Posted on 05 Mar 2012
Warren Buffett, the former hedge fund manager who built Berkshire Hathaway Inc. into a $195 billion company by gaining leverage through insurance premiums, said this traditional source of new funds is drying up.
Berkshire’s insurance units, which cover risks from fender benders to asbestos-related hospital bills, can no longer be relied on to provide new investment funds in the form of float, or accumulated premium, Buffett said in a Feb. 25 letter. Float, which rose to $70.6 billion as of Dec. 31 from $65.8 billion a year earlier and $39 million in 1970, is unlikely to “grow much -- if at all -- from its current level,” Buffett said.
Buffett, 81, entered insurance in 1967 with an $8.6 million acquisition. The expansion in float, together with Berkshire’s earnings, gave the billionaire funding for his stock picks and acquisitions. The result has been comparable growth in Berkshire’s stock price and float over a quarter-century.
“It’s an engine of growth that is running out of gas,” said Jeff Matthews, a Berkshire shareholder and author of “Secrets in Plain Sight: Business & Investing Secrets of Warren Buffett.” Berkshire “has now officially become a conglomerate. It no longer has the culture of an investment vehicle.”
Berkshire’s success in attracting more insurance business each year than it loses has allowed Buffett to use policyholder funds to buy securities and keep them, in some instances, for decades. “Money we hold but don’t own,” as Buffett called float in 1997, has advanced in 27 of the last 28 years.
Float funding is similar to “a very low-interest” loan, said Tom Lewandowski, an analyst with Edward Jones & Co. in St. Louis. The decision to curb float, which falls when claims paid exceed premiums collected, may limit Buffett’s ability to maintain current investments while pursuing new deals, said Meyer Shields, an analyst with Stifel Nicolaus & Co.
“Float has always been their secret sauce,” said Shields, who has a “hold” rating on Berkshire stock. “This is a pretty dramatic change.”
Buffett accumulated the biggest holding in Coca-Cola Co. (KO) from 1988 to 1994 as Berkshire’s float more than doubled to $3.06 billion. The stake in the beverage maker, which cost about $1.3 billion to build, is held in Berkshire units including insurer National Indemnity Co. and is now valued at more than $13 billion.
Competition among insurers has made it more difficult for the industry to write profitable business, Buffett said last month in the letter, which accompanied the firm’s annual report. If float should eventually decline, “it would almost certainly be very gradual and therefore impose no unusual demand for funds on us,” Buffett said.
Float grew by almost $20 billion in the five years ended Dec. 31, providing Buffett with funds to invest during the financial crisis and economic slump. Berkshire has made net investments of more than $90 billion since the end of 2006 as Buffett drew on the firm’s cash and issued debt and equity.
The resources allowed the company to get returns of more than 10 percent on financing for Goldman Sachs Group Inc. (GS) and General Electric Co. and pay $26.5 billion to take over railroad Burlington Northern Santa Fe.
The only decline in float of the last two decades was a slip of less than 1 percent in 2008, coinciding with claims tied to Hurricanes Gustav and Ike.
Insurance is “Berkshire’s core operation and the engine that has propelled our expansion over the years,” Buffett said in the letter. “The value of our float is one reason -- a huge reason -- why we believe Berkshire’s intrinsic business value substantially exceeds book value.”
Better Than Free
The value of Berkshire’s float depends on underwriters’ ability to price business above the cost of claims and expenses. The company has posted an underwriting profit in each of the last nine years, yielding float that is “better than cost- free,” Buffett said. Todd Bault, global risk and insurance analyst at Sector & Sovereign Research, said Buffett’s cost calculation overlooks the possibility of investments going bad.
“He’s employing double leverage: using the same money for two risky purposes,” said Bault, who cited the use of float to both back policies and fund investments. When Berkshire posts an underwriting profit, Buffett “argues his cost is ‘free’. But that’s wrong: it ignores the cost of risk.”
Berkshire may be scaling back growth in anticipation of greater competition among reinsurers, Lewandowski said. The curb on float growth may also indicate that Buffett’s deals to take on asbestos liabilities in the last five years have reduced Berkshire’s capacity for new risks, said Shields.
Berkshire was paid about $11 billion since 2007 to take asbestos risks once borne by Lloyd’s of London underwriters, American International Group Inc. (AIG) and CNA Financial Corp.
“It’s important to see premiums grow, so that’s a negative,” said Lewandowski, who has a “buy” rating on Berkshire. “I think that will be reflected in shares if you see some consistent decline in insurance float.”
Berkshire has declined 7.6 percent in New York in the last 12 months through yesterday, compared with a gain of 5.2 percent in the Standard & Poor’s 500 Index. Buffett’s firm surged in the 24 years ended Dec. 31 at a compound annual rate of about 16 percent as float grew 17 percent a year. Expansion slowed in the last decade to 4.3 percent for the stock and 7.1 percent for the float.
Buffett has reduced the firm’s reliance on insurance and, consequently, on his ability to pick securities as Berkshire expands manufacturing, energy and transportation operations.
“If the insurance businesses are shrinking then it’s a reversal of the whole leverage model,” said Alice Schroeder, author of “The Snowball, Warren Buffett and the Business of Life” and a Bloomberg View columnist.