Flirting with Floats: Part I

There is a company which has the world’s strangest bond outstanding. Strange, because this bond has no maturity date. Stranger, because the bond issuer pays no interest on it. Strangest, because year after year, the issuer gets paid to have this bond on its balance sheet.

What better source of financing is there than one in which neither do you have to return the borrowed money, nor are you charged any interest to use it? In fact, you are paid to use it!

This is not a small bond issue in some obscure little country. As of end December 2011, this bond had a book value of about $71 billion and the issuer is an American company having a current market cap of $205 billion.

I am, of course, referring to the “float” enjoyed by the insurance businesses of Warren Buffett’s Berkshire Hathaway. “Float” in the insurance business, says Buffett, “arises because most policies require that premiums be prepaid and, more importantly, because it usually takes time for an insurer to hear about and resolve loss claims.”

This float, which has grown from $17 million in 1967 to an astounding $71 billion by the end of 2011, is a key reason behind Warren Buffett’s fame and fortune.

OPM: As Addictive As Opium

Float, as he explains is “money we hold but don’t own,” which, by the way, is how one would describe “other people’s money” or “OPM”, of which debt is the most common form.

The problem with plain-vanilla debt, however, is that its quite onerous for borrowers. When you borrow money conventionally you have to: (1) pay back the loan by some definite date; (2) pay the lender interest on the money borrowed over the course of the loan period; and (3) put up adequate collateral until full repayment of loan has been made. How very onerous!

Over the last 45 years, Berkshire’s insurance float enabled the company to effectively borrow huge amounts of cash, with no set repayment date, and with no tangible collateral put up. Even more astonishing is the fact that this money cost Berkshire less than nothing.

How did this happen?

For a typical insurer, the premiums it takes in do not cover the losses and expenses it must pay. That leaves it running an “underwriting loss” – the cost of float – which is the functional equivalent of interest on conventional debt. An insurance business is profitable over time if the cost of its float is less than the cost the company would otherwise incur to borrow funds. The business will have a negative value if the cost of its float turns out to be higher than market rates for money.

For Berkshire, the cost of its float, over the long term, has been less than zero. The net result of all this is that Berkshire has not only been able to borrow funds at a cost which is less than that of the U.S Treasury, it has been been paid to borrow that money.

It’s already well-known that the value of this large float with a negative cost has been huge for Berkshire’s owners. After all, access to tens of billions of dollars of less-than-free capital in the hands of one of the world’s greatest allocators-of-capital, has to be winning combination, isn’t it?

However, no matter how good an allocator-of-capital Warren Buffett is, that has little to do with the value of Berkshire’s insurance float to its owners. That’s because of a principle of finance (MM on Capital Structure) according to which the value of a firm’s assets have little to do with how they are financed. So, we mustn’t let Buffett’s brilliant track record in capital allocation influence us on how we should think about Berkshire’s insurance float. But we do need to understand just how does that float create value for Berkshire’s owners. That’s because, once we have understood how to evaluate Berkshire’s float, we will use that knowledge to understand other types of floats in a variety of business models.

Berkshire’s cost-less float can be best understood by comparing it with other forms of financing. When compared with plain-vanilla debt, it is obvious that borrowed funds which cost money, require posting of collateral, and which have to be repaid by a definite date are vastly inferior to Berkshire’s float which suffer from none of these disadvantages.

Warren Buffett on Insurance Floats

It’s when we compare Berkshire’s insurance float with equity, things gets really interesting. Buffett explained this point in his 1995 letter:

“Since our float has cost us virtually nothing over the years, it has in effect served as equity. Of course, it differs from true equity in that it doesn’t belong to us. Nevertheless, let’s assume that instead of our having $3.4 billion of float at the end of 1994, we had replaced it with $3.4 billion of equity. Under this scenario, we would have owned no more assets than we did during 1995. We would, however, have had somewhat lower earnings because the cost of float was negative last year. That is, our float threw off profits. And, of course, to obtain the replacement equity, we would have needed to sell many new shares of Berkshire. The net result – more shares, equal assets and lower earnings – would have materially reduced the value of our stock. So you can understand why float wonderfully benefits a business – if it is obtained at a low cost.”

He explained it again in his 1997 letter:

“Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.”

And again in his 2007 letter:

“Insurance float – money we temporarily hold in our insurance operations that does not belong to us – funds $59 billion of our investments. This float is “free” as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur. Of course, insurance underwriting is volatile, swinging erratically between profits and losses. Over our entire history, however, we’ve been profitable, and I expect we will average break-even results or better in the future. If we do that, our investments can be viewed as an unencumbered source of value for Berkshire shareholders.”

And finally in his 2011 letter:

“So how does this attractive float affect intrinsic value calculations? Our float is deducted in full as a liability in calculating Berkshire’s book value, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to view float, which should instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this liability is far lower than the accounting liability.”

General Principles

The lessons in these four excerpts from Buffett’s letters are just about all we need to know to evaluate not just quality of Berkshire’s float, but that of just about any other float. Here, then, are a few general principles:

  1. Floats are wonderful if they cost less than nothing. They are also wonderful if they are free;
  2. Perpetual floats are better than non-perpetual ones;
  3. Funds provided by free, or less-than-free floats, are more attractive than those raised through conventional debt or even equity; and
  4. The true value of a liability represented by an attractive float is far lower than its accounting value.

Invert, Always Invert

One way to see how the true value of an attractive float is far lower than its accounting value is to use the “inversion” trick often used by Charlie Munger by looking at the problem from the float provider’s viewpoint.

Imagine that you subscribe to a bond issued by a company at Rs 100. Imagine further that this bond carries no interest, and has no definite repayment date. For the moment, suspend your disbelief and ignore the question “Why the hell would I ever buy subscribe to such bond?” Just assume that you did.

How would you value this “perpetual, zero coupon bond?” What price would any rational person pay you for your bond? Almost nothing, isn’t it?

Now let’s invert the situation again and at look at this example from the viewpoint of the bond’s issuer. The bond appears as a liability on the issuer’s balance sheet at Rs 100. Now, if the corresponding asset on your balance sheet is almost worthless, should not the true value of this liability also be almost worthless from the issuer’s viewpoint? Of course it should!

Now let’s add a twist. Imagine that for some reason the company must pay back Rs 100 it owes you, but that it can find someone else to give money to it on identical terms so that even if you get paid, the company’s overall liability on account of the float remains unchanged. In effect, the company gets to use OPM to retire a liability represented by OPM. Even if some of the older providers of OPM have to be made whole, they are paid through refinancing on identical terms by newer providers of OPM. If this sounds like a ponzi scheme (without its derogatory connotation), then you’re right on spot!

A Revolving Fund

That’s precisely what Buffett meant when he wrote the above-mentioned extract in his 2011 letter, which I am reproducing here with emphasis on key words:

“Our float is deducted in full as a liability in calculating Berkshire’s book value, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to view float, which should instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this liability is far lower than the accounting liability.”

Unencumbered Source of Value

So long as one is certain that the size of a free float will not diminish over time because it resembles a “revolving fund,” one should value such a book liability  at virtually nothing. And when that happens, then assets financed by such a float become “unencumbered.” This is what Buffett meant in his above-mentioned 2007 quote which I reproduce again with emphasis on key words:

“Insurance float – money we temporarily hold in our insurance operations that does not belong to us – funds $59 billion of our investments. This float is “free” as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur. Of course, insurance underwriting is volatile, swinging erratically between profits and losses. Over our entire history, however, we’ve been profitable, and I expect we will average break-even results or better in the future. If we do that, our investments can be viewed as an unencumbered source of value for Berkshire shareholders.”

This insight – as to how do assets, when financed with cost-less floats become unencumbered, will be instrumental in our understanding the role of floats in evaluating the economics of businesses outside of the insurance industry.

That’s the subject matter of a subsequent post.

To be continued…

16 thoughts on “Flirting with Floats: Part I

  1. harishbihani says:

    Thanks sir. Eagerly awaiting the next post.

  2. Sir, looking from Taleb’s point of view…..Isn’t insurance business exposed to negative black swans?…..Like take for example AIG….For a number of years, this float can be a cheap source of fund, infact cheaper than equity…but one fine day, the unexpected might happen….

  3. rohitc99 says:

    ramachandra – AIG did not get hurt by insurance claims. they had (almost closed now) unit called AIGFP which sold cheap CDS on RMBS which turned out worthless. thats like insuring a warehouse full of dynamite where the owner then throws a match in

    the cost of float for AIG also has been a few hundred basis points …ofcourse not as cheap as berkshire

    prof – dont want to spoil the surprise …but i am guessing you are planning to cover companies which work with minimal AR and large accounts payables or take large customer advances ?

  4. rronak1234 says:

    Hello Sir,

    Excellent Post. I guess you would be talking about companies with negative working capital, where they receive advances from customers (int. free), which they can park to create assets. In case the order gets cancelled and they have to repay advance, this could be funded from other advances received from other customers, as they would receive advances from several customers as a part of their business operations.
    It’s brilliant….

  5. Arpit Ranka says:

    Great article, Sir!

    Being ever skeptical, when it comes to banking and insurance industry about projecting past performance into future (even with BRK given that half of its float is in super catastrophe/reinsurance), whereby the yearly under-writing profits enjoyed so far could look like peanuts and reverse the economics of float from costing them ‘less than nothing’ to a lot, I was going through the annual report to understand it better..

    Here is an excerpt, which highlighted Buffett’s worst-case scenario evaluation.. Its Buffett’s credibility more than anything else which makes one trust this evaluation and conclude that the skepticism could be misplaced.. but not sure how many people are out there whose judgments we can trust when its a matter of do or die for the enterprise as a whole..

    Also, using Buffett metaphor of a great business being one which any fool can run (without jeopardizing its franchise).. I am not sure if BRK’s insurance arm can be clubbed as a great business as eventually Mr. Buffett and Mr. Jain will not be looking after the two critical aspects of making this float work for them beyond a decade or two..

    From Annual Report 2011: “First by float size is the Berkshire Hathaway Reinsurance Group, run by Ajit Jain. Ajit insures risks that no one else has the desire or the capital to take on. His operation combines capacity, speed, decisiveness and, most importantly, brains in a manner that is unique in the insurance business. Yet he never exposes Berkshire to risks that are inappropriate in relation to our resources. Indeed, we are far more conservative in that respect than most large insurers. For example, if the insurance industry should experience a $250 billion loss from some mega-catastrophe – a loss about triple anything it has ever faced – Berkshire as a whole would likely record a moderate profit for the year because of its many streams of earnings. Concurrently, all other major insurers and reinsurers would be far in the red, and some would face insolvency.

    From a standing start in 1985, Ajit has created an insurance business with float of $34 billion and significant underwriting profits, a feat that no CEO of any other insurer has come close to matching. By these accomplishments, he has added a great many billions of dollars to the value of Berkshire. Charlie would gladly trade me for a second Ajit. Alas, there is none.”

    • Yes Arpit, I think it would be very hard to replicate the skills of Mr. Buffett and Ajit Jain. I am not suggesting it would be easy. All I am saying is that Mr. Buffett has been extremely creative in producing floats of many kinds (covered in parts I & II), and those floats have played a very major role in the success of Berkshire. I am also using this series to give my thoughts on what’s the right way to think about floats for passive investors in the stock market, and the relationship between floats and moats which will be covered in part III.

      Thanks for your inputs.

  6. rohitc99 says:

    arpit
    insurance is definitely a business which cannot be run by a monkey ..on contrary if a monkey does run it, like in case of AIG, the company can go bankrupt very easily, without an investor realising it
    case in point – gen re which warren buffett bought and then realised that they had been under-reserving and it took him 6-8 years to fix the culture.
    however if you have a the right person like warren buffet in berkshire then insurance is a very profitable business as prof bakshi has pointed out. also buffett has indicated that they are constantly looking at total loss exposure (max loss) in any event …as in long tail insurance one cannot estimate the probabilties with any certainty

    you may want to look at FFH (fairfax holdings) in canada which is headed by prem watsa and he is called the warren buffett of canada (for good reasons). very similar in operations and this company is a partner in icici lombard.

    so you are right in the sense, that insurance is truly a management driven business. good management can do wonders, whereas the wrong one can bankrupt it …much like banks isnt it ?

  7. […] Note: This post is a continuation of a previous post titled “Flirting with Floats: Part I.” […]

  8. manishmns says:

    Sir , I understand that understanding Floats is good as an Investor and How Floats helped WB to amass such a great fortune ( of course not denying the capital-allocating skills of Mr.Buffett). As an Indian Investor all Insurance companies are non-listed . I have two queries :
    1) which business have the float ?
    2) How can a business person create floats ?

  9. svetlanakoslov says:

    Very interesting as I am a bond investor

  10. […] Flirting with floats-Parts 1,2,3  (FundooProfessor) […]

  11. […] doing a series of posts on this subject, recently, I presented my thoughts to students at MDI. That presentation […]

  12. […] more on the relation between moats and floats read this excellent series by Sanjay Bakshi at the “Fundoo […]

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