Berkshire Hathaway's (BRK.A) CEO makes no secret of his fascination with the investment possibilities opened up by insurance company float. Insurance companies receive a steady flow of premium income, and hold the money, sometimes for years, until it finally is paid out as losses. In the meantime, investment returns add up.
But the following remark, in his most recent shareholder letter, merits a closer look, and some discussion and analysis:
... Charlie and I believe the true economic value of our insurance goodwill - what we would pay to purchase float of similar quality - 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 book value.
Buffett's point is, that float appears on an insurance company's books as liabilities - loss and unearned premium reserves. However, if premium income is equal to or less than paid losses over a substantial period of time, the company has low or no cost funds to invest. The long term use of low cost money is worth quite a bit.
He thinks of this additional value as goodwill - an asset. Goodwill gets a bad name, as the accounting residue of bad acquisitions, sooner or later to be written down. But in the sense Buffett is using it, it is the portion of intrinsic value that exceeds tangible assets. Coca Cola (KO) and Procter & Gamble (PG), two favorites, have goodwill in this sense.
Quantifying the Value of Float
Unless underwriting results are breakeven or better, the value of float is considerably diminished. Insurance company liabilities may not be stable - during the bad years for asbestos and environmental liability, some companies found their reserves were inadequate by 10% or more, necessitating painful reserve adjustments, sometimes on an annual basis.
To this could be added a second reservation - when investing other people's money, it's important not to lose it. You might need to recapitalize, never good for shareholders, who will be diluted.
As an agent of USF&G, back in the late 80's and early 90's, I watched in wonder as the company recorded splendid investment results, fueled by a concentration in commercial mortgages. Ralph Nader suggested the company had financial problems, which they denied. The real estate involved was well diversified, by industry and geography. What remains of USF&G is now part of Travelers (TRV).
Allstate (ALL), CNA Financial (CNA) and Hartford Financial (HIG) all experienced some difficulty with investments in CRE, CDO's, CMBS and RMBS during the financial crisis. Having lost other people's money, they were obligated to replace it, by raising capital, borrowing TARP funds, or retaining earnings that otherwise could have been paid out as dividends.
Buffett's investment gains were not earned by savvy investments in high yielding bonds. They are derived from equity investments.
Cincinnati Financial (CINF) at one time was well known for having a very large amount of equity investments, mostly in dividend paying stocks. Many of them were financials, to include an outsize investment in Fifth Third Bank (FITB). Soon enough the value of the equity portfolio dwindled, as FITB encountered difficulties.
Before considering float as a source of intrinsic value, the investor should verify that underwriting results are profitable and stable, and that investments are managed prudently. If both of these requirements are met, then it is realistic to think of intrinsic value as being higher than book value.
Factors Affecting P/B Multiples
As a way of understanding Buffett's thinking, I did some work on scatter charts that illuminates some of the factors affecting Price/Book Multiples. Here are some charts:
This makes sense. Cincinnati Financial is not being punished for a very bad year in 2011. It seems that investors are looking past the punishment inflicted by a very tough year for tornadoes.
Consistency of investment results counts for something. The companies with the most consistent investment results are clustered in the upper left at P/B's between 1.0 and 1.2. I left Hartford Financial out of this study, because it was a serious outlier. It would be out there at a standard deviation % of 235%, and a P/B of 0.40.
This requires some explanation. As a way of getting at the leverage created by float, I computed investment income as a % of shareholders equity, using pre-tax figures. R(2) at 0.61 is not that bad. This demonstrates that investors don't like companies that don't have ample shareholders equity to support their policy liabilities. The float becomes too risky.
Berkshire Hathaway's P/B
Insurance is no longer the primary operation for this conglomerate. While the company's P/B is 1.19 at recent share prices, many of its businesses aren't appropriately evaluated using that metric.
Looking at the other businesses, the Annual Report notes that their revenue has been growing at approximately 20% annualized over the past ten years. Buffett anticipates that the company will be doing other acquisitions with its large cash hoard, a realistic expectation. I've had good results looking for a P/E of 17 for companies that can consistently grow at 7% or better. 7% going forward is a lot less than 20% historical.
How Do They Deploy the Capital?
The forgoing treats Berkshire Hathaway on a par with insurance holding companies that will deploy excess capital into doing more insurance, or else return it to shareholders as dividends or buybacks.
Buffett has an excellent track record doing acquisitions, and hiring and retaining skilled managers who can operate businesses successfully in a decentralized organization. So the non-insurance portion of Berkshire can grow both by acquisition and organically. The insurance businesses continues as a source of funds, to include the float. This deployment of capital can be expected to be more productive than what other insurance companies are doing, and merits a higher multiple.