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Berkshire is a legal pyramid scheme!


jawn619
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Now that I have your attention from the eye catching title, I wanted to talk about something in Berkshire's Annual report that I found really interesting.

 

On page 10/11 of the 2015 annual report, Warren talks about the all important insurance float that brings much value to Berkshire.

 

"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 $24.5 billion to more than six million claimants in 2015 – and that reduces float. Just as surely, we each day write new business that will soon generate its own claims, adding 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, however, are treated as equals under GAAP."

 

Summarized: Cash premiums are collected now, which uncle Warren and Charlie get to invest for the benefit of shareholders. They owe claims, which show up on the balance sheet as a liability. Warren is saying that this liability isn't like debt that comes due and as long as new customers premiums are used to pay off old claims, the cycle continues and the true value of that liability is less than its stated GAAP value.

 

 

 

Please discuss or feel free to flame me for mentioning WB in the same sentence as Ponzi Schemes!

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You misunderstand what a ponzi scheme is. A ponzi scheme requires new money into the system to perpetuate the fraud. What Warren is talking about is because Berkshire can always count on new money to replace existing claims, they are able to delivery superior performance. If you are never dipping into float, then it's reasonable to consider using a good proportion of that float to invest with a longer-term in mind. If new premium money was to fall below payout claims, that doesn't make Berkshire a fraud. It would only mean that Berkshire could be forced into selling securities to cover payouts.

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You misunderstand what a ponzi scheme is. A ponzi scheme requires new money into the system to perpetuate the fraud. What Warren is talking about is because Berkshire can always count on new money to replace existing claims, they are able to delivery superior performance. If you are never dipping into float, then it's reasonable to consider using a good proportion of that float to invest with a longer-term in mind. If new premium money was to fall below payout claims, that doesn't make Berkshire a fraud. It would only mean that Berkshire could be forced into selling securities to cover payouts.

 

Exactly. He's been saying this for a few years. I think he recognized this when he and Charlie bought into Bluechip Stamps: When you don't have to dip into the float it's essentially an eternal loan which functionally makes the money your property. This aspect of Berkshire is very well described in Snowball.

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We've been having a similar discussion on the BRK discussion board about how BRK's float relates to debt, and whether it should be considered leverage in the ordinary sense.  Essentially float (assuming a well-run insurer - no mean feat) is like LT debt that can be refi'd indefinitely and has low or negative coupons.  You can't borrow money on those terms for the most part.  And better yet, a retail insurance business (eg car insurance) won't experience greater pressure from claimants during a financial meltdown - although reinsurance is a different kettle of fish.

 

The point that WEB often glosses over a bit is than insurance is a tricky tricky business - perhaps even more so than banking.  Particularly with reinsurance, it might be 20, 30, or 50 years before you determine the true cost of carry.  There's a reason he refers to derivatives as "financial WMDs" - a few of those almost ripped into the hull of the unsinkable pre-08.  There are few living who understand the insurance business as well as B does and know how to exploit it for exceptionally low-cost capital through financial economies of scale - and that's what worries me.  If Buffett died today and Berkshire made a stupid insurance purchase tomorrow, it might take ten years for the bomb to go off.  That's the main advantage of debt - you know when the claims will come due and how big they will be.

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