The practice of earning interest income on a customer’s money is widespread over many industries.  Whenever a consumer buys a gift card, purchases a monthly transit ticket, or takes out an insurance policy, the receiving company gets to invest the funds, or “float”, until it has to supply the products or services that the consumer bought.  In essence, the float is really like an interest-free loan that a company uses to produce investment income.

In the case of the insurance industry, the float is the money that an insurance company gets to hold onto between the time customers pay premiums and the time they make claims on their policies.  In fact, this collect-now, pay-later model is central to the way the insurance industry operates.  No matter if a company generates an underwriting profit or loss from its core business, it can still earn investment income from the float.  Perhaps the most famous example of the float is Warren Buffett’s insurance holding company, Berkshire Hathaway (BRKA), which had a float of $62 billion at the end of 2009.  Since an insurer’s float can be significant sources of revenues and profits, companies are sometimes accused of deliberately stretching out claims processing to increase the size of the float.  The level of interest rates is very important, because a company can earn more interest income on its float when rates are high than when rates are low.  Regardless of interest rates, however, the positive impact of investing the float can be material.

Another industry group that benefits from the float is the payroll processing segment of the computer outsourcing industry, which includes Automatic Data Processing (ADP) and Paychex (PAYX).  The Employer Services unit of ADP earns interest income on the float that is created by the lag between payroll deductions, the payment of taxes, and the issuance of pay checks.  At the end of 2009, ADP’s balance sheet held $21.4 billion of these client funds, which are invested with safety of principal, liquidity, and diversification as the primary goals.  Secondarily, the company seeks to maximize interest income and to minimize volatility.  Typically, about 85% of the funds are invested in U.S. Treasury and government agency securities with a maximum maturity of ten years.

ADP utilizes a laddering strategy to extend the maturities of its investment portfolio, and employs short-term financing arrangements to satisfy short-term funding requirements.  This strategy allows ADP to average its way through an interest rate cycle, thus reducing fluctuations in yield.  During the December 2009 quarter, the investment portfolio had a yield of 3.8%, versus 4.2% in the year-earlier period.  Those figures compare to average yields of 4.0% in fiscal 2009 (ended July), 4.4% in fiscal 2008, and 4.5% in 2007.  The laddering strategy exposes the company to interest rate risk as proceeds from maturing securities are reinvested.  Recent results at ADP show how lower yields can lead to lower income.  During the December 2009 quarter, interest income on funds held for clients dropped 13%, year to year.  The impact of rate changes is also affected by the overall portfolio mix between short-term and long-term investments.  Of course, when lower rates reduce portfolio yields, they also decrease interest costs on short-term debt.  In the six months ended December 2009, the interest rate on U.S. commercial paper borrowings was 0.2%, versus 1.4% in the prior-year period.

In summary, the float is an important source of incremental profit for payroll processors like ADP and insurance companies like Berkshire Hathaway, as well as retailers, transit authorities, and many other kinds of businesses.  Investors should understand the concept when examining certain industries.  Moreover, keen attention should be given to what is being done with these assets before initiating a position in a company that benefits from the float.