The Brilliance of Buffett's Float Strategy
- Oops!Something went wrong.Please try again later.
- By
One of the most incredible parts of Warren Buffett (Trades, Portfolio)'s strategy to build wealth over the past six decades is his strategy of leveraging other people's money.
I need to take a step back here and explain what I mean by this. Since he took over Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), Buffett has embraced the insurance businesses. Insurance is an industry that he knows well, and that's one of the reasons he has such an interest in the sector. But it also allows him access to the investment reserves of these companies in the form of insurance float.
The nature of the insurance business
When a customer buys an insurance policy, they hand over a set fee to the company. This fee then forms part of the company's reserves until it needs to be paid out. It can either be paid out to the policyholder or to other policyholders, or, if not needed to pay claims, it will remain in the company's reserves.
A good insurance company always prices risks in such a way that policy income received for the year exceeds losses. If this figure is negative, it can dig into its reserves.
A large percentage of the industry does not turn a profit on the underwriting side of the business. Instead, these companies rely on income generated by the investment portfolio to make up the difference. How do they get the money to invest? Buffett has frequently referred to Berkshire's investment portfolio as the company's "float." Float is the money paid by policyholders but not paid out in claims. It is this float that insurance companies can use to invest.
The brilliant thing about this strategy is that as long as the insurance business remains profitable, this is not only free money, it also effectively has a negative interest rate because Berkshire does not have to pay anything to use it to generate income from investments. If it were to borrow this money, it would have to pay an interest rate.
This structure is relatively unique to the insurance industry. Technically, Berkshire's float counts as a liability because it may have to pay this money out to policyholders in the event of a significant catastrophe or disaster. In the meantime, it can invest this money. Other companies exposed to significant risks don't have the same luxury.
In fact, many other insurance companies don't use the same approach as Berkshire. They tend to adopt a more conservative investment strategy, placing the bulk of their portfolios in fixed income securities, with only a tiny slice invested in equities or hedge funds.
This is the sort of conservative investment strategy regulators want to see, but if regulators want insurance companies to use a conservative strategy, why have they always allowed Berkshire to take more risk?
Taking more risk
I have no unique insight into regulators' thoughts on this topic, but there are a couple of reasons why I think they might be more lenient with the conglomerate than other companies in the sector.
First of all, all the company's insurance operations have been profitable for the most part, which shows a conservative underwriting policy. On top of this, the group has always owned other private businesses, which produce cash flow away from the insurance division.
At the end of the day, regulators are focused on making sure an insurance company can meet its liabilities. Even if Berkshire's float was wiped out tomorrow, the group would still own one of the largest railroads and one of the largest utility providers in the United States, as well as a selection of other businesses.
So, not only has the Oracle of Omaha been able to build his business empire by effectively using money borrowed with a negative rate of interest, but he has also been able to turbocharge Berkshire's growth by diversifying into private businesses, which has allowed him to allocate more capital to the equity markets than would be traditionally allowed for an insurance group.
This article first appeared on GuruFocus.
