Why Warren Buffett Loves Reinsurance

In his most recent letter to Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) shareholders, Warren Buffett discussed why the company originally got into the insurance business and why reinsurance is particularly appealing to it. Here's a rundown of the current state of its insurance business and why it has been the bedrock of Berkshire Hathaway's success for more than 50 years.

How insurance became (and remained) the cornerstone of Berkshire Hathaway's business

If you aren't familiar with the history of Berkshire Hathaway, the company was nothing more than a struggling textile manufacturer when Buffett bought a majority of its stock and took the reins in 1964.

However, Buffett didn't have much of an interest in turning around a textile business. In fact, he had agreed to sell his Berkshire shares back to the then-current managers of the company for a substantial gain -- and until the managers refused to honor the agreed-upon price, that's exactly what he intended to do. Buffett was so upset that he bought even more Berkshire stock. Enough, in fact, that he had the power to fire the company's manager, which he did.

Buffett did, however, love the insurance business.

Berkshire's first venture into the insurance business was its acquisition of National Indemnity in 1967. Though it paid a $1.9 million premium over book value for the insurer, it received $19.4 million of float, which is the money collected as premiums from customers but not yet paid out as claims.

Here's the point: Buffett and his team could invest this cash while waiting to pay claims and keep 100% of the investment profits. In other words, Berkshire paid a $1.9 million premium, but received more than 10 times that amount in other people's money to invest.

Today, the float from its insurance business isn't Berkshire's only source of capital to expand. Its subsidiary companies also generate cash flow, which can then be reinvested. Even so, it is this concept of float that allowed Berkshire to develop its massive portfolio of subsidiary companies as well as its closely watched stock portfolio, and it remains a key component of its strategy. Today, Berkshire is the largest property-casualty insurance company in the United States in terms of float, with $114.5 billion.

Why reinsurance fits Buffett's investing goals

Because Buffett's main goal is to invest the float during the time period between when premiums are paid in and claims are paid out, the logical goal is to focus on forms of insurance that tend to take the longest amount of time to pay out claims -- a concept known as "long-tail" insurance businesses.

Now, Berkshire's best-known insurance operation, GEICO, is not one of these. Auto repairs are paid out almost immediately after a claim is filed.

However, people not too familiar with Berkshire are often surprised to learn that GEICO is a relatively small part of Berkshire's insurance business. The majority of its insurance business is reinsurance, which essentially means insurance for other insurance companies. For example, in order to avoid excessive losses due to a natural disaster, a property-casualty insurer might purchase a reinsurance policy that covers losses above a certain amount.

Reinsurance is not only a long-tail business, but Berkshire specializes in jumbo reinsurance policies that let it assume long-tail losses of other insurers. Its leading position in this type of insurance has allowed its float to grow tremendously over the years, and also lets the company maximize the returns from investing this money.

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Matthew Frankel owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.