Why does Warren Buffett love insurance companies?

Buffett understood the biggest advantages of having ownership of insurance companies, especially one that gives dividends.

Warren Buffett, fondly known as the Oracle of Omaha, has amassed a personal wealth worth over a hundred billion USD and has grown his conglomerate holding company Berkshire Hathaway to a valuation of 640 billion USD. While it is important to understand it is nearly impossible to replicate his processes for an average retail investor, it is crucial to look at how his understanding and confidence in the insurance sector companies he has invested in has been able to generate a 19.1% compounded annual growth rate since 1965, a period over which the S&P 500 generated a 9.6% compounded annual growth rate.

A brief overview of Berkshire Hathaway

In 1955, two cotton mill companies by the names of Berkshire Fine Spinning Associates and Hathaway Manufacturing had a merger after both were struggling to keep their mills alive separately. After this merger, the company had 15 plants employing over 12,000 workers with over $120 million in revenue. However, seven of these plants were closed off by 1960, accompanied by massive layoffs.

In 1962, young Warren Buffett noticed a pattern in the direction of the price of the stock whenever Berkshire Hathaway closed a plant and started buying stock despite knowing the industry was dying. However, an argument with the CEO of the corporation in 1965 made Buffett act irrational and bought up majority shares in the country, firing the then-CEO. However, he was now the majority owner of a failing business in a dying sector and he had to pivot.

Fun fact: Much later, in 2010, Buffett admitted that this rage against the CEO of Berkshire Hathaway cost him over $200 billion over forty-five years of compounding.

Berkshire’s insurance-based business model

Buffett understood the biggest advantages of having ownership of insurance companies, especially one that gives dividends. The premiums which are collected from customers but isn’t used for claim settlements are what Buffett calls “floats”. These “floats” are the stable flow of premiums that can be used for further investment and acquisitions. And as these insurance companies pay out dividends, Buffett can use this stable dividend amount for his investments as well.

This neat strategy is how the insurance companies grow, how Buffett’s price per share in these companies grow, and how Buffett’s investments in companies like Coca-Cola, Dairy Queen, Duracell, etc. grow.

Apart from just this stable source of premiums, Buffett understands how important insurance as a business is in everyday people’s lives. For instance, having car insurance is mandatory to buy a car in the United States, just as it is mandatory to have health insurance in the United States to avail of healthcare.

The scale of Berkshire Hathaway’s float

Berkshire Hathaway wholly owns multiple insurance companies that can generate massive float. Collectively, their insurance floats have grown from $39 million in 1970 to $114.5 billion at the end of 2017 with a remarkable growth rate of 74% per annum for a company of that size. These only drive home the merits of floats, perseverance, and long-time compounding growth.

Today, Berkshire Hathaway has three primary insurance subsidiaries which are Berkshire Hathaway Re (Re stands for reinsurance), General Re and GEICO, apart from National Indemnity Insurance which was purchased in 1965, without which Buffett says Berkshire Hathaway would be lucky to have half the wealth it currently has.