U.S. Markets open in 2 hrs 37 mins

A Look at Berkshire Hathaway's Insurance Business

Recently, I've been spending a lot of time studying Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) insurance businesses. Not only is the group's insurance division its most profitable over the long-term, it has also provided the float Buffett has used to invest in stocks and other businesses over the past seven decades.

Buffett and insurance

Buffett has said that he initially decided to buy his first insurance company, National Indemnity, because it was in an industry he understood. He'd had an understanding of the industry since his first experience with an insurance company's management in the early 1950s.

The young investor was interested in GEICO and traveled up to the company's headquarters one weekend. There, he spent hours speaking with director Lorimer Davidson. In 1951, Buffett had around 50% of his net worth invested in the business.

But while Berkshire has made tens of billions of dollars in profit from its insurance businesses, it hasn't been easy. The insurance market is not an easy market to dominate.

Unique advantage

As insurance is a commodity product, buyers are focused on price above all else. This means the seller has to have plenty of experience pricing contracts at the right level.

Berkshire's leading insurance executive, Ajit Jain, has the experience required. Here's how Buffett explained the pricing of insurance contracts at the 2017 Berkshire annual meeting:

"And the question is how fast we pay out the money and how much money we pay out. And Ajit does 99% of the thinking on that. And I do one percent. And we project out what we think will happen."

This is where pricing insurance and investing has a lot of in common. It all comes down to pricing probabilities. Sometimes the seller will get the possibilities wrong, and they will have to pay out more than expected, but as long as the average is positive, the business will prosper over the long term:

"And we've been wrong on one transaction that involved something over a billion of premium. I mean clearly wrong. And there are a couple of others that may or may not work out depending on what you assume we have earned on the funds. But they're OK. But they probably didn't come out as well as we thought they would, though. But overall, we've done OK on this.

It's less OK when we're sitting around with $90-plus billion of cash. So the incremental $10.2 billion we took in in the first quarter is earning us peanuts at the moment. And peanuts is not what fits into the formula for making this an attractive deal.

So we have -- we do have to assume we'll find uses of the money, but the money will be with us quite a while. And I think our calculations are on the conservative side."

As the quote above details, it is not just the pricing on the contracts that is important. It is what a company does with the premiums.

Best investor

A considerable part of Buffett's success as an investor has been his ability to effectively invest premiums received. This is something most insurance companies don't try to do because investing is an enirely different business. The bulk of insurance companies invest premiums in fixed income, which limits long-term returns.

Berkshire has grown so big because of this critical competitive advantage, and now the company's size is its principal competitive advantage. There are very few insurance companies that can commit to $10 billion or $20 billion in liabilities over a multi-decade time frame. The fact that Berkshire can do so means that the group will continue to suck in cash for many years to come.

Disclosure: The author owns shares in Berkshire Hathaway.

Read more here:

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.