Warren Buffett has made such an impression on value investors and insurance investors, that they think that float is magic. Â Write insurance, gain float, invest cleverly against the float, and make tons of money.
Now, the insurance industry in general has been a great place to invest, but we need to think about float differently.  Float is composed of two things: claim reserves and premium reserves.
- Claim reserves are the assets set aside to satisfy all claims that likely will be made as of the current date.
- Premium reserves are the assets set aside representing prepaid premiums that have not been earned yet.
Claim reserves can be long, short or in-between.  Last night’s article dealt with long claim reserves — asbestos, environmental, etc.  Those reserves can be invested in stocks, real estate, long bonds, etc.  But most claim reserves are pretty short, like a year or so for most personal insurance auto & home claims — those typically get settled in a year.
The there are classes of insurance business that are in-between — workers comp, D&O, E&O, commercial liability, business continuation, etc. Investing the claim reserves should reflect the length of time it will take until ultimate payoff.
The premium reserves are very short.  If premiums are paid annually, the average period for the premium reserves is half a year.  If premiums are paid more frequently, the average period for the float falls, but the premiums rise disproportionately to reflect the insurance company’s desire to have the full year’s premium on hand.  It usually makes sense for policyholders to pay at the longest period allowed — thus, thinking about premium reserves as having a duration of half a year on average makes sense.  Except auto — make that a quarter of a year.
Earnings financed by float should be divided into two pieces — non-speculative, and speculative.  The non-speculative returns on float reflect what can be earned by investing in high quality bonds that match the time period over which the float will exist.  Short for premium reserves, longer for claim reserves.  So, the value of float is this:
