Analyzing Float

 |  Includes: IAK, KBWI, KBWP, KIE
by: David Merkel, CFA

One of my readers recently posed the following question:

I’ve been reading your blog for quite sometime and I’ve always been astounded by your vast knowledge of just about everything in investments. I’m new to this game and I hope to learn from you, which brings me to the following:

I know we have to calculate “float”, “cost of float” and find the “combined ratio” for an insurance company to value it more accurately. However, I’ve spent hours googling around and I still can’t find what exactly in the balance sheet/P&L/CF statement (or even in the footnotes!) that constitutes as:

loss adjustment expense, unearned premiums, other policyholder liabilities, premium balance receivable, loss recoverable from reinsurance ceded, deferred policy acquisition costs, deferred charges on reinsurance, related deferred income tax, etc.

In most insurance companies’ balance sheets, all I see are the usual suspects “cash & cash equivalents”, “goodwill”, “intangible assets”, “derivative financial instruments”, “PPE” and the likes. I’ve never seen any of those above-mentioned terms, are there substitute words for them? I’m obviously missing something out. Thank you for your time!

Let’s clear something up here — there is no GAAP financial statement item called float. What is float? Let me teach you something deeper. How does a property & casualty insurer invest?

There is some wiggle room around this, but typically, the premium reserves are invested in high quality short-term debt. Premium reserves represent the premiums paid in advance that have not yet been taken into income, because some insureds don’t pay month-by-month, but they have paid for many months in advance. They are often called unearned premiums.

Claim reserves are typically invested in longer-term debt, where the term of the debt will approximately match the period over which the claim will be paid. Much of the claim reserves fall into the category “Incurred but not Reported [IBNR]. Insurance claims are not always filed immediately.

Finally, the surplus of the insurance company is usually invested in risk assets — equities, private equity, real estate — whatever area the insurance company thinks they have expertise to make money.

The first two categories, premium and claim reserves, comprise float. You can try to measure them by looking at the statutory statements of the insurer, where those are real line items on the liabilities page, or you can approximate it by looking at the current liabilities, and adding in the claim reserve, which is usually in one of the footnotes.

Reinsurance can mess this up a little, so try to work with numbers net of reinsurance.

Property & Casualty Insurers do not have to credit interest as they delay paying claims, or receive premiums in advance. Thus the concept of float. Few insurers use float to be as aggressive as Buffett. They invest more conservatively, especially among insurers where claims get paid quickly (home & auto). With long-tailed claims, like asbestos & environmental, the claims may take so long to emerge that the insurer can be investing in stocks, and that will be the optimal investing decision.

The so-called “cost of float” is net underwriting losses. If there are no net underwriting losses, float is free, or more often, is a source of profit.

But float isn’t worth much unless you have a clever investor investing the cash that stems from the delay of paying claims. Even with Buffett, that advantage is uncertain.

Tell you what, I never analyze float in insurance. I analyze management teams. Insurance is uncertain enough, that I want a margin of safety, and the best way that I can do that is find management teams that are conservative. Do they consistently make money on underwriting? Do they occasionally/frequently deliver negative surprises?

I wouldn’t spend time on float. Any insurer can generate float. Look at how they make money. How do they underwrite? How do they invest? Are they conservative in their accounting? That is what you should look for.