Cost of Float

The Cost of Float is a metric that reveals the net cost—or profit—an insurance company incurs for holding onto its float. In the world of value investing, particularly as championed by Warren Buffett of Berkshire Hathaway, this concept is pure gold. Imagine someone lending you a massive amount of money for years, and instead of charging you interest, they sometimes pay you to hold it. That’s the magic of a negative cost of float. An insurance company collects premiums from customers upfront but pays out claims later. The money it holds in the meantime is the float. This float can be invested for the company's own profit. The cost of float tells you how well the company is managing its core insurance business. If its underwriting (the process of pricing policies) is profitable, the cost of float is negative—a powerful tailwind for investors. If it consistently loses money on underwriting, the cost is positive, meaning the float acts like a loan with an interest rate.

At its heart, float is simply other people's money that an insurance company gets to hold temporarily. Think of a high-end baker who requires customers to pay for a wedding cake six months in advance. For those six months, the baker holds the customer's cash. He hasn't yet paid for the expensive flour, sugar, or a decorator's time. He can put that cash in a bank account and earn a little interest before his own bills are due. That's a simple form of float. For an insurer, this happens on a gigantic scale. The business model is:

• Collect premiums from thousands or millions of policyholders today.
• Pay out claims for accidents and disasters that may happen weeks, months, or even decades in the future.

This pool of prepaid premiums that hasn't yet been paid out in claims is the float. It's a liability on the balance sheet because it's money the insurer eventually owes, but in the meantime, it's an enormous asset they can invest.

Understanding the cost of float is crucial because it reveals the quality of the insurance operation. Is the company getting its investment fuel for free, or is it paying a high price for it?

While professional calculations can be complex, the core idea is straightforward. The cost of float is the company's net loss from its insurance activities, expressed as a percentage of the float it held. Formula: Cost of Float (%) = (Underwriting Loss / Average Float) x 100

• Underwriting Loss (or Profit): This is the key figure. It’s the total claims paid out plus all operating expenses, minus the premiums earned. If the result is negative, the company actually made an underwriting profit.
• Average Float: The average amount of float the company held over the period (usually a year).

The result of this calculation is incredibly insightful:

• A Positive Cost (e.g., 2%): This means the insurance business lost money. For every $100 of float the company held, its insurance operations cost it $2. This is essentially a loan with a 2% interest rate. If the company can invest that float and earn 10%, its net return is a still-respectable 8%.
• A Negative Cost (e.g., -1%): This is the ideal scenario! It means the company ran an underwriting profit. It was paid $1 for every $100 of float it held. Not only do they get free money to invest, but they also get paid for the privilege. If they invest that float and earn 10%, their total return is a spectacular 11%.

For a value investor, a company that consistently achieves a low or negative cost of float is a thing of beauty. It represents a massive, sustainable competitive advantage, or moat. This cheap (or free) source of funds provides incredible leverage. Berkshire Hathaway, for example, has used the float from its insurance subsidiaries like GEICO and National Indemnity Company to buy stocks and acquire whole businesses. When the investment returns generated by the float are higher than the cost of acquiring that float, shareholder value compounds at a blistering pace. It's the engine at the heart of the Berkshire Hathaway empire. A consistently low cost of float signals a disciplined management team that knows how to price risk—a hallmark of a superior business.

Let's imagine a fictional insurer, “Durable Insurance Inc.,” to see this in action. The company maintains an average float of $50 billion.

• Scenario 1: A Great Year

Durable runs a tight ship and its underwriting profit is $500 million. This means its “underwriting loss” is -$500 million.

  //Cost of Float = (-$500 million / $50 billion) = -1%//
  Durable was paid 1% to hold $50 billion of other people's money. If it invested that float and earned a 9% return, its total economic gain from the float is 10% (9% investment return + 1% underwriting gain).
* **Scenario 2: A Tough Year**
  A major hurricane leads to an underwriting loss of $1 billion.
  //Cost of Float = ($1 billion / $50 billion) = 2%//
  This year, Durable had to pay 2% for its float. It's essentially a $50 billion loan with a 2% interest rate. If it still earned 9% on its investments, its net economic gain is 7% (9% investment return - 2% cost of float). A 2% loan of this size is still an incredibly attractive source of funding that is nearly impossible to get anywhere else.

The cost of float is more than just a metric; it's a window into the soul of an insurance company. It separates the disciplined underwriters from the reckless ones who “chase premium” at any cost. When analyzing an insurer, don't be mesmerized by its sexy stock portfolio alone. Dig into its financial statements and assess its historical cost of float. A long track record of low-cost or negative-cost float is a powerful indicator of a well-managed business built for long-term compounding.