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A Deeper Look at Berkshire Hathaway's Competitive Advantage in Insurance

In a recent article on Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) and its competitive advantages compared to other insurance giants, I noted the fact that the insurance business counts Berkshire's railroad, BNSF, as part of its capital.

This is different from most insurance companies. Indeed, most insurance companies invest the majority of premiums earned in a portfolio of low-risk bonds. This is sensible because it reduces the risk that the company will see a shortfall in capital reserves. These assets are also very liquid.

However, owning bonds can limit the return insurance companies can earn on their funds, or as Warren Buffett (Trades, Portfolio) would say, their "float."

BNSF not only provides a healthy return on capital invested but also has bond-like qualities from an investment stability perspective.

Bond-like qualities

Buffett gave some more detail on this structure at the 2012 Berkshire annual meeting. One shareholder asked the Oracle of Omaha if he could explain why Berkshire's subsidiary, BNSF, was owned by National Indemnity rather than the holding company. Buffett explained:

"Having the railroad in National Indemnity was just something we thought was nice to have a huge asset like that there that should make the rating agencies and everyone feel comfortable, and there's no disadvantage to us."

After providing a bit more color on how rating agencies viewed the asset, Buffett handed the microphone over to his right-hand man, Charlie Munger (Trades, Portfolio), who added the following:

"Well, two things are peculiar about that casualty operation. One is that it has so much more capital, in relation to insurance premiums, than anybody else. And the other is that it has, among the assets in that great surplus of capital, is something like the Burlington Northern Railroad, which makes it immensely stronger from the viewpoint of the policyholder. It's a huge advantage you're talking about, not a disadvantage."

BNSF's profits boost the bottom line

BNSF not only provided National Indemnity with a large capital backstop, but it also provides a high return on the float in the business. Buffett also explained this principle in 2012.

He explained that by buying BNSF, National Indemnity had acquired "an asset in it that, unrelated to insurance, will probably make $5 billion pretax or more." This was important because insurance companies generally rely on investment returns to make up for losses on the underwriting side of the business in bad years.

So, as Buffett went on to explain, in a year when National Indemnity writes $25 billion of premiums, it can stomach a combined ratio of 120% before taking a loss. The combined ratio is a measure of insurance company profitability. It's a mix of the loss ratio, commissions paid to brokers and costs deducted from premiums written. Anything below 100% signifies an underwriting profit, while anything over 100% means the operation is losing money.

In this case, National Indemnity could lose $30 billion before the operation would need to dig into reserves for the year. Few insurance companies would be able to sustain a loss of this scale, even on a one-off basis. With BNSF on the balance sheet, National Indemnity could do it year after year.

Berkshire's edge

This is just one of the reasons why Berkshire has such an edge in the global insurance market. Insurance can be a tricky business, but Berkshire has all the best qualities. It has high-quality underwriting, relatively low costs and a strong balance sheet, bulked up by assets such as BNSF.

Only a handful of other companies in the sector take such a long-term view of capital allocation and deployment. Berkshire can because its CEO is also its largest shareholder, and he's always been focused on building a long-term business. This culture should remain in place long after Buffett leaves the business.

Disclosure: The author owns shares in Berkshire Hathaway.

Read more here:

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  • Charlie Munger on the Art of Stock Picking

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This article first appeared on GuruFocus.