A Closer Look at Warren Buffett's Success

Warren Buffett, the CEO of insurance conglomerate Berkshire Hathaway, is often called the world’s greatest investor. As Buffett admirers, we’re not going to quibble with that title. But some recent research points out that Buffett’s success can be chalked up as much – if not more – to the structure of Berkshire’s insurance operations as it can be to Buffett’s investing prowess. Joe Taussig, of Ineichen Research and Management, reverse-engineered Buffett’s investment returns with Berkshire Hathaway over the past 40 years. The conclusion? Most of Buffett’s stunning outperformance can be attributed to the successful investing of Berkshire’s insurance reserves – a structural advantage that insurance companies enjoy.

“Had the shareholders of Berkshire Hathaway sold all of their holdings in 1969 and reinvested the proceeds in the S&P 500, their $70 million would have compounded at 8.9 percent for 40 years and be worth $2.1 billion today,” Taussig wrote. “But what of Warren Buffett, the ‘world’s greatest investor’? We have reverse-engineered his investment record within Berkshire Hathaway: 12 percent per year. In investment parlance, his investment ‘alpha’ is 3.1 percent per year. This is pretty good, but does it qualify him for the reputation he has as the ‘world’s greatest investor’? Had the same investors liquidated their holdings in Berkshire Hathaway and had Buffett the asset manager manage the proceeds in the Buffett Partnership, the $70 million would have grown to $4.4 billion in 40 years. This is a far cry from the $153 billion of market cap that Berkshire Hathaway enjoys today. This difference between $153 billion and $4.4 billion is what we call ‘structural alpha.’”  

This structural alpha comes from the singular way that insurance companies operate. In the front end of the insurance business, underwriting profits or losses equal premiums minus claims, minus operating expenses. The industry average “cost of insurance,” or COI, is an underwriting loss of 3 percent per year for each dollar of reserves. These reserves constitute the back end of the business. They are typically invested in fixed income or a conservative blend of bonds and equities. 

“Assume that the fixed income generates 5 percent per year,” Taussig wrote. “Thus, for every dollar of reserves in a traditional insurer, returns are 2 percent per year (5 percent for investments minus 3 percent COI). In terms of ROEs, the key is the ratio of reserves to equity (leverage), which runs around 5x in the industry. With its equity invested in the fixed income portfolio at 5 percent plus 5x of reserves earning 2 percent per increment of reserves, pre-tax ROEs tend to be 15 percent and after-tax ROEs are roughly 10 percent. Under Buffett’s leadership, Berkshire never had a cumulative underwriting profit until 2006 (after which time his cumulative cost of ‘float’ or COI became less than 0). Up until that time, Berkshire’s underwriting losses were still better than the industry norm (his COI was 1 to 2 percent). Furthermore, at 2x, his level of leverage was far less than the industry standard of 5x. Investing the equity at 12 percent and adding 10 percent for each increment of reserves (investment returns of 12 percent minus the 2 percent COI), the total was a pre-tax 32 percent (12 percent + 2×10 percent). Taxes reduced it to an after-tax 20.3 percent. 20.3 percent compounding for 40 years turns $70 million into $120 billion. A price to book of 1.29x brings it to $153 billion. Thus the structure generated $149 billion of alpha ($114 billion in better ROEs and $35 billion in a premium to book value),” Taussig concluded. 

The lesson? The structure of insurance companies provides investors with an immense advantage and source of alpha when reserves are invested successfully.