If you're like most people, chances are you've fallen for a big myth surrounding Warren Buffett.
Buffett is considered by many to be the best investor in history. He regularly ranks in the top three of America's richest people. He controls one of the greatest fortunes ever compiled.
Entire books have been written about Buffett's stock-market skills. When someone starts out in stocks, they'll say, "I'm going to buy stocks like Warren Buffett does"… just like a young basketball player wants to play like Michael Jordan.
Buffett is a great stock-market investor. But the stories about his fortune almost always fail to identify the real secret behind his success. When people refer to him as the "world's richest investor," they reveal a deep ignorance about the source of his wealth.
It's not the stock market.
The real story is that Buffett actually got rich by owning what some financial insiders consider to be the world's greatest business. It's a business that, managed properly, is mathematically guaranteed to make you wealthy. But not one investor in 10,000 knows this to be the case.
Despite the power of this business... and despite the wealth it has brought Buffett and others like him, few investors understand how to use this business for themselves.
You see, Buffett did not get rich because he is a great stock investor. He didn't get rich with "buy and hold" investing... or through his famed purchase of Coca-Cola shares.
Buffett got rich because he's a world-class insurance man.
It started in 1952. Buffett took a train ride to Washington, D.C. in hopes of meeting with executives at GEICO's headquarters. GEICO was a small insurance company at the time. And at 21, Buffett was trying to find out why his future mentor – Benjamin Graham – was on the board of directors.
Buffett did not get a chance to meet Graham that day. However, he did sit down with Lorimer Davidson, GEICO's vice president. The two discussed the insurance business for hours. This turned out to be one of the most important meetings in Buffett's career.
Buffett quickly understood that insurance was one of the best businesses in the world. That's because people pay insurance premiums upfront. Yet, this money gets paid out at a later date – when an accident or natural disaster occurs.
For example, when a licensed driver pays his car insurance... these payments are made despite the fact that he has not been in an accident yet. And all of this money sits in a pool (called a "float") until an accident occurs – which could be never.
The brilliant part... Buffett knew he could make exceptional returns on these floats. It was like a license to borrow money for free. And based on his annual returns, he could simply invest this float in his favorite stocks, like Coke and Procter & Gamble.
You can see why Buffett's fortune is much more than buying brand-name stocks and holding on forever. By purchasing insurance companies, he was essentially buying massive pools of cash (increasing his leverage). This cash was then invested – earning returns far greater than the market…
Some of the top money managers in the world are now following in Buffett's footsteps… They are setting up mini-insurance companies as small-cap stocks.
These small stocks provide a "backdoor" way for you to invest alongside some of the brightest hedge-fund managers. And buying these names today could set you up for triple-digit returns within the next 18 months. Long-term, these stocks could become their own mini-Berkshire Hathaways – having billions of dollars in excess cash to invest in some of the best businesses in the world.
So let's take a closer look at why almost every billionaire hedge-fund manager is rushing into the insurance industry...
Insurance Companies Need to Offload Risk
It was the storm of the century. At least that's how New Yorkers described it...
"Superstorm Sandy" hit New York City on October 29, 2012. With winds over 80 miles per hour, the Category Three hurricane flooded one-fifth of the city. Much of Manhattan was in darkness for over a week... Subway tunnels were filled with water... More than 150,000 homes were damaged... And more than 100 homes burned to the ground in a small beach town called Breezy Point...
I mentioned insurance is one of the best businesses in the world... That's true – as long as insurers don't have to pay huge claims. But Superstorm Sandy caused more than $68 billion in damages, making it the second most destructive hurricane in U.S. history (behind Hurricane Katrina).
Sandy is just one of several natural disasters to hit insurance companies since 2010…
|•||A large earthquake wiped out thousands of buildings in Haiti.|
|•||Two deadly earthquakes struck New Zealand and damaged more than 100,000 buildings.|
|•||An earthquake triggered a massive tsunami in Japan that wreaked havoc on buildings and a critical nuclear reactor in Fukushima.|
|•||Torrential rains caused massive flooding along Australia's east coast that damaged thousands of homes.|
|•||And a typhoon devastated the Philippines and killed an estimated 10,000 people (and counting), destroyed homes, and caused major flooding.|
These are just a handful of the natural disasters that have occurred in the past few years. Combined, they have caused over $100 billion worth of damage. (According to the United Nations, since 2000, that total has reached $2.5 trillion.)
Remember, insurance is one of the world's best businesses... when insurers don't have to pay out big claims. And due to these large claims over the past few years, insurance companies are rushing to unload some of their risk.
This has created a huge opportunity for hedge funds.
You see… in order for insurance companies to reduce risk, they are selling off part of their insurance portfolios.
For example, if an insurer sells 100 policies, each with a $1 million policy limit – the insurer theoretically could lose $100 million in the event of a natural disaster. Instead of taking 100% of this risk, insurers will sell off maybe 20% of the portfolio. The companies that buy these policies are called reinsurers.
The reinsurance business can be a no-nonsense departure from running a regular insurance company. After all, you don't need to spend millions on TV advertisements with lizards and whatnot. As long as you have the infrastructure set up, you can sit back and take a piece of their "extra" business.
And the reinsurance industry is huge. According to Aon Benfield Analytics, global reinsurer capital totaled $505 billion in 2012. To put that in perspective, the tablet industry – which includes the Apple iPad – generated $40 billion in global sales in 2012. It's also bigger than the car insurance industry – which is roughly $160 billion, according to the National Association of Insurance Commissioners.
Chris Mayer, editor of the Capital & Crisis newsletter and a regular speaker at the prestigious Value Investing Congress, talked to us about the resurgence of the reinsurance industry last week. He said…
Hedge-fund managers are following in Buffett's footsteps... They have recently created reinsurance companies to avoid paying income taxes and [are] reinvesting this money within their fund tax-free.
Chris is dead-on. Over the past 18 months, some of the largest hedge-fund managers have piled into the reinsurance industry. They created small companies (outside of their hedge funds) to buy these massive pools of money...
Why Hedge Funds Are Jumping into the Reinsurance Industry
Over the past few years, hedge-fund managers have been looking for ways to outperform the market. With stocks hitting record highs day after day, that has not been an easy task.
Interest rates also remain at historically low levels. That makes it difficult to earn interest on your investments over long periods... a strategy Warren Buffett credits for making him wealthy.
Today, hedge funds are finding huge returns through the reinsurance industry. There are three reasons for this…
First, hedge-fund managers can buy pools of low-cost permanent capital (assets under management) to invest in their funds… which eliminates the risk of redemptions.
One of the biggest risks facing the hedge-fund industry is market risk. Market risk is almost impossible to predict. If economies around the world slip into recession, this could cause investors to take cash out of hedge funds after their initial "lock up" period ends. (The lock-up period is the amount of time – usually a few years – hedge-fund investors are not allowed to redeem shares.)
These redemptions create a ripple effect... The fund manager has to sell assets (stocks or bonds) to pay back his investors. This forced selling causes assets to fall further – resulting in even more redemptions.
However, when hedge funds use the float from an insurance unit... they don't have to worry about redemptions. This cash is a stable pool of money (permanent capital) that can then be invested in the fund. In other words, hedge-fund managers are able to raise cash (increasing leverage) through their reinsurance companies. And they do so without paying high interest rates (like investors do when they go on margin).
Second, hedge-fund managers enjoy considerable tax benefits through their reinsurance companies.
Most reinsurance companies are set up in the Cayman Islands and Bermuda. The tax structure in these areas provides a huge advantage to hedge funds and their investors...
These tax advantages are significant. Hedge-fund investors pay nearly 40% in taxes for ordinary income on their profits. If you invest in a hedge fund's reinsurance company set up in Bermuda, this cash will instead grow tax-free until you decide to sell it. Then, you only have to pay 20% in capital-gains tax (if you hold this investment longer than 12 months).
Third, the premiums reinsurance companies receive are surging due to a sharp increase in claims.
Think back to the natural disasters I listed earlier. Hurricane Sandy flooded several towns along the east coast in 2012. A few months later, homeowners living in close proximity to affected areas saw a massive increase in flood insurance premiums. Residents went from paying $2,000 in annual flood insurance to over $20,000.
These huge premiums are terrible for homeowners. But they are great for insurance (and reinsurance) companies who pocket more cash for each policy they write.
You can see why hedge-fund managers are diving headfirst into the reinsurance industry. They can buy cheap pools of permanent capital to invest in their funds. They can save money on taxes. And they can generate much bigger premiums, which in turn leads to higher profits.
The good news for investors... There's an easy way to invest in hedge fund-created reinsurance firms. These entities have been set up as small-cap, publicly traded companies.
In short, buying these reinsurance companies gives us a "backdoor" way to invest alongside the greatest hedge-fund managers in the world.
Crux note: Frank's Phase I Investor is not for everyone. Phase I specializes in little-known small-cap stocks. These companies are out of the mainstream… and offer the potential for explosive 500%-1,000% gains you won't find anywhere else. To take advantage, click here.
More on Warren Buffett:
Porter Stansberry: The secret behind Warren Buffett's newest investment lesson
The three big reasons Warren Buffett isn't buying stocks today
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