Over the past few weeks, I've been taking a look at Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) insurance business. In my opinion, this is the most overlooked part of Warren Buffett (Trades, Portfolio)'s business empire.
Most investors and analysts concentrate on the conglomerate's equity portfolio when analyzing the business's success, but what they fail to realize is that Berkshire's insurance business has been responsible for virtually all of the conglomerate's growth over the past few decades. Indeed, ever since Buffett acquired his first insurance business in the late 1960s, he has been relying on this part of the business to produce "float" or capital to invest.
Here's how the Oracle explained this principle in his 2010 annual letter to investors:
"Insurers receive premiums upfront and pay claims later. ... This collect-now, pay-later model leaves us holding large sums -- money we call "float" -- that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit."
The most important part of this entire process is trust. Customers of Berkshire's insurance businesses have to trust that these businesses will be around to pay out when the time comes.
For the average life, medical malpractice or auto insurance company, this isn't as important, but Berkshire's size means that it attracts risks few other companies would be able to underwrite.
The buyers of the multi-billion dollar insurance policies have to be sure that Berkshire will a) be around in a decade to meet the claim and b) be able to meet the claim if it falls due. This is the group's primary competitive advantage. Buffett has been investing Berkshire's capital so that any customer can be sure that the group will last the test of time.
He spoke about this competitive advantage at the 1996 annual meeting of shareholders. Talking about a new long-term business Berkshire was setting up, which primarily provided annuities to severely injured customers, Buffett said:
"And when the advisors to the injured person think, "Who is going to be around in 50 years to pay money to this person who's been incapacitated," they frequently, and in our view, logically, think of Berkshire. So we have become much better known in that over the last couple of years....
It's not a big business. And it won't be a big business. But it's a perfectly decent business. And it's one where we have a competitive advantage over time. We don't obtain the competitive advantage by price. We obtain the competitive advantage from the peace of mind that the injured party obtains from knowing that that check will be in the mail 50 years from now."
This isn't the only occasion where Buffett has discussed this competitive advantage. However, the example he gave in 1996 is a great case study. Anyone buying an annuity, pension or long-term insurance contract wants to be sure that the company they are buying from will be around in several decades. Berkshire is one of the only companies in the world that has this competitive advantage.
One point to consider is that this competitive advantage is only acquired through time. Over the past few years, a whole range of new tech startups have emerged to revolutionize the insurance marketplace. These startups might have the best technology and plenty of funding, but it will take years for them to earn the trust of their customers. That's something that cannot be bought overnight, and it's Berkshire's most significant competitive advantage. As the conglomerate gets older and continues to build its asset base, this advantage is only going to expand.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Keeping Rational in a Rising Market: Thoughts from Seth Klarman
- 'A Way to Stay Real Rich' - Warren Buffett on the Utility Business
- Buffett's Latest $10 Billion Deal Looks Great for Berkshire
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