Hey YouTube I'm Jimmy in this video
I'm going to walk through how the legendary investor
Warren Buffett used the insurance
companies that he owns to build his wealth
to be more than 80 billion dollars.
Now we all know that Warren Buffett
is known as one of the greatest investors
of all time if not the
greatest investor.
So let's look at how he did
it. And unfortunately this video
is not going to be an illustration of
how we investors can duplicate
what Buffett did
but it will point out how
he did.
Thanks to his ownership in insurance
companies and maybe we can get some pointers
as when we analyze insurance companies.
So the key to Warren Buffett's amazing returns
is really ultimately his ability
to pick great long term companies.
But there is a math trick that really
helps with his returns
that most people can't duplicate.
Well really it's an insurance thing that
allows for Buffett to get returns
that no one else has been able to match.
So if we go back to Warren Buffett's
recent annual letter
well, on the first page we can see that
Berkshire Hathaway has a nineteen
point one compounded annual
growth rate since 1965.
And Buffett was kind enough to point out that
the average return of the S&P 500
over that same time period was just
short of 10 percent.
But with this very impressive
19 percent annual gain it's
important for us to realize that this
gain is the gain to the book
value of Berkshire Hathaway.
And this is the perfect number
to use because
if we want to value insurance company
using price to book value is
the ideal way of doing it.
So the goal of any insurance company should be
to grow their book value.
And I bring this out because this is key to
realize that what Warren Buffett has done
is he has grown the
book value of his company by
more than 19 percent a year.
So the question is how does he do this.
And the secret lies in the insurance companies that
he owns. So my latest video
I did. I reviewed my analysis of
the Travelers Companies.
They're an insurance company so I'm going
to use traveler's numbers to illustrate how
Buffett pulled off a 19 percent
growth rate of Berkshire Hathaway's book
value and then I'll tie it
to the modern version of Berkshire Hathaway.
Now this is not intended to be an analysis
of travelers.
In fact the numbers that are in use are very
very loose numbers
but they are based on travelers numbers.
It's not even intended to be an analysis of Berkshire
Hathaway. It's the concepts whereafter.
Okay so the first thing that we should do
is make sure we're all on the same page
regarding what book value is.
So here's the formula
for the balance sheet assets
equals liabilities plus owners equity.
Now owners equity
and book value are generally the
same thing. So we're going to replace
owners equity
with book value.
Now let's add some numbers.
So travelers has
assets of about 100 billion dollars.
And then they have liabilities of
but 80 billion dollars.
Now that means that book value
must be about 20 billion dollars
since the two sides must balance.
OK now just to recap the way an insurance
company works so in
and turns company collects payments
from their customers they are called premiums
and then they collect them from a whole
bunch of different customers from all over the place.
And then when a claim comes in well
the insurance company goes ahead
and they pay that claim.
The insurance company keeps a giant
pile of cash that they've
brought in and they've yet to
pay out. Although in theory they will
need to pay it out in the future.
Buffett calls this pile of money
the float.
This brings us back to a balance sheet formula.
So this insurance company
Traveler's Insurance has about 50
billion dollars in their float.
This is money that they expect to one day have
to pay out.
This makes the 50 billion dollars
a liability.
So of this 80 we know that 50
is being held for future payouts.
But this 50
is actually cash.
So we're more than likely it's probably investments
but either way it's an asset.
So let's stop right here
and take a closer look.
So right now if we assume
that this insurance company did not
earn a profit
or loss based on their insurance
business. So if they go out
and they sell more insurance
and they bring in more premiums
and they pay some out
but they don't make either profit
or a loss well nothing would
change. As far as the value of the company
instead of a float of 50 if they were able
to increase their float to let's say 60
by selling additional insurance
and paying out claims assuming
no profit well both liabilities
and assets would go up by
10 to 60.
But now let's switch back to 50
and let's assume that they invest
that 50.
And also let's assume that they get a 10
percent return on that money.
Now that's a bit high of a target return
for an insurance company but let's pretend so they get 5
of the 50 that they invested thanks to an impressive
10 percent return.
Well that 5 billion returns gets added
to the income statement.
And most of it goes to the
bottom line
and if the insurance business itself
had losses well
they this 5 billion would help
help offset those losses if
it gains well this 5
billion would add to the gains making them even
more profitable.
Now assuming nothing else changes no additional
dividends are paid
or no buybacks are down
or anything like that.
Well the profits that go to the income
statement that are not paid out
will they end up in the equity
section of the balance sheet
or as we're calling it in the book value section.
Now technically the way it would
work is that the profits
would end up in a line item called retained
earnings on the balance sheet that's within
the equity section.
Either way the result is the same book
value moves higher liabilities
doesn't move at all since it does matter return
10 percent
or 2 percent.
Either way we're going to owe the same 50.
But this is the amazing part of the insurance
business and ultimately
the amazing part to Buffett's success
and his use of the insurance
business. So let's add that
five billion to our book value
will now book value jumped from 20
to 25.
Liability stays exactly the same at
80 in assets jumps
to 105.
Both sides of the balance sheet remain
in balance which is perfect.
That's exactly what we need.
But the amazing part is when we start to
do the math what was the growth rate
for book value.
Well we can see that the growth rate
was 25 percent which
is a crazy impressive return
from investing standpoint.
Now we could've actually done this math quite
simply without going through this entire process.
All we have to do is look at the assets
being invested
and compare that to the size of the book value
in our example we had 50
billion dollars in assets being invested
and the book value was 20 billion.
Therefore the assets being invested
was 2.5 times
the size of the book value.
So a 10 percent increase
is a 25 percent increase
in book value.
If a float had been 40 Well
we would have had two times the size of book
value. So a 10 percent return would have given
us a 20 percent gain to book value.
Now in the case of Berkshire they're actually so
large at this point
and they own so many different companies
that their book value is actually larger
than their float.
But this doesn't take away the advantage
it might take away the multiple
of the advantage.
But either way if Buffett has 100
billion dollars in float
and the book value of the company is
200 billion.
Well if he returns the same 10
percent on the investments
of the float.
Well that would add 5 percent growth
to the book value.
And this doesn't include any of the returns
on all the other businesses that Buffett owns.
Perhaps those businesses generate
a solid growth rate of 8 percent
on their own.
Well thanks to the insurance
float returns now that
that return for that year turns
out to be 13 percent.
Assuming we add the 5 percent
to the book value.
And that's how you end up
with such fantastic returns like Buffett
has now.
I think this is also useful for anybody analyzing
insurance companies.
That's actually how I came up
with the idea for this video because
as I was doing my research for a traveler's video
well I thought people might find it interesting
to learn how much the
float helps add
to an insurance company's returns many
insurance companies aren't that profitable
in the insurance business alone because it is such
a competitive business.
But the investments allow
for returns to be amplified
like we saw.
And that makes a business very profitable for
them. But what do you think.
Did you find this video interesting would you think of a topic
in general. Let me know what you think in the comments below.
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