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Warren Buffett's Ace in the Hole: Insurance?

By Dan Weil   |   Sunday, 10 Feb 2013 12:15 PM

Insurance helps explain why the risk-adjusted investment return of Warren Buffett’s Berkshire Hathaway has beaten all mutual funds and stocks since 1976.

That’s according to a new paper from researchers at New York University and AQR Capital Management, The Economist reports.

Berkshire’s insurance and reinsurance companies lend money to the parent firm, providing it with more than a third of its funding. Buffett can then use that leverage to purchase large quantities of high-quality stocks.

“This would be an expensive strategy if the [insurance] company undercharged for the risks it was taking,” The Economist states.

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“But thanks to the profitability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2 percent, more than 3 percentage points below the average short-term financing cost of the American government over the same period.”

And the insurance company gives Buffett a lender in good times and bad. “The long-term nature of the insurance funding has protected Mr. Buffett during periods (such as the late 1990s) when Berkshire shares have underperformed the market,” the magazine states.

"Without leverage ... Mr. Buffett’s returns would have been unspectacular," The Economist says.

Using the leverage from his insurance operations, Buffett has the resources to buy shares in high-quality companies that are experiencing hard times, such as Coca-Cola in the 1980s and General Electric during the recent financial crisis, The Economist says.

The publication quotes Buffett as having said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Buffett also has "steered largely clear of more volatile sectors, such as technology, where he cannot be sure that a company has a sustainable advantage," The Economist notes.

Still, not everything Buffett touches is golden. Berkshire, the biggest shareholder of Moody’s rating company, may have lost $340 million on that position last week, when the stock plunged 22 percent.

The drop came after news that the government may sue Moody’s rival Standard & Poor’s over its ratings practices prior to the financial crisis.

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