How Buffett is posing as a crook on rising interest rates

Warren Buffett’s Berkshire Hathaway benefits from low-cost investment funding – Image: Shutterstock

Warren Buffett’s Berkshire Hathaway (BRKb) is doing like a bandit due to rising interest rates.

For much the same reason that Warren Buffett is in the list of the 10 richest people.

It is inherent in the operation of an insurance company in fact. They end up with heaps of money – interest rates go up and that money makes more money. Interest rates are rising, Berkshire Hathaway is making more money – sounds simple enough, right?

Berkshire Hathaway (BRKb) Stock Price Chart

But this leads us to have to understand why this is happening. Because only if we get the why can we then think about the implications. So, a quick lesson on how the insurance industry works:

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Insurance Industry Insider

An insurance company collects premiums from its customers and pays out if bad things happen. That is just about everything. If he assesses the risk correctly, he profits, if he does not charge enough, he loses. But while that’s basically how insurance works, that’s not all.

To understand how Berkshire Hathaway works, we need to add time. Because, of course, those premiums are collected now – but the claims are only paid if the wrong thing happens, at some point in the future.

This means that the insurer must sit on the money between these two times. Moreover, the insurer manages to invest this money between these two moments and the profits of this activity belong to the insurer, not to the insured.

Why is this important? Because Berkshire Hathaway’s “float” — the amount it can sit on or invest — is close to $109 billion these days. That’s what funds his investments in Coca Cola, IBM and all that other stuff. Only the cash portion is currently earning $400 million in interest per quarter. As interest rates rise, this profit will also increase.

But, you know, a few hundred million here or there isn’t really that big for a company the size of Berkshire. There’s more to it than just interest – much more.

Self-serve buffet

Warren Buffett is a very savvy investor, there’s no doubt about it. An excellent stock picker and buyer of whole companies. But that’s not enough to explain how rich he became. There is another element to this. This academic article explains it:

However, Berkshire’s more anomalous leverage cost is due to its insurance float. Collecting insurance premiums in advance and paying a diverse set of claims later is like taking out a “loan”. Table 3 shows that the estimated average annual cost of Berkshire’s insurance float is just 2.2%, more than 3 percentage points below the average Treasury bill rate. Consequently, Buffett’s low-cost insurance and reinsurance business gave it a significant advantage in terms of unique access to cheap and forward leverage.

This float is what Buffett has invested in for all these decades. The cost to him of financing this float is significantly less than what the US government is paying to borrow. Wouldn’t we all like that? To be able to borrow cheaper than governments and then invest that money?

Of course, we still have to make the right investments, like Warren here, but it’s much easier to turn around if your financing costs are lower than anyone else’s.

The important point here is that rising interest rates also affect this advantage – Berkshire Hathaway also benefits. Because everyone’s funding costs have been reduced over the past decade, with central banks everywhere printing money. Everyone could borrow at 1 and 2% and so on. This is one of the reasons why asset prices have risen so high.

It also means that Warren and Berkshire have lost some of their competitive edge. If everyone has access to cheap leverage, your own cheap leverage is no longer a comparative advantage, is it?

But as interest rates rise, everyone who has to borrow in the market has to pay more. Buffett still has that internal funding — $109 billion in fact — that he pays nothing on. So its opportunity cost if invested is not the cost of borrowing money, it is the price of lending – rather lower.

The higher interest rates rise, the greater this comparative advantage for Berkshire Hathaway becomes.

There is always a caveat

But, unfortunately, it’s all about investing and markets, so nothing will be that simple.

Berkshire’s earnings won’t just soar into the stratosphere as interest rates rise. There is also a clearing process here.

Saber Insurance stocks halved when they revealed the problem – inflation. So if you’re charging something now that you’ll have to pay in the future, you’ve got a problem.

Insurers write their policies based on today’s prices. But the complaints come later, after prices have risen. If you have rising or unexpected inflation, then you’re going to get screwed – Saber was, by exactly that. The company has taken out car insurance based on the current costs of repairing a car. At the time the accident happened there had been 10% inflation – often more with cars in fact. This will kill the margins.

Now, interest and inflation, there should be a relationship between the two. In fact, interest should be higher than inflation, at least in a well-ordered economy. Or, in the other direction, real interest rates should be positive – if inflation is 10%, then interest should be 11% or more. As we can all see, that’s not how it is right now.

So, inflation and inflation alone make insurers lose money – and yes, that happens inside Berkshire Hathaway too. Rising interest rates bring money to insurers, which increases the return on the float. Plus broadening competitive advantage by being able to finance investments below market rate. It is the balance of the two that will determine the overall effect on an insurer’s margins.

The really interesting point comes when interest rates exceed the rate of inflation. This will most likely happen when inflation drops – no one really predicts that even nominal, let alone real, interest rates will rise to 9 and 10% of the current inflation rate. But when that happens, when real interest rates are positive, the two factors stop pulling in opposite directions.

Inflation ceases to be a drag on profits, as interest earned more than offsets price increases between receipt of premiums and settlement of claims. Insurers – and not just Berkshire Hathaway – stand to benefit hugely at this point. The trigger is when real interest rates, adjusted for inflation, are positive. When the Federal Funds Rate, or the Bank Rate here in the UK, is above the CPI announced by the authorities.

At what point our only remaining question is when will that be? Unfortunately, these are indeed investments, markets, so we don’t know. We can either take our positions now and hope, or wait for these tow rates to converge and hope that we are not too late to capture price movement.

The underlying economy here is solid. Insurance companies profit from higher interest rates, suffer from inflation. There is an equilibrium point where the overall effect is definitely beneficial, when real interest rates are positive. The investment question is OK, when?

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