Amid all the coverage of Warren Buffett (Trades, Portfolio)'s investment activities, it's very easy to overlook the performance of Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) core insurance business.
Insurance is the beating heart of Buffett's conglomerate. Over the past six decades, cash flow from Berkshire's insurance operations has provided capital for Buffett to invest at a much lower rate of interest than he would have been able to achieve elsewhere. Indeed, Buffett's own calculations estimate that the cost of this capital, or as he calls it "float," has been negative for many years.
When the float's cost is negative, it essentially means that Berkshire can borrow cash from its insurance clients at a negative rate of interest. When the insurance business is making a profit, the rate is negative.
However, when the division has to pay out to meet losses, Buffett has to pay so the float rate essentially becomes positive (or he has to pay to borrow the money to invest). Put simply, when the insurance business is profitable, Buffett has free money to invest. When it's losing money, Berkshire is losing money.
Losses rise
In most years, Berkshire's insurance business has earned an adequate level of profit. However, 2020 has not been like most years. The pandemic, coupled with one of the most active hurricane seasons on record, has been a double gut punch for the insurance market.
Berkshire has not been able to escape the market carnage. According to the firm's third-quarter SEC filing, for the first nine months of 2020, the firm's two core insurance businesses, Berkshire Hathaway Primary Group and Berkshire Hathaway Reinsurance Group, saw total underwriting losses of around $2.1 billion. For some comparison, for the first nine months of 2019, these two divisions reported a loss of only $10 million.
Berkshire's overall insurance result was nowhere near as bad, however. The firm benefitted from two factors. First of all, GEICO, which is not included in the other two insurance businesses, benefitted from lower insurance claims during the pandemic and a higher number of customers looking for a value offering in tough times. The same trend played out after the financial crisis, which provided Buffett with a large chunk of extra capital at just the right time. Thanks to those two tailwinds, for the first nine months of 2020, GEICO's total underwriting profit was $3.3 billion, which was more than double the figure for the same period last year.
As well as the GEICO boost, Berkshire also reported a profit from its insurance investment income. At the end of September, the group owned $333 billion of investments across its insurance businesses. Of this, $228 billion was invested in equity securities, $83 billion in cash and Treasury Bills and $19 billion in fixed maturity securities. On these assets, during the first nine months of 2020, Berkshire earned $3.6 billion in dividend income and nearly $900 million in interest and other income. After taxes, net investment income was $3.8 billion. When combined with the positive underwriting income from GEICO, this was enough to push the insurance business into profit for the nine months to the end of September.
As such, Berkshire avoided a positive float cost for the first nine months of the year. As the SEC report noted:
"Our average cost of float was negative for the first nine months of 2020 as our underwriting operations generated pre-tax earnings of $1.2 billion."
This is a testament to Berkshire's operating model. The diversification across the insurance businesses has helped the firm prosper in a highly hostile insurance environment over the past year. This size is, in itself, one of the conglomerate's most significant competitive advantages.
Disclosure: The author owns shares in Berkshire Hathway.
Read more here:
- Warren Buffett Has Sold $29 Billion Worth of Stock so Far in 2020
- Berkshire Hathaway Buys Back Record Amounts of Stock in 3rd Quarter
- Warren Buffett: Why Politics and Investing Never Mix
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