Berkshire 's single most important business is insurance, consisting of Government Employees Insurance Company (GEICO), General Re, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group. These four generated $58.5 billion in float as of year-end 2008 and during the year earned $25.5 billion in premiums and $2.8 billion in pretax profits.
In general, insurance companies make money in two ways. First, like any other business, they can make an operating profit by charging more than they pay out in expenses (in this case, claims plus overhead). Over time, the best insurance companies are lucky to break even on their operations. Second, and this is where insurance companies can become fabulous businesses (and investments), they can invest the float—the premiums charged to customers, but which have not yet been paid out in claims—and pocket the returns as profit.
Berkshire Hathaway's returns over time have been driven by extraordinary success in both areas. First, Berkshire 's insurance operations, over time, have been consistently profitable, meaning the cost of float has been negative. In other words, Berkshire has effectively been able to borrow money at a cost significantly below that of the U.S. government. That's quite remarkable.
At year-end 2008, Berkshire had $58.5 billion in float, up from $22.8 billion 10 years earlier, after the acquisition of General Re (that's 9.9 percent compound annual growth). The growth and negative cost of float—coupled with Buffett's superior investment talent—have had the effect of turbo charging Berkshire 's results over time.
GEICO sells auto insurance directly to consumers, cutting out the brokers and other intermediaries used by almost all of its competitors, and thus it can offer lower prices while making higher profits. It was founded in 1936 and was one ofWarren Buffett 's first major stock purchases in 1951. It is the third largest auto insurer in the United States, having grown its market share from 2.0 percent in 1993 to 7.7 percent in 2008, and is poised to continue this growth. In his 2008 annual letter to Berkshire Hathaway shareholders, Buffett wrote: "As we view GEICO 's current opportunities, Tony and I feel like two hungry mosquitoes in a nudist camp. Juicy targets are everywhere."3 (Tony Nicely has been at GEICO for 48 years and has been CEO since 1993.)
Berkshire Hathaway's reinsurance business includes both General Re and Berkshire Hathaway Reinsurance Group, which specializes in "super cat' ' policies ("cat" stands for catastrophe). A typical super cat policy might be written when, say, Allstate insures homes on the Florida coast against hurricane damage. Allstate 's total exposure could be billions of dollars, so it will sell some of its exposure to reinsurance companies like Berkshire 's.
The economics of the reinsurance business are volatile: A reinsurer might pocket hefty profits in years with few claims, but will have to pay out very large claims in some years, such as 2005 when hurricanes Katrina and Rita hit. The competitive advantages of Berkshire Hathaway's reinsurance businesses are its willingness to write very large policies, unsurpassed capitalization to back up them up, long-standing presence and unsurpassed reputation in the market, global reach, and the ability to make quick underwriting decisions. It also has the singular ability to withstand long periods of declining business activity if pricing isn't commensurate with the risks taken. Buffett doesn't care about market share or business volume; he cares about being properly compensated for the risks taken. Very few reinsurers have this type of discipline.
Given Berkshire 's success, why don 't other insurers use their float to buy companies and stocks rather than mostly bonds? The reason is that the float is needed to pay claims, so insurance regulators, rating agencies, and investors will not allow most insurance companies to invest more of their float in equities, which can be quite volatile (as we 've certainly seen recently!). But Berkshire Hathaway is an exception, for reasons explained by then-PaineWebber analysts Alice Schroeder and Gregory Lapin in a January 1999 research report:4
Berkshire is the only insurer with an unlimited investment universe and maximum flexibility to allocate capital. Thanks to its track record of superb investing and superior capitalization, the Nebraska insurance department, the rating agencies and investors give Berkshire Hathaway investing latitude not granted to any other insurer. This enables Berkshire to invest for an equity return any capital that it is not using in the insurance business, eliminating the "burden" of subpar returns on excess capital. Because no competitor has, or could develop in a reasonable time horizon, an inves tment record similar to Berkshire 's, we believe that this is an overwhelming and practically permanent competitive advantage.
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