Warren Buffett Explains The Genius Of The Float : Planet Money In his latest annual letter, Buffett explains a key concept at the core of Berkshire Hathaway's success.

Warren Buffett Explains The Genius Of The Float

Warren Buffett's latest annual letter to Berkshire Hathaway shareholders is out. As usual, it's a good read.

There are a bunch of interesting passages, including an explanation of why so many companies overpay when they make acquisitions, and a call for "meaningful sticks" to be used against CEOs of bailed out companies.

The letter also has a useful explanation of "float," an idea that's at the core of Berkshire's success, and that's central to the way the insurance industry works. In short, float is the money that an insurance company gets to hold onto between the time customers pay premiums and the time they make claims on their policies.

(Note that when Buffett says "P/C industry," he's referring to property/casualty insurance, which is defined here.)

Here's Buffett on the float:

Insurers receive premiums upfront and pay claims later. ... This collect-now, pay-later model leaves us holding large sums -- money we call "float" -- that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit. ...

If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money -- and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float. ...

Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most -- though certainly not all -- future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.

Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry's overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses.