Advantages Of Insurance Float
Hey there In this article I'm going to walk through how the legendary investor Warren Buffett used the insurance companies that he owns to build his wealth to be more than 80 billion dollars.
Now we all know that Warren Buffett is known as one of the greatest investors of all time if not the greatest investor. So let's look at how he did it. And unfortunately this video is not going to be an illustration of how we investors can duplicate what Buffett did but it will point out how he did.
Thanks to his ownership in insurance companies and maybe we can get some pointers as when we analyze insurance companies. So the key to Warren Buffett's amazing returns is really ultimately his ability to pick great long term companies.
But there is a math trick that really helps with his returns that most people can't duplicate. Well really it's an insurance thing that allows for Buffett to get returns that no one else has been able tomatch. So if we go back to Warren Buffett's recent annual letter well, on the first page we can see that Berkshire Hathaway has a nineteen point one compounded annual growth rate since 1965.
And Buffett was kind enough to point out that the average return of the P 500 over that same time period was just short of 10 percent. But with this very impressive 19 percent annual gain it's important for us to realize that this gain is the gain to the book value of Berkshire Hathaway.
And this is the perfect number to use because if we want to value insurance company using price to book value is the ideal way of doing it. So the goal of any insurance company should be to grow their book value. And I bring this out because this is key to realize that what Warren Buffett has done is he has grown the book value of his company by more than 19 percent a year.
So the question is how does he do this. And the secret lies in the insurance companies that he owns. I reviewed my analysis of the Travelers Companies. They're an insurance company so I'm going to use traveler's numbers to illustrate how Buffett pulled off a 19 percent growth rate of Berkshire Hathaway's book value and then I'll tie it to the modern version of Berkshire Hathaway.
Now this is not intended to be an analysis of travelers. In fact the numbers that are in use are very very loose numbers but they are based on travelers numbers. It's not even intended to be an analysis of Berkshire Hathaway. It's the concepts whereafter.
Okay so the first thing that we should do is make sure we're all on the same page regarding what book value is. So here's the formula for the balance sheet assets equals liabilities plus owner's equity. Now owner's equity and book value are generally the same thing. So we're going to replace owners equity with book value. Now let's add some numbers.
So travelers has assets of about 100 billion dollars. And then they have liabilities of but 80 billion dollars. Now that means that book value must be about 20 billion dollars since the two sides must balance. OK now just to recap the way an insurance company works so in and turns company collects payments from their customers they are called premiums and then they collect them from a whole bunch of different customers from all over the place.
And then when a claim comes in well the insurance company goes ahead and they pay that claim. The insurance company keeps a giant pile of cash that they've brought in and they've yet to pay out. Although in theory they will need to pay it out in the future.
Buffett calls this pile of money the float. This brings us back to a balance sheet formula. So this insurance company Traveler's Insurance has about 50 billion dollars in their float. This is money that they expect to one day have to pay out. This makes the 50 billion dollars a liability.
So of this 80 we know that 50 is being held for future payouts. But this 50 is actually cash. So we're more than likely it's probably investments but either way it's an asset. So let's stop right here and take a closer look.
So right now if we assume that this insurance company did not earn a profit or loss based on their insurance business. So if they go out and they sell more insurance and they bring in more premiums and they pay some out but they don't make either profit or a loss well nothing would change. As far as the value of the company instead of a float of 50 if they were able to increase their float to let's say 60 by selling additional insurance and paying out claims assuming no profit well both liabilities and assets would go up by 10 to 60.
But now let's switch back to 50 and let's assume that they invest that 50. And also let's assume that they get a 10 percent return on that money. Now that's a bit high of a target return for an insurance company but let's pretend so they get 5 of the 50 that they invested thanks to an impressive 10 percent return.
Well that 5 billion returns gets added to the income statement. And most of it goes to the bottom line and if the insurance business itself had losses well they this 5 billion would help offset those losses if it gains well this 5 billion would add to the gains making them even more profitable.
Now assuming nothing else changes no additional dividends are paid or no buy backs are down or anything like that. Well the profits that go to the income statement that are not paid out will they end up in the equity section of the balance sheet or as we're calling it in the bookvalue section.
Now technically the way it would work is that the profits would end up in a line item called retained earnings on the balance sheet that'swithin the equity section. Either way the result is the samebook value moves higher liabilities doesn't move at all since it does matter return 10 percent or 2 percent.
Either way we're going to owe the same 50. But this is the amazing part of the insurance business and ultimately the amazing part to Buffett's success and his use of the insurance business. So let's add that five billion to our book value will now book value jumped from 20 to 25.
Liability stays exactly the same at 80 in assets jumps to 105. Both sides of the balance sheet remain in balance which is perfect. That's exactly what we need. But the amazing part is when we start to do the math what was the growth rate for book value.
Well we can see that the growth rate was 25 percent which is a crazy impressive return from investing standpoint. Now we could've actually done this math quite simply without going through this entire process. All we have to do is look at the assets being invested and compare that to the size of the book value in our example we had 50 billion dollars in assets being invested and the book value was 20 billion.
Therefore the assets being invested was 2.5 times the size of the book value. So a 10 percent increase is a 25 percent increase in book value. If a float had been 40 Well we would have had two times the size of book value. So a 10 percent return wouldhave given us a 20 percent gain to book value.
Now in the case of Berkshire they're actually so large at this point and they own so many different companies that their book value is actually larger than their float. But this doesn't take away the advantage it might take away the multiple of the advantage. But either way if Buffett has 100 billion dollars in float and the book value of the company is 200 billion.
Well if he returns the same 10 percent on the investments of the float. Well that would add 5 percent growth to the book value. And this doesn't include any of the returns on all the other businesses that Buffett owns. Perhaps those businesses generate a solid growth rate of 8 percent on their own.
Well thanks to the insurance float returns now that that return for that year turns out to be 13 percent. Assuming we add the 5 percent to the book value. And that's how you end up with such fantastic returns like Buffett has now. I think this is also useful for anybody analyzing insurance companies.
That's actually how I came up with the idea for this article because as I was doing my research for a traveler's video well I thought people might find it interesting to learn how much the float helps add to an insurance company's returns many insurance companies aren't that profitable in the insurance business alone because it is such a competitive business.
But the investments allow for returns to be amplified like we saw. And that makes a business very profitable for them. But what do you think. Did you find this video interesting would you think of a topic in general. Let me know what you think in the comments below.
