Warren Buffett and the Float

Why property insurance costs will continue to go up, shaking real estate markets

I like listening to Warren Buffett's voice. I do. I like that he's 93 years old and running shareholder meetings with folksy, gravelly gravity. I like that he says he's been doing the same thing for decades. So when the news broke last week that Berkshire Hathaway had spent nine months buying nearly $7 billion in insurance giant Chubb Ltd. stock, I was intrigued. And it seems to me that the story behind this investment has implications for the intersection of rapidly accelerating climate change with property insurance.

In a nutshell, insurance companies generate free money—premiums paid by policyholders—that can be invested for higher returns. That's why private equity firms (as well as publicly-traded Berkshire Hathaway) love acquiring and partnering with insurance companies. They're like banks that pay you to borrow money from them. The better an insurance company is at picking who it insures in the first place, and how carefully (and sometimes slowly, or not at all) it pays any eventual claims, the better an investment it is. 

When it comes to property insurance, this system can work out reasonably well for everyone in a competitive, supervised marketplace within a context of predictable, largely unchanging, climate risks. But that's not the world we live in.

It's more likely that we're emerging with a structure in which a few very large players dominate particular market segments, exercise pricing power in those segments, and exit those that don't make business sense to them. At the same time, thinly-capitalized, smaller, geographically concentrated marginal insurers may crumple quickly when they have to make substantial claims payments—in part, perhaps, because they experienced unfavorable investment returns or were looted for their cash flows. And state backup insurance plans, those FAIR plans I've written about before, will continue to balloon until they, too, go insolvent.

Given all this, and in light of the information asymmetries and accelerating effects of extreme weather that exist in the world today, it's tricky to point to the insurance industry as a separate actor that should be acting altruistically and proactively to help homeowners recover from weather disasters and smooth the transition to a better, safer future. Insurers are part of a large financial structure in which almost everyone involved has no real incentive to change behavior. Rapid increases in property insurance bills will continue to surprise homeowners and make more and more homes feel both unaffordable for current owners and undesirable for future buyers. 

It turns out it's all about "the float." And to understand the float, all you have to do is listen to Warren Buffett. 

One of the reasons Warren Buffett is revered is that he explains why he makes particular investments. Back in 2000, he told investors that the "main business" of Berkshire Hathaway (a conglomerate that now has a $876 billion market cap) was insurance: "It's the best one I know about that we can do in increasing scale over time," he said during that year's investor meeting. 

Policyholders pay premiums long before losses are paid. During that interval, which can extend over many years, the insurer can invest the money. That's "the float." Policyholders tend to keep signing up year after year, so up-front premiums arrive predictably—"which are then available for investment." 

Buffett called this process a "pleasant activity." 

For decades, he's been on the hunt for insurance companies with a proven track record of profitable underwriting—which means that the total costs and expenses involved in providing insurance are lower than the amount of premium coming in. Indeed, if that ratio is sufficiently favorable the free money from premiums is effectively accompanied by a modest investment return—as if investors of the float were being paid to deploy policyholders' cash for their own purposes. Profitable underwriting over time includes the ability to raise premiums when needed to keep that costs/premium ratio low, so companies facing less price competition or oversight in their particular lines of business are particularly prized. As an investor, you want to see price increases over time that are at least tracking inflation, or preferably exceeding that rate. 

Buffett recognizes that the tradeoff for this very pleasant use of float is that there will be, eventually, losses and expenses when policymakers make claims. Several years ago, Berkshire apparently had a practice of taking on claims-handling for insurers that wanted to put their pasts behind them (e.g., asbestos and environmental claims), and then delegating that operational responsibility to a separate company, Resolute Management, Inc., that was very aggressive in reducing and slowing down payouts—and attracted a number of lawsuits. 

Why would Berkshire do this? To get the float, the cash reserves the former insurers had set aside to pay claims, for its investment purposes. Whether or not Berkshire still hives off claims-handling to separate entities so as not to infect the rest of its business with legal liability, it's useful to understand that keeping payouts to policyholders as low and slow as possible is part of this overall structure.* 

The Chubb investment that was revealed last week fits this overall story.

(The SEC gave Berkshire permission to keep the investment confidential while it was buying shares over the last nine months. That's interesting, too, but a separate subject.)

Chubb, now one of the 10 biggest holdings in Berkshire's portfolio, has a long track record of keeping costs low and premiums high. It's the world's largest publicly traded property insurance company. In the US, Chubb is known as a market leader in property insurance for high-net-worth families, dominating the rapidly-growing niche business of insuring properties in Florida, California, Texas, Louisiana, and New York that are in the "Excess and Surplus" category—where insurers have more freedom to set their own rates and policy terms without asking for state regulatory permission. Chubb is also very large in commercial insurance. All of this means risk selection and pricing power is part of Chubb's strength. There's a big moat around Chubb's business that would be very difficult for a new entrant to cross. 

Berkshire now owns about six percent of Chubb, but might want to own it all some day. Just listen to Warren Buffett, from a year ago:

Property-casualty insurance provides the core of Berkshire's well-being and growth. We have been in the business for 57 years and despite our nearly 5,000-fold increase in volume—from $17 million to $83 billion—we have much room to grow.

The more you can reduce your overall ratio of expenses to premiums, the more you can wring out money from the system to invest in other ways. Operating efficiencies increase as you service more customers while spending the same amount to run the business. Increasing returns to scale are part of the pleasant story of float. 

Once you understand float, it's easy to see why private equity investors are also interested in partnering with or acquiring insurance companies. This week, Liz Hoffman of Semafor Business labeled what's going on "the private-equity industry's insurance gold rush." She reports that, "As of last summer, US private equity firms owned 137 insurers and controlled one in every $15 paid by policyholders, according to the industry’s own tally." Most of this is life insurance, with property/casualty holdings amounting to 4 percent of the total, but the picture is shifting quickly. Many investments in our financial system are driven by private asset managers that are using the float to provide capital. Insurance companies themselves invest hugely in corporate and municipal bonds.

What does all this have to do with climate risks and property markets? It shows that many financial actors are aligned in wanting to keep steady premiums coming in, and some will want insurers to consolidate to keep those operating costs and payouts low.

Countervailing pressures are few. Because all regulation of and information about the property insurance world is at the state level, there are often few guardrails in the form of competition or oversight that might keep companies from raising premiums, consolidating, and picking favorable market segments to serve. Upstart local entrants may show up promising to provide insurance, but they will be serving markets the larger players don't want to sell to. If reinsurance (insurance risks passed on to unregulated global insurance companies) is even available, it will be more expensive for everyone, and those costs will be passed to policyholders to the extent possible. The larger players also have better information about climate risk. 

This is likely to lead to very expensive insurance for those who can afford it, and awful or non-existent and also more expensive insurance for others. Both of these outcomes have consequences for real estate markets around the country. 

Meanwhile, the drumbeat of extraordinary weather events will make homeowners even more desperate to stay insured. They'll "recognize their need to buy promises only from insurers that have enduring financial strength," as Buffett put it in his 1987 letter.

That's a good thing for Buffett's beloved float.

A different Buffett

*If you're interested, take a look at the similar and equally morally hazardous idea of "runoff insurance," where acquiring companies dump the potential claims liability of newly-acquired entities into separate corporate buckets.