BERKSHIRE HATHAWAY FLOAT MEMO

In valuing BRK’s insurance operation, one of the main valuation short cuts I use is that:

$1 of investments (including cash and cash equivalents) per share = $1 of value per
share.

Buffett has been using this metric (investments per share) to value the insurance business
since at least 1995. [Buffett uses two metrics to value the whole of BRK: (i) investments
per share, and (ii) pre-tax non-insurance earnings.]

Investments on BRK’s insurance balance sheet reflect approximately (i) BRK’s

surplus capital, and (ii) BRK’s float.

BRK’s insurance business is over capitalized. During 2005’s annual meeting, Buffett
asserted that BRK could dividend $52BN to shareholders and still write the same amount
of insurance business comfortably. So,

$1 surplus capital / share = $1 of value / share. Hopefully, this is self-evident.

That leaves Float.

Does $1 Float / share = $1 of value / share?

In BRK’s case, yes.

First clue: great insurance companies tend to trade at premium to their book value. For
example, Markel Insurance (MKL) one of the most disciplined insurance underwriters
trades at ~2x book value.

Similar to how accounting book value is unable to value a brand business like Coca-Cola,
insurance book value is also unable to reflect the economic reality of a good insurance
company.

*****

Float is:

“is money we hold but don't own. In an insurance operation, float arises because
most policies require that premiums be prepaid and, more importantly, because it
usually takes time for an insurer to hear about and resolve loss claims.” (1995 AR)

Buffett has always calculated BRK’s float in the AR. But, according to Buffett float can
be calculated by:

“adding loss reserves, loss adjustment reserves, funds held under reinsurance
assumed and unearned premium reserves, and then subtracting agents' balances,
prepaid acquisition costs, prepaid taxes and deferred charges applicable to assumed
reinsurance” (1995 AR)

*****

Over the years, Buffett has made various comments that point to $1 of float being at least
equal to $1 of value:

“Since our float has cost us virtually nothing over the years, it has in effect served as
equity. Of course, it differs from true equity in that it doesn't belong to us.
Nevertheless, let's assume that instead of our having $3.4 billion of float at the end
of 1994, we had replaced it with $3.4 billion of equity. Under this scenario, we
would have owned no more assets than we did during 1995. We would, however,
have had somewhat lower earnings because the cost of float was negative last year.
That is, our float threw off profits.” (1995 AR)

“[If] I were offered $7BN for [$7BN of] float and did not have to pay tax on the gain,
but would thereafter have to stay out of the insurance business forever-a perpetual
noncompete in any kind of insurance-would I accept that? The answer is no. That’s
not because I’d rather have $7BN of float than have $7BN of free money. It’s
because I expect the $7BN to grow” (1996 Shareholder’s meeting, as quoted by OID)

“Since 1967, when we entered the insurance business, our float has grown at an
annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has
made us money. Therein lies an accounting irony: Though our float is shown on our
balance sheet as a liability, it has had a value to Berkshire greater than an equal
amount of net worth would have had.” (1997 AR)

Conceptually, valuing float would require:

-estimating earnings generated by the float

-estimating cost of the float (underwriting profitability)
-estimating growth of float
-using appropriate discount rate

BRKs float has grown by 22% since 1967 and by 7.5% since 2001.

BRKs float has been virtually free.

BRKs earnings generated by the float have been large but lumpy.

All above ingredients yield HUGE numbers that are silly.

For example:
2006 Float: $50BN

Assumed float growth rate: 3% (inflation)

Assumed float after-tax investment returns: 3.25% (5% risk-free rate @ 35% tax rate)

Assumed float cost: 0% (BRK underwrites profitably)

Discount Rate: 3.25% (same as after-tax investment return)

$50BN * 3.25% = $1.625BN / (3.25% - 3%) = $650BN

In addition, coming up with a reasonable discount rate that makes sense and yields
reasonable results is very hard…

This is what Buffett and Munger had to say about BRKs discount rate during 1997’s
annual meeting (as quoted per OID):

Shareholder: What is Berkshire’s cost of capital?

Buffett: That question puzzled people for thousands of years. So I’ll let Charlie
handle it…

Munger: I find the way that subject is taught at most business schools incoherent.
I’m usually the one who asks that question and gets incoherent answers. I don’t
have a good answer to what I consider a stupid question.

Buffett: We’re better at stupid answers to good questions.

Munger: What’s the cost of capital a Berkshire when we keep drowning in a

torrent of cash we have to reinvest?

*******

I think Buffet’s solution to valuing float is simply to say, “$1 of float is worth AT
LEAST $1 of value” and keep track of it as it increases yearly.

However, for smaller segmentable portion of the float, a float valuation is possible.

Attached find a spreadsheet that attempts to calculate value of Berkshire’s recently

announced Equitas deal. My calculations show that the PV of the cashflow’s generated
by the Equitas premium after taking into account loss payments roughly equals the value
of float generated in the deal. i.e., $1 float = $1 of value.

For a very good (and brief) explanation of the Equitas deal read pages 8 and 9 of BRKs
2006 Annual Report.