Berkshire Annual Letter 1995 (Part 6)
What counts in the insurance business is the amount of float generated (money held but not owned) and the cost of it. There is float because premiums are always paid upfront and it takes time to resolve claims.
Usually, the premiums that an insurer takes in will not cover the losses and expenses that it must pay. This is called an “unwriting loss” and reflects the cost of float.
If this cost of float is lower than market rates for money, then that insurance company is profitable.
At times when there is no underwriting loss, the cost of float is acutually negative, giving “free money”.
In any business, its profitability is determined by three things:
1) What its assets earn;
2) What its liabilities cost; and
3) its utilization of leverage – the extent by which assets are funded by liabilities rather than by equity.
Berkshire has always done well on the first point. What most people don’t realise is that they have also benefited greatly from the low cost of their liabilities.
Often, they are able to generate plenty of float on very advantageous terms.
At the end of 1994, they had $3.4 billion of float. If they had replaced that with $3.4 billion of equity, it would have meant more shares, equal assets and lower earnings attributed to each share.
The acquisition of GEICO will increase their float by $3 billion, with the probability that the cost of the float will be nothing (due to underwriting profits).
Berkshire is able to stand out in the field of super-cat and large risk insurance because of:
1) Their unmatched financial strength;
2) Their ability to supply quotes faster than anyone else.
3) Their ability to issue policies with limits larger than anyone else.
The nature of the super-cat insurance business is such that it can show large profits in many years but there could be occassional years of huge losses. Thus, it will take many years to evaluate the profitability.
Both Warren Buffett and charlie Munger are quite willing to accept relatively volatile results in exchange for better long-term earnings.
However, they will never write business at inadequate rates. A bad insurance contract is like hell; you can get surprises from it even 20 years down the road.