Warren Buffett ( Trades , Portfolio ) is widely considered to be the greatest investor in history. Accordingly, many people view Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) as similar to a fund, or an investment firm. Now, while that may have been true earlier in Buffett's career, these days Berkshire's returns are more a result of the superior structure and management of its subsidiary businesses. This is the key insight from value investor Bill Ackman ( Trades , Portfolio )'s mid-year update to shareholders of Pershing Square.
It's all about insurance
Far from being an investment firm, Berkshire Hathaway is these days primarily an insurance company. Ackman broke down why he believes this will give Berkshire a strong advantage going forward:
"Berkshire's primary asset is the world's largest insurance business, which we estimate represents nearly half of Berkshire's intrinsic value. In its primary insurance segment, Berkshire focuses on the reinsurance and auto insurance segments. In reinsurance, Berkshire's strong competitive advantages are derived from its enormous capital base, efficient underwriting (a quick yes or no), ineffable trustworthiness, and its focus on long-term economics rather than short-term accounting profits, all of which allows the company to often be the only insurer capable of and willing to insure extremely large and/or unusual, bespoke insurance policies."
Harry Markopulos recently wrote a report on General Electric (NYSE:GE), in which the whistleblower accused the company of hiding billions of dollars of losses from its long-term care reinsurance unit. The report alleged that GE has been pocketing the premiums paid by policyholders to pad out its earnings, instead of using that money to build a float to pay out future claims. Only time will tell whether GE specifically is actually guilty of this; however, this kind of behavior has buried many an insurer. Not Berkshire Hathaway:
"The enduring competitive advantages of Berkshire's insurance businesses have allowed it to consistently grow its float (the net premiums received held on Berkshire's balance sheet that will be used to pay for expected losses in the often distant future) at a higher rate and a lower cost than its peers. While Mr. Buffett is best known as a great investor, he should perhaps also be considered the world's greatest insurance company architect and CEO because the returns Berkshire has achieved on investment would not be nearly as good without the material benefits it has realized by financing these investments with low cost insurance float."
Ackman pointed out that while most insurers lose money on their core businesses and have to make it up with investment returns, Berkshire has incurred an underwriting loss in just one of the last 15 years. Moreover:
"For more than the last decade, Berkshire has grown its float at an 8% compounded annual growth rate while achieving a negative 2% average cost of float due to its profitable insurance underwriting."
Insurance is a difficult business, but Berkshire should be well positioned to succeed in this market, even after Buffett is no longer at the reins.
Disclosure: The author owns no stocks mentioned.
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