Graham Osborn Posted April 4, 2018 Share Posted April 4, 2018 Hi there, looking for some help. I've been studying the way Buffett calculates the cost of float in his letters, and it seems wrong to me. This is the formula he uses: "cost of float" = (underwriting profit or loss)/ (net loss reserves + loss adjustment reserves + funds held under reinsurance assumed - agents balances - prepaid acquisition costs - prepaid taxes - deferred charges applicable to assumed reinsurance) The problem is that what you are really interested in is the total cost of a policyholder relative to premiums paid by that policyholder. In the case of a "steady-state" insurer (one where premiums received and claims paid out are both relatively constant over time) you can calculate that cost on a population basis. I did a little simulation ("constant float") of what that would look like for a hypothetical group of policyholders that each pays in at the start of year 1 and makes a claim for the same amount at the start of year 5. As expected, this generates a constant level of float so long as inflows and outflows remain constant. Note that the cost of float is zero in steady-state - again as expected. Notice also that the float appears unusually cheap (so much so that you're getting paid to hold it) until the "tail" begins (the longer the tail, the longer the period of apparently low-cost float). Now the interesting case is where the insurer never reaches steady state because premiums grow each year ("diverging float"). This is the case at Berkshire. Note that in this case float is costless for as long as the premiums continue to grow. Notice this has nothing to do with the quality of the underlying underwriting and everything to do with an ever-increasing supply of fresh premiums that haven't yet hit tail. The final case is one of declining premium volume - a point that most aging insurers will reach sooner or later. In this case float appears very expensive for the entire period using Buffett's formula - although the underlying underwriting quality was identical. Hopefully you understand my concern now. The calculation Buffett does makes float look great even with poor underwriting so long as the premium growth continues. But there would conceivably come a point where - as premium growth inevitably slows - that poor underwriting would start to manifest as an increasing cost of float. And by the time Berkshire reached steady-state float, they'd be contending with extremely high-cost capital that they couldn't give back. I worry that catalysts could be reduced compounding in float and book in future years - a certainty. Buffett made some serious underwriting screwups in the 70s and I worry that this a uniquely long-tail diagnostic issue. Float is - after all - still leverage, and leverage always has a downside. cost_of_float.xlsx Link to comment Share on other sites More sharing options...
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