Here is Warren Buffett’s genius breakdown of the most important concept in the insurance business

Here’s Warren Buffett on the most important concept in insurance: float.

From his 2014 annual letter (via Ed Borgato):

So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think of float as strictly a liability is incorrect; it should instead be viewed as a revolving fund. Daily, we pay old claims and related expenses — a huge $22.7 billion to more than six million claimants in 2014 — and that reduces float. Just as surely, we each day write new business and thereby generate new claims that add to float.

If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. Owing $1 that in effect will never leave the premises — because new business is almost certain to deliver a substitute — is worlds different from owing $1 that will go out the door tomorrow and not be replaced. The two types of liabilities are treated as equals, however, under GAAP.

A partial offset to this overstated liability is a $15.5 billion “goodwill” asset that we incurred in buying our insurance companies and that increases book value. In very large part, this goodwill represents the price we paid for the float-generating capabilities of our insurance operations. The cost of the goodwill, however, has no bearing on its true value. For example, if an insurance company sustains large and prolonged underwriting losses, any goodwill asset carried on the books should be deemed valueless, whatever its original cost.

Fortunately, that does not describe Berkshire. Charlie and I believe the true economic value of our insurance goodwill — what we would happily pay for float of similar quality were we to purchase an insurance operation possessing it — to be far in excess of its historic carrying value. Under present accounting rules (with which we agree) this excess value will never be entered on our books. But I can assure you that it’s real. That’s one reason — a huge reason — why we believe Berkshire’s intrinsic business value substantially exceeds its book value.

“Float” in the insurance business is what you get when you collect premiums. And so as Buffett lays out, in accounting practice you must assume that all of these accrued premiums could be paid out at one time. This makes your float a liability.

But Buffett, however, argues that every $1 paid out will be replaced by more $1 of new float, making Berkshire’s insurance operations immensely profitable and running for “free” (or better).

Accounting rules, however, prevent Berkshire’s book value from reflecting its intrinsic value as Buffett sees it because these future uses of float in a profitable way can’t be put on the company’s ledger.

Berkshire’s 2015 letter is expected to come out on Saturday morning.

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