Insurance Float
(12-31-2002)
Central to any attempt to value Berkshire is the ability to understand and value the company's enormous ($43+ billion) insurance float. What follows is a weak attempt to justifying adding some value for insurance float when calculating Berkshires intrinsic value.
1. What happens to the float if the insurance business disappears?
In order to keep the math simple I will start with the unhappy premise that Warren, Charlie, Ajit Jain, Joe Brandon, and Tony Nicely are all killed in a plane crash on their way to a baseball game in Tulsa. Warren had been scheduled to be the starting pitcher, Ajit was to play first base, and Charlie was going to play center field.
After the crash the board of directors decides that these people cannot be replaced and that the insurance operation should therefore be placed in runoff.
So what happens next? Bye, bye float, right?
Not exactly.
Note 10 on page 42 of the annual report lists cash payments from the insurance operation in 2002. These payments totaled $4.042 billion for the current accident year and $6.666 billion for all prior accident years. If we average the figures for the last three years, payments have been $4.355 billion for current year and $5.974 billion for all prior years.
Again for simplicity sake, lets say no new insurance is written after the accident and the liabilities remain at the level they were on 12/31/2002 ($43.925 billion).
Additional Assumptions
- Investment income remains the same as 2002 ($3.067 billion).
- Pre-tax operating income of non-insurance companies remains the same as 2002 ($3.574 billion).
- Cash payments for current and prior-year claims remain the same as the last three years.
- We establish a fictional asset account for float, out of which prior-year claims can be paid ($41.224 billion). (See table below.)
- Capital expenditure at operating companies is held to a level that equals the depreciation from these units.
The first year there would be insurance payments of $10,329 billion, $4.355 billion for the current year and $5.974 billion for prior years. This assumes there is no premium income after runoff begins, were as in an actual case there would probably be enough premium income to cover the current year's losses and expenses. There would be investment and operating income of $6.642 billion so we would theoretically have to take $3.687 billion from the float account to meet these obligations. The second year investment income would decrease because there was now less float, but now our pay-out would be less because there are only prior-year claims to pay.
Berkshire Hathaway - Operating Income and Float
| Insurance Payment | Insurance Liabilities | Investment Income | Operating Income | Float Account | |
|---|---|---|---|---|---|
| $43.925 | $41.224 | ||||
| Year One | $10.329 | $33.596 | $3.067 | $3.574 | $37.536 |
| Year Two | $5.974 | $27.622 | $2.777 | $3.574 | $37.913 |
| Year Three | $5.974 | $21.648 | $2.777 | $3.574 | $38.290 |
| Year Four | 5.974 | $15.674 | $2.777 | $3.574 | $38.667 |
| Year Five | $5.974 | $9.700 | $2.777 | $3.574 | $39.044 |
| Year Six | $5.974 | $3.726 | $2.777 | $3.574 | $39.421 |
| Year Seven | $3.726 | $0.000 | $2.777 | $3.574 | $42.046 |
| Year Eight | $0.000 | $2.777 | $3.574 | $48.397 | |
| Year Nine | $0.000 | $2.777 | $3.574 | $54.748 | |
| Year Ten | $0.000 | $2.777 | $3.574 | $61.099 |
By the seventh year, prior-year liabilities would be paid off and there is still $39.4 billion left in the float account. Yes, I know there are all kinds of problems with these assumptions. First of all we know that Charlie would never voluntarily play center field. In addition there is the matter of underwriting expenses, which while greatly reduced in a runoff would never go to zero. Also with Warren absent, the income from finance and financial products business would decrease. On the plus side, operating income should take a large jump next year because of the huge amount of capital that Buffett committed to investments in 2002.
Unlike human beings, all float is not created equal, and it seem to me that Berkshire's particular brand is a whole different animal from what is carried on the books at most insurance companies. It is my opinion Berkshire's float has value to the extent that the company's operating income would cover payments necessary to meet the insurance liabilities that generated the float. Berkshire is unique in this, because it has very high level of operating income relative to insurance written, and because of the large amount of long-tail insurance that it has on its books. This float is cash that we may not own, but if we will never have to give it back, why can we not treat it the same as equity? (If it walks like a duck, and quacks like a duck, etc.)
I do not claim that the figures quoted above will not change, and that we know with any certainty at this time what future income or claims will be. However, what I am proposing is, to the extent that operating income is sufficient, to pay future insurance claims, float becomes an asset, and that to value float you must consider not only the growth, cost, and tail of that float, but also all the income that is available to pay the insurance claims that generated the float.
2. Letter Comments on Valuing Berkshire's Float
Client Letter October 2002
"Omaha Cash Flow" An attempt to rearrange the numbers published in Berkshire Hathaway's Annual Reports for the last ten years. The numbers are the same but hopefully they are presented here in a fashion that provides some new insight into value of the company.Client Letter June 2002
"Owner Earnings, Cash Flow, and Berkshire Hathaway" I have no clear idea how to value the float when computing intrinsic value, but I am fairly confident of two things: 1) money is going to keep pouring into Omaha, and 2) I am not sure that any future attempt to value Berkshire based solely on reported earnings will be satisfactory for me.Client Letter June 2003
"The Power of Float" If the present trend continues, Berkshire's after-tax income this year would equal $6.9 billion, up from $407 million in 1992. This means for the last 11 years Berkshire's after-tax earnings have grown at an average annual rate of 29%.