Understand how Warren Buffett uses float
“Float” is defined as the time delay between a bank check being written and the time funds are deducted from the payer’s account. Once the recipient of a check deposits it in his or her account, the bank immediately credits the account. The assumption is the check payer’s bank will send the funds to cover the issued check.
Until the check issuer’s bank releases the funds, both the payer and the payee have the “same” money in both of their accounts. This duplication is called “the float.” Both banks technically have the use of the same funds.
The “Float” is also used in the insurance industry. As an example, it works like this: an insured pays a premium for automobile insurance. The insurance company banks the premium but has no obligation until a claim is filed, if ever. In actuality, premiums are mixed to help offset current claims from the insured’s joint premium paying pool. But in our example, let’s say the insurance company uses the premium and only has to cover a claim if it ever happens.
The use of the money known as the “float” allows the insurance company to use the funds for investment. If a claim is never paid, the float can become a significant amount of investable capital. Warren Buffett discovered this concept years ago and has used the float to increase his investible assets. According to his annual letter to investors, last year the “float” was over $77 billion, allowing him to bank money before having to cover any claims. Even in a low-interest-rate environment, calculating the potential yield on $77 billion shows a considerable amount of money earned while waiting to pay a claim.
How about the annuity side of the insurance industry: we place our retirement money on deposit, allow it to sit for years, and then use it as we need it for retirement. The insurance company could have the use of the funds for 20 years or more. How is that fair?
It is fair in this way: the ultimate and best use of the funds in an annuity will probably be as retirement funds. If I know exactly that my future value will be based on a guaranteed interest rate, then I don’t care about any float benefit. As an example, an insurance company offers me 6% per year for 20 years guaranteed, if I agree to use the funds as income. Since annuities are tax-deferred the very best possible use should be as income and not saving for a new boat. I can manage the income and spread the tax liability fully when I use it as income.
As an example, suppose I deposited $200,000 in a guaranteed 6% rate of return income fund (income rider). How much money would I have saved for retirement in 20 years?
$641,427.09
Now at retirement time, I use this account for income for my spouse and me, income neither one of us can ever outlive, lifetime income. So do I care about an insurance company earning “float” on my long-term retirement account? No, I could care less because I have traded the use of my significant funds for income, income that is fully guaranteed.
The actual secret is this, my “float” which is fully guaranteed is the winner. Let the insurance company assume the risk, I will take the guarantees.
