Warren Buffett has made such an impression on value investors and insurance investors, that they think that float is magic. Write insurance, gain float, invest cleverly against the float, and make tons of money.
Now, the insurance industry in general has been a great place to invest, but we need to think about float differently. Float is composed of two things: claim reserves and premium reserves.
- Claim reserves are the assets set aside to satisfy all claims that likely will be made as of the current date.
- Premium reserves are the assets set aside representing prepaid premiums that have not been earned yet.
Claim reserves can be long, short or in-between. Yesterday's article dealt with long claim reserves - asbestos, environmental, etc. Those reserves can be invested in stocks, real estate, long bonds, etc. But most claim reserves are pretty short, like a year or so for most personal insurance auto & home claims - those typically get settled in a year.
The there are classes of insurance business that are in-between - workers comp, D&O, E&O, commercial liability, business continuation, etc. Investing the claim reserves should reflect the length of time it will take until ultimate payoff.
The premium reserves are very short. If premiums are paid annually, the average period for the premium reserves is half a year. If premiums are paid more frequently, the average period for the float falls, but the premiums rise disproportionately to reflect the insurance company's desire to have the full year's premium on hand. It usually makes sense for policyholders to pay at the longest period allowed - thus, thinking about premium reserves as having a duration of half a year on average makes sense. Except auto - make that a quarter of a year.
Earnings financed by float should be divided into two pieces - non-speculative, and speculative. The non-speculative returns on float reflect what can be earned by investing in high quality bonds that match the time period over which the float will exist. Short for premium reserves, longer for claim reserves. So, the value of float is this:
Present value of (investment earnings of high quality duration-matched assets plus underwriting gains [or minus losses]).
This is a squishy calculation, because we do not know:
- the number of years to calculate it over
- future underwriting gains or losses
The speculative earnings from float come from assuming that float will stay at the same levels or grow over many years, and so the insurer invests more aggressively, assuming that float will be a permanent or growing thing. He speculates by financing stocks or whole businesses using the float that could reduce, or that could become more expensive.
How could that happen? P&C insurance often gets very competitive, and the cost of maintaining float in a soft underwriting environment is considerable. Also note the claim reserves mean that the company took a loss. That the company earns something while waiting to pay the loss does not help much. Far better that there were fewer losses and less float.
Smart P&C insurance companies reduce underwriting in soft markets, and in such a time, float will shrink. Let aggressive companies undercharge for bad business, and let them choke on it, while we make a little less money.
Well-run insurers let float shrink - they don't depend on float being the same, much less growing. If it does grow, great! But don't invest assuming it will always be there or grow forever. That way lies madness.
Berkshire Hathaway (NYSE:BRK.A) has benefited from intelligent underwriting and intelligent investment over a long period. That is not normal for insurance companies. That is why it has done so well. Float is a handmaiden to good results, but not worth the attention paid to it. After all, all insurance companies have float, but none have done as well as Berkshire Hathaway. Better you should focus on underwriting earnings rather than float.
Underwriting insurance produces premium float. Underwriting bad business produces claim reserve float. Float is not an unmitigated good. Good underwriting is an unmitigated good. So focus on underwriting, and not float.
Berkshire Hathaway has been in the fortunate position of having had wise underwriters, and and ability to expand into new markets for many years. Guess what, that was AIG (NYSE:AIG) up until 2003 or so. After that, they could not find more profitable markets to underwrite, and results began to deteriorate. They ran up against the limits of their ecosystem.
Buffett is a brighter man than Greenberg; he can consider a greater realm of possibilities in how to run an insurance conglomerate, and the results have been better. All that said, there is only so much insurance to underwrite in the world, and big insurers will eventually run out of places to write insurance profitably.
All that said - float is a sideshow. Focus on profitable underwriting - that is what drives the best insurers.