Author Topic: how to calculate the cost of float?  (Read 2114 times)

Cigarbutt

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Re: how to calculate the cost of float?
« Reply #10 on: April 06, 2018, 10:37:28 AM »
"I think it is fair to say that BH carries more cash and bonds than it otherwise would if it didn't write a bunch of insurance. To the extent that any of that is funded by equity, suboptimal returns on that equity should be included when valuing the float, imo, because those suboptimal returns are part of the cost of using that float."

Let's take this further.
-BH is unusual in the sense that it is made of many components and one of the components (main one) is the insurance business.
-Financial instruments are fungible so this topic is more conceptual in nature.

Not to focus on semantics but I would suggest that float is not funded, as it accumulates in the normal course of operations. Think of this as a component with a the new label of "long term insurance working captal" assets (float) and matching liabilies (reserves). It just builds over time. I see the equity (or multiple sources of equity for BH) as a cushion that needs to be financed or funded. Even if you consider a newly formed insurance firm, the funding part to start operations would be temporary as float assets would accumulate in parallel to reserves and allow these initial funds to be given back to owners.

How the owner/CEO manages (allocation) the float is the fascinating question. In reply #1 above, I referred to an article (Buffett's alpha) which implies that a significant part of the magic was that Mr. Buffett "simply" used float as cheap leverage in order to buy cheap and safe equities.

What's the evidence. Early on, that may have been true to some extent. Not so much since 1995, it seems.
http://brooklyninvestor.blogspot.ca/2017/11/is-buffett-bearish.html

These are not GAAP numbers but the table clearly shows that Mr. Buffett has essentially matched insurance reserves with a "float" portfolio of cash and fixed income. One could say that he may have dipped in the float portfolio to some degree when faced with cyclical opportunities ("coverage ratio" going slightly below 100% in periods where stock prices were decreasing faster than GDP). But I suggest that float has not been "funded" by equity.

I submit that the above allocation concept can be generalized to many or most insurance companies although the end result is rarely if ever as satisfacory in comparison to what Mr. Buffett has accomplished.

Again, maybe a way to reconcile the perspectives is that the cost of equity of an insurance company needs to reflect the fact that it is effectively a leveraged structure (in the sense that there is a risk the corresponding assets and liabilities won't match) even if the capital structure has no true debt.
« Last Edit: April 06, 2018, 11:01:23 AM by Cigarbutt »


bizaro86

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Re: how to calculate the cost of float?
« Reply #11 on: April 06, 2018, 04:41:29 PM »
Thanks cigarbutt! I agree BH is a special case, as for most insurers I think looking at the firm wide roe would suffice.

That table in the link is a great one, as it indicates that float and cash/bonds have been roughly equal. If you assume the float funds the least risky assets, that means equity is nearly all invested in equities and subsidiaries, aside from a small cash buffer that the operating businesses probably need. I agree money is fungible, but do think it makes sense to mentally assign the float to the lowest risk assets since it is money that the firm is holding for its clients.

So while I still think a theoretical adjustment makes sense, given the facts it isn't necessary for BH, imo.

That might be one of the advantages of the BH structure, as I suspect given their balance sheet strength they get more leeway on cash balances than others might.