What Is Cost of Float?
The cost of float is a key metric in insurance finance that measures the true expense or benefit an insurance company derives from holding and investing policyholders' funds between the receipt of premiums and the payment of claims. Essentially, it quantifies how much an insurer "pays" for the use of this temporary capital, considering both the investment income generated from these funds and any underwriting profit or loss. A low or negative cost of float indicates that the company is effectively managing its liabilities and generating value from the funds entrusted to it by policyholders. Conversely, a high or positive cost of float suggests that the insurer's underwriting losses outweigh its investment gains from the float, making it an expensive source of capital.
History and Origin
The concept of "float" as a valuable, temporarily available pool of capital for investment gained significant public recognition through the insights of Warren Buffett, particularly as articulated in his annual letters to shareholders for Berkshire Hathaway. Buffett famously highlighted how the insurance business, by its nature, collects premiums upfront and pays claims later, creating a pool of money—the float—that the insurer can invest in the interim. He explicitly discussed the value and cost of this float in his 1996 Chairman's Letter, noting how "our cost of funds has been less than nothing" in many years, which significantly boosted Berkshire's performance. Thi11, 12s emphasis shifted the perception of float from merely a liability to a potential asset, depending on its cost.
Key Takeaways
- The cost of float indicates whether an insurance company is profitable from its combined underwriting and investment activities related to policyholder funds.
- A negative cost of float means the company generates investment income that exceeds its underwriting losses, effectively getting "free" capital or even being paid to hold funds.
- A positive cost of float implies that underwriting losses are greater than investment gains, making the float an expensive source of funding.
- Managing the cost of float is central to an insurance company's overall profitability and risk management.
Formula and Calculation
The cost of float can be calculated by comparing the investment income generated from the float against the underwriting profit or loss. A common way to express it is:
Where:
- Underwriting Loss: Represents the loss incurred from the core insurance operations (premiums minus claims and expenses). If there is an underwriting profit, this value becomes negative in the numerator.
- Investment Income on Float: The earnings generated from investing the float, typically in bonds, stocks, and other assets.
- Average Float: The average amount of funds held by the insurer over a given period, representing the pool of money available for investment. This is essentially the sum of policyholder reserves and other accrued liabilities that have not yet been paid out.
If the numerator is negative (i.e., investment income exceeds underwriting loss or there is an underwriting profit), the cost of float is negative, indicating a favorable outcome for the insurer.
Interpreting the Cost of Float
Interpreting the cost of float involves assessing its implications for an insurer's financial health and operational efficiency. A negative cost of float is highly desirable, as it means the company is effectively being paid to hold and invest policyholder funds, contributing positively to its bottom line. This often occurs when strong underwriting practices lead to profits or minimal losses, and the investment portfolio generates solid returns. Conversely, a positive cost of float signals that the underwriting segment is experiencing significant losses that are not offset by investment earnings from the float, thereby eroding capital. For analysts, a consistently low or negative cost of float is a strong indicator of a well-managed insurance operation with a sustainable competitive advantage.
Hypothetical Example
Consider "Horizon Insurance Co." which collects $500 million in premiums over a year. During the same period, it pays out $350 million in claims and incurs $100 million in operating expenses related to underwriting. This results in an underwriting profit of $50 million ($500M - $350M - $100M = $50M).
Horizon Insurance also maintains an average float of $1 billion throughout the year, which it invests. From these investments, it generates $80 million in investment income.
To calculate the cost of float:
Since there's an underwriting profit of $50 million, we can consider the "underwriting loss" as -$50 million for the formula.
In this scenario, Horizon Insurance Co. has a negative cost of float of -13%. This indicates that the company is generating significant value from its float, as its investment income and underwriting profit combined more than offset any implicit cost of holding policyholder funds. This demonstrates a strong ability to manage both its insurance operations and its investment portfolio for favorable cash flow.
Practical Applications
The cost of float is a critical analytical tool for investors, regulators, and insurance company management alike. For investors, it offers insight into the efficiency and underlying profitability of an insurer beyond just reported net income, revealing how effectively the company leverages its unique funding source. Regulators, such as those overseen by the National Association of Insurance Commissioners (NAIC), use metrics related to float management to assess an insurer's solvency and financial stability, ensuring that companies maintain adequate reserves to meet future claims. Fur8, 9, 10thermore, it informs strategic decisions for insurance executives regarding underwriting discipline and investment strategy. An insurer aiming for a low or negative cost of float will prioritize profitable underwriting and robust investment management to maximize the benefit from its policyholder funds. The Federal Reserve's Financial Stability Report often includes assessments of the insurance sector's financial health, implicitly considering how insurers manage their assets and liabilities, which is directly tied to float.
##4, 5, 6, 7 Limitations and Criticisms
While the cost of float provides valuable insights, it also has limitations. Its calculation relies on estimates for future claims and expenses, particularly for long-tail insurance lines (e.g., professional liability, workers' compensation), where the ultimate cost of claims may not be known for many years. This introduces a degree of uncertainty into the calculation. Furthermore, a company might aggressively underwrite policies at a loss, hoping to offset these losses with high investment income from the resulting float. This strategy, while potentially lowering the apparent cost of float in the short term, exposes the insurer to significant risk management challenges if investment returns falter or claims escalate unexpectedly. External factors, such as sustained low interest rates or volatile financial markets, can also significantly impact the investment income component, making it harder to achieve a consistently low or negative cost of float, regardless of underwriting discipline. Rising interest rates, for example, can create unrealized losses in an insurer's bond portfolio, impacting their overall financial position.
##1, 2, 3 Cost of Float vs. Float (Insurance)
It is crucial to distinguish between "cost of float" and "float (insurance)" itself. Float (insurance) refers to the actual amount of money an insurance company holds and has available for investment, representing the difference between the premiums collected and the claims and expenses paid out. It is a liability on the insurer's financial statements because it ultimately belongs to policyholders and must eventually be paid out. It is a measure of the volume of temporary capital.
In contrast, the cost of float is a performance metric that evaluates the effectiveness of managing that float. It quantifies the net expense or benefit derived from the float after considering both underwriting results and investment returns. While a large float is generally desirable as it provides more funds to invest, a company could have a large float but still incur a high positive cost of float if its underwriting losses are substantial. Conversely, a smaller float could still be highly beneficial if managed with strong underwriting profits and solid investment returns, resulting in a negative cost of float.
FAQs
Q: Why is a negative cost of float considered good for an insurance company?
A: A negative cost of float indicates that the investment income generated from the policyholders' funds (the float) is greater than any underwriting losses incurred. This means the company is effectively being paid to hold and invest money that isn't its own, boosting overall profitability.
Q: Can all insurance companies achieve a negative cost of float?
A: Not all insurance companies achieve a negative cost of float. It requires a combination of disciplined underwriting (to minimize underwriting losses or achieve profits) and successful investment income generation from the float. Many companies may have a positive, albeit low, cost of float.
Q: How does the investment strategy of an insurer affect the cost of float?
A: The investment strategy significantly impacts the cost of float. If an insurer's assets generate high returns, it can offset potential underwriting losses, leading to a lower or negative cost of float. Conversely, poor investment performance will increase the cost of float.
Q: Is the cost of float applicable to other financial industries besides insurance?
A: While the term "cost of float" is primarily associated with the insurance industry due to its unique business model of collecting premiums upfront, similar concepts exist in other sectors where companies temporarily hold funds that don't belong to them (e.g., banks with deposits). However, the specific calculation and terminology may differ.