One of the core components of Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) business model is the insurance division. Without this business, I do not think it is unreasonable to say that the conglomerate would be nowhere near as big as it is today.
Insurance is an interesting industry. It can be very profitable, and earn incredibly desirable returns on capital. But it can also be disastrous in the hands of the wrong people.
Insurance is all about balancing risk. Insurance companies offer to take on the risk of insuring a product or service for a set fee, or insurance premium. If the company has done its sums correctly, aggregate fees received from policyholders should exceed total losses paid out on claims every year.
More often than not, companies get these sums wrong. In fact, after paying all of their normal business expenses on top of claims, much of the industry does not make money on the pure insurance business alone. Instead, a large percentage of the insurance industry relies on returns from investment portfolios to cover additional losses.
Berkshire is relatively unique because it generally achieves a profit on its insurance business without including returns from the investment portfolio. There are only a couple of times in the group's history when it is had to pay out more than it has received from policy income.
This creates a fascinating dynamic. When policyholders pay Berkshire, they are essentially giving the group an interest-free loan. Warren Buffett (Trades, Portfolio) can then invest this money as he sees fit. As long as the group remains profitable, he will not have to sell investments to cover losses.
Therefore, the cost of the company's so-called insurance 'float' is generally negative, although that has not always been the case. In 2001, large losses meant that the cost of the float went up to 13%, a relatively high-interest rate for Berkshire's funding.
What is really fascinating about this approach is the fact that with the cost of money essentially being negative, Buffett does not really have to do much at all to grow the float substantially in the long run.
In 2002, the year after one of the worst performances for Berkshire's insurance business on record, Buffett told an audience of the company's investors that with the float costing 13% in 2001, "we didn't have a way to make money," with capital costing a double-digit rate.
However, he went on to add that in the first quarter of 2002, Berkshire's float grew by $1.8 billion. Therefore, it had a negative cost. "We will make a lot of money if we can obtain float at no cost," the Oracle of Omaha explained.
He went on to add:
"The most important thing to do is to focus at getting it at a very low cost. If we get $37 billion at no cost, or very low cost, you know, then if we don't do — if we don't make money with that, shame on us. I mean, the troops have delivered and then it's up to Charlie [Munger] and me to figure out ways to use that money. So the important thing is the cost of the float and not the size of the float, although, obviously, we would like it to grow and we will do what we can to make sure that happens."
I think all investors should spend time understanding how Berkshire's float has helped transform the business over the past few decades. It is also interesting to see how Buffett has been able to leverage other people's money to grow the company's investment portfolio at a cost of less than zero. It would be very difficult for him not to make money with this tailwind.
