Legendary investor Warren Buffett (Trades, Portfolio) is known for his superb investment skill. His company, Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial), has grown consistently for more than 50 years.
In addition, the company's share price has risen from $18 in 1965 to $307,000 at the time of writing, compounding 19.8% annually.
Apart from Buffett's investment talent, another key success factor for Berkshire Hathaway is its group of insurance companies. These insurance companies have produced an increasing amount of float for Buffett to invest in high-quality businesses. Let’s dig deeper to understand how they have helped Berkshire Hathaway grow.
Insurance exists to help protect people from unexpected losses. The company receives a premium upfront and pays claims later. Essentially, the collect-now, pay-later business model produces a lot of temporary free cash flow, which is called “float.” Insurers often invest this float to maximize returns. Thus, insurance businesses have two sources of income: underwriting income and investment income.
The underwriting income is generated from a company's insurance operations, the management of premiums and claims, while the investment income is generated from investment returns. If the underwriting income is positive, it means the insurers were paid to hold other people’s money. If the underwriting income is negative, it means the insurers paid to generate float.
In his 2017 letter to shareholders, Buffett mentioned that prior to 2017, Berkshire Hathaway had recorded 14 consecutive years of underwriting profit, with the total amount being $28.3 billion in pre-tax profit. Indeed, Berkshire Hathaway’s insurance business has grown considerably over the past 50 years. Since 1970, its premium volume has increased from $39 million to nearly $60.6 billion, while the float has risen from $39 million to $114.5 billion.
Berkshire Hathaway’s insurance business began when Buffett purchased National Indemnity in 1967 for $8.6 million, a premium to its book value at the time. He was attracted to the frequent underwriting profit the business had delivered and its $19.4 million in float.
Berkshire Hathaway has also been hit by unexpected losses, however, which resulted in underwriting losses. In fact, the three large hurricanes that hit Texas, Puerto Rico and Florida in 2017 drove Berkshire’s losses to more than $3 billion for the year. This was not a huge loss, however, as it reduced the shareholders' equity by less than 1%. As a result, the company's cost of float was approximately 3%, slightly lower than the AAA corporate bond yield of 3.4% to 6.3%.
With a strong balance sheet, careful insurance operations and Buffett’s investing talent, Berkshire Hathaway will continue to thrive, delivering strong returns to shareholders.
