathaway’s insurance premium float kept rising faster and faster and the firm now reports a huge $83.921 billion of assets at its disposal in float. It’s no surprise the firm can invest such huge sums in established global businesses, such as Coca Cola, American Express, IBM and Wells Fargo.
However, Buffett cautioned his investors on expecting this float to continue growing. His insurance and reinsurance businesses can only be so expansive, especially in a challenging market environment. Plus, at some stage some of the bigger liabilities Berkshire Hathaway has taken on will begin to see increasing claims levels that could erode the float. However this is expected.
Buffett explained; “Further gains in float will be tough to achieve. On the plus side, GEICO and our new commercial insurance operation are almost certain to grow at a good clip. National Indemnity’s reinsurance division, however, is party to a number of run-off contracts whose float drifts downward.”
In fact a decline in the float is possible, but the expected rate would not be significant Buffett wrote; “If we do in time experience a decline in float, it will be very gradual – at the outside no more than 3% in any year.”
The fact is that having built up float by underwriting insurance and reinsurance business over years, with many of the contracts longer-tail risks, the claims will come but they will be spread out over years into the future making a run on the float very unlikely.
“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. This strength is a key pillar in Berkshire’s economic fortress,” Buffett’s letter explains.
The float is one thing, but operating a profitable underwriting business to generate this is equivalent to having “free money” Buffett wrote. It’s no surprise that the more recent wave of hedge fund backed reinsurance firms are striving to operate at sub-100 combined ratios despite their higher investment return targets.
“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.”
However the industry as a whole has not been so lucky.
“Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous indeed that it frequently 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,” Buffett wrote.
And he went on to explain more about why the insurance industry is suffering, perhaps due partly to its ultra-conservative use of the float it generates.
The letter continues; “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. The prolonged period of low interest rates our country is now dealing with causes earnings on float to decrease, thereby exacerbating the profit problems of the industry.”
Buffett went on to explain more of his thinking on re/insurance float, how he and Berkshire Hathaway approach its use and consider it as a pool of investable capital. It’s worth reading some of our coverage of last year’s Buffett letter which explained more about how Warren Buffett and Berkshire Hathaway think of reinsurance float.
“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 and related expenses – a huge $22.7 billion to more than six million claimants in 2014 – 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.
Owing $1 that in effect will never leave the premises – because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the door tomorrow and not be replaced.”
Buffett said that one of his reinsurers, General Re’s float “has been considerably better than cost-free.” His other reinsurer, Berkshire Hathaway, has under the watch of Ajit Jain “created out of nothing an immense reinsurance business that produced both a huge “float” and a large underwriting gain.”
Buffett’s letter also includes some industry commentary and he went to some lengths to explain that scale does matter when you’re Berkshire Hathaway, as it places you as the counterparty many want to do business with as the firm is expected to be the most reliable for really large contracts in the world.
“Simply put, insurance is the sale of promises. The “customer” pays money now; the insurer promises to pay money in the future should certain unwanted events occur.
Sometimes, the promise will not be tested for decades. (Think of life insurance bought by people 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.”
Buffett has built something enduring over his 50 years and the time since Berkshire Hathaway first bought that insurance business for $8.6m has seen the firm develop into one of the largest financial power houses in the world.
As yet, nobody is truly emulating the expansive and float based model of Berkshire Hathaway. The hedge fund reinsurers follow a similar approach, but the investments are different, being hedge fund focused rather than taking such big bets on businesses that Buffett has done.
The growth of Berkshire Hathaway’s insurance and reinsurance businesses has been incredible over the last decade or two as well, with the accelerating generation of premium float a major contributing factor to the rapid scaling out of these entities.
Will we ever see anyone truly emulate the Buffett model, being as expansive or as willing to take big bets on businesses with their premium float? Perhaps, or perhaps a new model will emerge that enables the premium float to be enjoyed while leveraging a lower-cost source of capital or a more efficient business model.
However, Buffett does not feel that all of the insurance and reinsurance competition are being particularly disciplined currently, in the softened rate environment, explaining the need to “be willing to walk away if the appropriate premium can’t be obtained.”
“They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance.”
Wise words from the Sage of Omaha that the traditional, hedge fund backed and alternative insurance and reinsurance markets would do well to heed.
You can read Warren Buffett’s full letter to the shareholders of Berkshire Hathaway here.