Why Is Warren Buffett Buying Up Shares of This Company?

Late last year, Warren Buffett and his holding company, Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) , started plowing billions of dollars into a single stock. In most cases, this would have triggered a disclosure, forcing the company to reveal which stock, in particular, it had been buying. However, Buffett and his team requested an exemption from the Securities and Exchange Commission (SEC), allowing it to accumulate a large position in secret.

What stock was Buffett buying? It turns out that Berkshire now has a $7 billion stake (roughly 6% of shares outstanding) in the world's largest publicly traded property and casualty insurance operation.

What does Buffett like so much about this insurance stock?

The insurance company that Buffett and Berkshire were building a stake in is none other than Chubb (NYSE: CB) . Most investors aren't too familiar with insurance companies like this one, even though insurance companies have been the foundation of Buffett's long-term investing success. Why? Insurance companies that Berkshire wholly owns give Berkshire consistent levels of investable cash that it can deploy regardless of market conditions.

"Insurers receive premiums upfront and pay claims later," Buffett once explained to investors. "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."

This excess cash that Berkshire invests free of interest -- a pool of capital that Buffett calls float -- helps insurance businesses generate profits even if they write policies with zero expected profit. They can even turn a net profit by underwriting policies at a loss by generating enough investment income. But sometimes, an underwriting profit is also realized, adding yet more to Buffett's investable cash pile. "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," Buffett explains. "This combination allows us to enjoy the use of free money -- and, better yet, get paid for holding it."

Should you buy Chubb stock for your portfolio?

Chubb is a great fit in Buffett's portfolio. Berkshire already owns a portfolio of insurance businesses, and it's a space Buffett knows very well. While Buffett won't have direct control over Chubb's investable float given Berkshire only owns 6% of the company, there's no doubt that his interest in the company could unlock a more optimal capital allocation strategy -- a win-win for both Berkshire and Chubb.

In recent decades, underwriting profits have shrunk considerably due to increased competition. Yet the tide is turning. Last quarter, Chubb posted a combined ratio of just 84.2%. That means for every $100 in premiums it collected, it only needed to pay out $84.20 in claims -- an underwriting profit of roughly 15%. This is no doubt part of the puzzle that attracted Buffett's attention. Chubb is a strict underwriter, and throughout its history, has avoided entering highly competitive markets with slim margins.

But is Chubb a good fit for your portfolio?

The one thing to know is that Chubb won't make you a millionaire overnight. This is a slow and steady business, just like Berkshire. And also like Berkshire, Chubb has proven an ability to outperform the market over the long term. You just need to remain patient. Since 1993, Chubb stock has risen a total of 5,290% in value versus a total return for the S&P 500 of just 2,170%. Over the last three years, Chubb has outpaced the market by nearly 33 percentage points. But there are many periods in which Chubb has been a laggard, even if it's overcome these deficits over time.

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Right now, Chubb's valuation is a perfect entry point for long-term investors. Clearly, the current valuation is good enough for Buffett's money. Shares trade at just 12 times earnings and 1.9 times book value, a figure that's actually overstated due to Chubb's multibillion-share repurchase program that has artificially depressed accounting book value. This company isn't a screaming value, but it's a high-quality business trading at a more than fair valuation. No wonder Buffett has been scooping up shares.