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Berkshire Hathaway: How Buffett makes out like a bandit on rising interest rates

By Tim Worstall

09:21, 8 November 2022

warren buffett
Warren Buffett's Berkshire Hathaway benefits from a low-cost of investment financing - Image: Shutterstock

Warren Buffett’s Berkshire Hathaway (BRKb) is making out like a bandit from rising interest rates.

For pretty much the same reason that Warren Buffett is in the list of the top 10 richest folk out there.

It’s inherent in how an insurance company works in fact. They end up with piles of cash – interest rates go up and that cash earns more money. Interest rates are going up, Berkshire Hathaway is earning more money – seems simple enough, right?

Berkshire Hathaway (BRKb) share price chart

But this leads us into having to understand why this happens. For only if we get the why can we then go on to thinking about the implications. So, a quick lesson in how the insurance biz works:

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An insurance company collects premiums from its clients and pays out if bad things happen. That’s pretty much it really. If it prices the risk correctly it profits, if it doesn’t charge enough it loses. But while that’s basically how insurance works that’s not all of it.

To understand how Berkshire Hathaway works we’ve got to add in time. Because, of course, those premiums get collected now – but the claims are paid out only if the bad thing happens, some point in the future.

That means the insurer gets to sit on the cash in between those two moments in time. Moreover, the insurer gets to invest that money between those two moments and the profits from that activity belong to the insurer, not the insured.

Why does this matter? Because Berkshire Hathaway’s “float” – the amount it gets to sit on, or invest – is near $109bn these days. This is what finances its investments in Coca Cola, IBM and all those other things. Just the cash part of that is bringing in $400m in interest per quarter at present. As interest rates rise so will this profit.

But, you know, a few hundred million here or there, that’s not really material to a business of Berkshire’s size. There’s more to this that just interest – much more.

All-you-can-eat Buffett

Warren Buffett is a very savvy investor, no doubt about that. A great stock picker and buyer of businesses whole. But that's not actually enough to explain how rich he’s become. There’s one more element to this. This academic paper explains it

Berkshire’s more anomalous cost of leverage, however, is due to its insurance float. Collecting insurance premia up front and later paying a diversified set of claims is like taking a “loan.” Table 3 shows that the estimated average annual cost of Berkshire’s insurance float is only 2.2%, more than 3 percentage points below the average T-bill rate. Hence, Buffett’s low-cost insurance and reinsurance business have given him a significant advantage in terms of unique access to cheap, term leverage.

That float is what Buffett has been investing all these decades. The financing cost to him of that float is significantly less than the US government pays to borrow. Wouldn’t we all love that? To be able to borrow more cheaply than governments, then go out and invest that cash?

Sure, we’ve still got to get the investments right, like Warren here, but it’s a lot easier to make a turn if your financing costs are lower than anyone else’s.

The important point here is that rising interest rates affect this advantage too – Berkshire Hathaway benefits from this as well. For everyone’s financing costs have been lowered this past decade as central banks everywhere printed money. Everyone could borrow at 1 and 2% and so on. That’s one reason asset prices have risen so high.

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

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But as interest rates rise all those others who have to go out and borrow in the market have to pay more. Buffett still has that internal financing – $109bn of it in fact – which he’s paying nothing on. So, his opportunity cost if invested is not the cost of borrowing money, it’s the price of lending it – rather lower.

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

There’s always a caveat

But, sadly, this is investing and markets so nothing is going to be purely as simple as that.

Berkshire's profits are not just going to climb off into the stratosphere as interest rates rise. There's also a countervailing process here.

Sabre Insurance shares halved when they revealed the problem – inflation. So, if you charge now for something you’ve got to pay for in the future you’ve got a problem.

Insurers write their policies based upon today’s prices. But the claims come in later, after prices have risen. If you’ve got rising, or unexpected, inflation then you’re going to get screwed – Sabre was, by exactly this. The company wrote car insurance based on today’s costs of repairing a car. By the time the crash happened there had been 10% inflation – often more with cars in fact. That’ll kill margins.

Now, interest and inflation, there should be some relationship between those two. Interest should be higher than inflation in fact, at least in a well-ordered economy. Or, the other way to say this, real interest rates should be positive – if inflation is 10% then interest should be 11% or more. As we can all see this isn't how it's going at present.

So, inflation and inflation alone is losing money for insurers – and yes, this is happening inside Berkshire Hathaway as well. Rising interest rates makes money for insurers – that increase in the return on the float. Plus the widening of the competitive advantage by being able to finance investments below market rate. It’s the balance of the two that will determine the overall effect on an insurer’s margins.

The really interesting point comes when interest rates rise above the inflation rate. This is most likely going to be when inflation falls – no one is really predicting even nominal, let alone real, interest rates up at the 9 and 10% of today’s inflation rate. But when that does happen, when real interest rates are positive, then the two factors stop pulling in opposite directions.

Inflation stops being a drag on profit as the interest earned more than makes up for the price rises between premium receipt and claim paid. Insurers – not just Berkshire Hathaway – should benefit hugely at that 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 as announced by the authorities.

At which point our only remaining question is when will that be? Unfortunately this is indeed investment, markets, so we don't know. We can either make our positions now and hope, or wait for those tow rates to converge and hope we’re not too late to capture the price movement.

The underlying economics here is sound. Insurance companies benefit from higher interest rates, suffer from inflation. There’s a balance point where the overall effect is definitively beneficial, when real interest rates are positive. The investing question is OK, when?

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