Most people know about insurance industry terms such as premiums (the money a policyholder pays every month or every year for an insurance policy) and claims (the money an insurer must payout when the policyholder gets in a car accident, has a medical operation, etc.).
But do you know what happens to your paid premiums once they’re actually sent to the insurance company?
Insurers don’t pay out all the money they collect right away. Rather, an insurance company will collect money in the form of premiums, invest that money, and then pay out claims as needed at some future date. The difference between premiums collected and claims paid out is called insurance float.
It’s a lot like how a bank will collect deposits, invest that money (through loans to other people or companies), and then will repay your money at some future date when you eventually make a withdrawal.
Insurance float has been a huge contributor behind Warren Buffett’s success with Berkshire Hathaway. Because premiums received are essentially like loans from policyholders (that only need to be paid back when a claim is made sometime in the future), Buffett has been able to use insurance float as leverage when investing in stocks and private companies, which has a significant (positive) impact on the company’s return for its shareholders.
It’s part of the reason why Berkshire Hathaway’s book value and market value have grown at ~20% per year since 1965 compared to just 10% per year for the S&P 500 (including dividends)!
So, let’s dive a little deeper into what insurance float exactly is and how Warren Buffett uses it to his advantage.
Warren Buffett and Berkshire Hathaway’s Insurance Float
As mentioned above, insurance float represents the available reserve, or the amount of funds available for investment once the insurer has collected premiums, but is not yet obligated to pay out in claims.
In his 2002 Berkshire Hathaway Shareholder Letter, Warren Buffett explains:
So insurance float is the difference between premiums received today over claims that must be paid many years in the future. During that time, the insurer invests the money. Insurance float is so valuable that insurance companies often operate at an underwriting loss – that is, the premiums received are not enough to cover the eventual losses (hurricanes, car accidents, etc.) that must be paid and the expenses required to resolve those claims, operate the business, etc.
Why would an insurer operate at a loss? Again, because the insurer can invest the insurance float and make even more money. In this sense, insurance float is like a loan and the underwriting loss is like the interest rate on that loan (i.e. cost of capital).
Now, for most insurers the cost of float is usually a few percentage points. Berkshire Hathaway’s insurance operations, however, are so well run that the company’s historical cost of float has actually been positive… meaning Berkshire Hathaway is actually being paid to take other people’s money!
Here’s an even more in depth explanation of insurance float from Warren Buffett’s 2016 Berkshire Hathaway Shareholder Letter:
At the end of 2016, Berkshire Hathaway’s insurance float totaled $91.6 billion! And because Berkshire Hathaway’s insurance operations are run at an underwriting profit, the company’s insurance float is essentially like a $91.6 billion interest-free loan that Berkshire is actually being paid to take (Buffett says Berkshire earned $28 billion of pre-tax income over 14 years – in other words, the Company was basically paid $2 billion a year to borrow $91.6 billion, which it could then use to invest).
Now, compare this investing model to that of private equity firms or hedge funds, who also use leverage to invest… but instead of cost-free insurance float, these PE funds and hedge funds usually use high yield loans with interest rates of 7%+ per year.
Moreover, Berkshire Hathaway’s insurance contracts are structured in such a way that it will never have to pay back more than 3% in any one year – while a high yield loan might have to be paid back in full if a private equity company or hedge fund’s performance falls below a certain level.
It’s really no wonder that Warren Buffett is the second richest person in the world.