67: Insurance Float: A Visual

Please excuse my horrible artwork...

I’m taking a break from writing the April edition of Watchlist Investing Deep Dives, which will feature Berkshire Hathaway. Insurance looms large at Berkshire and insurance float is a big part of its value.

Float is simply money that an insurer holds before a claim is either made or paid. There are analogs in other industries but we’ll keep it to insurance for now.

To use a familiar example, if you prepay your auto insurance a year forward the insurance company gets to hold that cash before it’s earned pro-rata over the year. If you get into an accident and the insurance company now owes you a claim, it gets to hold that money until it’s paid out.

Auto insurance is a short-tail line meaning claims are known and paid quickly, usually within a year. Other forms of insurance like workers’ compensation or D&O coverage are long-tail lines where losses could materialize or be paid out decades in the future. Both long- and short-tail lines create float along different time dimensions.

To help visualize it I’ve created a horrible drawing (it looked much better in my head), of a water system with water flowing in through a pipe, collecting in a tank, and then flowing out again. Think of the water as money.

In a short-tail line like auto insurance premiums come in and go out quickly. Increasing float means increasing premium volumes. This is the depth of the pool. Let’s say this insurer writes $10 billion of premiums annually. Float, in this example, is $10 billion, let’s say.

A long-tail line like reinsurance could have the same amount of float with lower premium volume. Let’s say it takes five years to pay the average claim and it does $2 billion of premium volume annually. Five years of $2 billion gets to the same $10 billion of float. Or maybe it’s $1 billion premiums that are held an average of ten years.

It’s basic algebra when it comes down to it.¹ It’s the reason why Berkshire doesn’t really care (to a degree) what types of insurance it writes. It could be asbestos or some other terrible-sounding risk, but that’s not what really matters. BRK caps the amount it can lose on any given policy, so the two variables it really cares about are the amount of the premium in relation to the total risk it is bearing and how quickly claims will pay out. Long-tail lines are all about the time value of money.

Hopefully my Kindergarten-level illustration helps you better visualize how insurance float is created and how it creates value for the insurance company.

P.S. Here’s a work-in-progress playlist of Buffett discussing float at Berkshire.

1. The real world is far more complicated but in general, certain lines have typical payout characteristics.