Brookfield Makes A Move Out Of Buffett's Playbook
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Investors that follow Brookfield Asset Management (BAM) closely have noticed that the company is actively doing insurance deals, and that it even created a subsidiary called Brookfield Asset Management Reinsurance (BAMR). In this article we'll explore the reason why, and speculate as to how big of an impact it can have on BAM. But for those eager to know the reason upfront, we can summarize it in one word: Float. Brookfield is interested in gaining control of large amounts of float, to then apply its credit investing knowledge and make money by improving returns.
BAM recently acquired American National Group for ~$5.1 billion, and according to its most recent 10-K the purchase brought with it ~$29 billion in assets, ~$23 billion in liabilities, and net equity of ~$6.5 billion. A significant portion of the assets are bond securities which BAM will probably reinvest in higher yielding credit, which is the specialty of its recently acquired Oaktree Capital. There is also ~$2 billion invested in equities, which Brookfield might increase and probably move into its high conviction ideas.
There have been other deals Brookfield has been part of, such as this annuity deal with GM Canada for $1.4 billion. We think that the overarching theme of these deals is that Brookfield wants to gain control of insurance float at a time when it is not properly valued due to the incredibly low interest rates, and difficulty generating meaningful returns. We believe Brookfield is betting that interest rates don't have much room to fall further, and that with its deep investment expertise it can generate higher returns than the discount rates used for the deals. In fact, that is what CEO Bruce Flatt hints at during a recent Q&A session at the Goldman Sachs 2021 US Financial Services Conference when asked how they were thinking of scaling insurance initiatives, whether additional acquisitions were being considered and the longer-term plans for the capital:
So look at every business we started, we always have mature businesses, mid stage businesses, early stage businesses. And many of these businesses we have that we started in the last two, three years, will not generate meaningful contributions to the company for 2, 3, 4, or 5 years. But what it does is it extends the growth trajectory that we have in the business, and that's very significant.
With reinsurance. Look, I think the reason why we started now, we didn't start before is that interest rates are zero, and the risk on the liability side is gone. We're just riding [ph] annuities this life either life, and we're giving away the life risk. And we're just we're basically creating annuities. This just we're taking on fixed income obligations, and with interest rates very low, the risk is gone on the liability side. And therefore, the risk in the business is can you invest the capital properly and earn a return? And we feel highly confident that we can out earn the liabilities that we're taking on? So that I guess, point number one, that's why we started into the business and that's why we've been buying blocks of reinsurance and we bought Anaco sizably last year this year. And so our view now is how do we grow the business further. And I guess what I'd say first is our balance sheet allows us to make sure that we're right before we ever bring a wealth or institutional client into a product with us.
So we and I'm going to say maybe this isn't the right way to say it, but we never practice on with other people's money. And until we're absolutely sure that we can manage the risk, we can invest the money properly, we can earn 20% returns on our capital, we can do everything right, we will never introduce an institutional client or wealth private client into an into an asset class.
So as we grow, and it looks like given where rates are and where the capital that's needed by insurers, there should be a big growth for this business, we're going to have to assess where the rest of the money comes from. And it's likely we'll bring in other money into this business at some point in time, probably it will be private money. We have a lot of institutional clients that have interest in this business with us. It may be portions of it. It may be into the reinsurance book, it may be a new insurance company, we're not sure. Okay, I just I, the bottom line is we've been funding the business ourselves. We have the luxury of being able to do that. And, and but in due course, I think it'll become very big. And we're going to have to figure out some other way to fund it, which is the money's there, right? We just need to figure out what's the best and perfect source for that great.
In the above quote we emphasized the parts that we consider more relevant to the discussion. Note how confident Bruce Flatt is that Brookfield can out-earn the liabilities they are taking, and make a good profit there. This is part of the playbook that made Berkshire the giant it is today, and it seems Brookfield couldn't have hoped for a better time to test the same strategy. If bringing external capital ends up working, the opportunity size could be even bigger, with earning fees added to it too.
Buffett did an excellent job explaining insurance float its benefits if one knows how to use it properly in his 2009 shareholder letter:
Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers' compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums - money we call "float" - that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float. If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money - and, better yet, get paid for holding it.
One distinction between Buffett's and Brookfield's strategies is that Buffett mostly kept all the risk that came with the insurance, having the possibility of an underwriting profit or loss, whereas Brookfield seems more interested in taking only the interest rate risk, leaving the underwriting results to others when possible.
A big question is how big this business can become for Brookfield, and as Bruce Flatt noted, it might not be that meaningful for the company for the next 5 years. We believe that if conditions are good and Brookfield manages to incorporate external capital, this could one day, perhaps in ten years, become the most valuable part of the Brookfield empire. After all, insurance is one of the biggest industries in the planet. Just in the US it was a $1.28 trillion industry in 2020, with life/annuity accounting for about half. Life/annuity cash and invested assets totaled $4.7 trillion in 2020. We therefore think that Brookfield is only getting started and there is a lot of room to grow.
Currently, Brookfield controls $29 billion of float thanks to the recent American National Group acquisition. We can imagine the insurance business one day controlling more than $200 billion of float, once this current initial concept has been proven and with the injection of external capital, and if they out earn their liabilities by 200 bps, that could be another $4 billion in profit for Brookfield. If that were to happen, insurance would become the main profit center for the company.
Conclusion
Brookfield and its CEO Bruce Flatt are taking a move out of Buffett's playbook in seeking control of large amounts of insurance float to reinvest a higher rates of returns thanks to their superior investment acumen, and make some formidable profits. Bruce Flatt seems to hint that he believes that returns on the capital employed can be up to 20% when he talks about when to bring external capital. If that proves accurate this can become an enormous component of value for Brookfield shares.
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