Medibank's risky investment portfolio

Warren Buffett has said “What counts in insurance is the amount of float and its cost over time.”

But what does Buffett mean when he says 'float' and why is it so important to Medibank, Australia's largest private health insurer?

When you take out an insurance policy, you pay your premium up front but, unless you're unlucky, generally won't make a claim until sometime down the track. Medibank receives cash from you today but it may be years before it has to pay for any of your healthcare expenses, such as a hospital visit.

In the meantime, Medibank gets to hold on to your money and it's this pool of funds that Buffett calls 'float'. Medibank's float doesn't belong to shareholders as it will eventually be paid out to policyholders – it's shown on the balance sheet as a liability. But, until it's paid out, Medibank gets to invest the float and keep the interest and investment income.

Medibank's investment portfolio is roughly $1.5bn – more than three times larger than NIB's. What's more, in 2013 it generated $130m in additional income for the company and accounted for some 40% of Medibank's pre-tax profit, compared to roughly 30% for NIB.

That may sound like a good thing, but it actually makes Medibank's earnings far more volatile. Medibank's investment portfolio has twice the exposure to equities as NIB so it has benefited from a rising share market. However, if stocks fall materially, Medibank's earnings will be hit hard – in 2009, the company's investment portfolio made a loss of $54m.

This isn't a problem when the Government is your only shareholder, but, when Medibank lists later this year, private shareholders may not have the stomach for wild profit swings. Medibank might need to invest its float more conservatively in bonds or other fixed-interest securities. This would stabilise its earnings but, with interest rates so low, is sure to act as an anchor on profit growth.

Shareholders would then be more reliant on Medibank's underwriting, which can only improve by increasing premium revenue and controlling costs. An insurer's underwriting ability is what Buffett referred to as the 'cost of float' and will be the subject of next week's Medibank update.