Source: StockMonkeys.com .
The insurance industry is baffling to many policyholders and investors alike. People often don't realize that one of the biggest money-making opportunities in insurance comes not from smart decisions about which risks to take on, but rather from the opportunity to use money held between the time customers pay their premiums to the time insurers have to pay it back out in claims. This temporarily available money is also known as float, and investing the float wisely has been the backbone of the strong returns of some of the greatest insurers in the business, including Berkshire Hathaway .
Why float matters
On its face, insurance companies' business model seems pretty straightforward: get a huge number of policyholders to pay regular premiums for coverage, and make sure that what you charge more than covers the claims that only a small fraction of those policyholders will make in any given year. Be smart about who you cover and how much you charge, and whatever you don't pay in claims is left as profit.
But float can make a big difference in both profitability and how competitive an insurance company is. Part of clients' insurance premium payments are used to cover the company'soperating expenses, but most of that money goes toward establishing loss reserves on which the company can draw as you and other policyholders file claims. For some types of insurance, such as auto insurance, insurers know very quickly when accidents happen and how much they'll owe in claims. But with other insurance, such as medical malpractice liability coverage, it can take years for loss events to make their way through litigation, giving insurers a long time to hold their float before they eventually must make final payments on claims.
Source: Northeast Underwriters.
Traditionally, many insurers invested their float in ultra-safe investments such as bonds, accepting relatively low returns to ensure that money would be available when necessary to pay out claims. Yet some insurance companies have realized that as long as they are collecting new premium revenue, they can manage their float at relatively constant levels, allowing them to expand their time horizons and make higher-return investments in the stock market and other securities. Berkshire is a particularly good example of this, with its vast portfolio of publicly traded stocks and wholly owned subsidiaries financed largely from float and the company's profits from float.
How can you tell how much float an insurance company has?
From an accounting standpoint, float generally starts with the loss reserves the insurance company establishes on its balance sheet to hold money it hasn't yet paid for losses. You then add in any unearned premiums the company has collected for future coverage periods, as well as other policyholder-related liabilities the company hasn't yet paid. From that amount, subtract any receivables from premium payment plans, deferred policy acquisition costs, and associated amounts such as deferred reinsurance and income tax charges.
Warren Buffett's Berkshire Hathaway uses float quite effectively.
That can look hard to calculate, but the companies that use float the best tend to tell you in no uncertain terms just how much they have. For instance, Warren Buffett's most recent annual letter to shareholders showed that Berkshire had $77 billion in float at the end of 2013, up from just $41 billion 11 years earlier. That increase played a large role in Berkshire's share-price gains over the past decade.
Float isn't the most commonly discussed term in the insurance industry, and it's not one you'll see mentioned in your insurance policies. For investors, though, float is a key concept, and the best companies take the greatest advantage of float in their operations.
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The article Insurance Industry Basics: Float originally appeared on Fool.com.
Dan Caplinger owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .
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