Insurance companies' investments come almost entirely from premiums that customers pay. These premiums show up as liabilities on the balance sheet because they represent future claims the company expects to pay out. Think of it this way: customers are paying now for a service (insurance coverage) they might need later.
Let's use an example: If an insurance company has $66 billion in premiums collected, they know they'll likely need to pay out about $66 billion in claims over the coming years. Instead of letting this money sit idle in a bank account, they invest it.
This is where the two sides of an insurance company come into play:
- The underwriting side (selling insurance policies) collects premiums
- The investment side uses these premiums as capital to make investments
It's similar to a loan system, but with a twist. When customers pay premiums, they're essentially "lending" money to the insurance company. This "loan" only gets "repaid" when the customer files a claim. Meanwhile, the insurance company invests the premium money. While they eventually have to pay out claims (repay the "loan"), they get to keep all the investment profits they made.
This explains why insurance companies often continue selling insurance even if they lose a small amount on the underwriting side - it's like getting a very cheap loan. Historical data shows insurance companies lose about 1.5% per year on underwriting. That's their effective borrowing cost, which is much cheaper than other forms of borrowing.
Why don't they just raise prices to make both underwriting and investments profitable? Because insurance is highly price-competitive. Customers will quickly switch companies for a better rate. If Company A tries to make a 2.5% profit on underwriting, while Company B is willing to lose 2.5%, Company B's prices will be 5% lower - and they'll attract more customers, giving them more premium money to invest.
please see my edit about the relevance of time delay. Im curious what you will say. Using the loan analogy, I understand how a firm can make money on loans with a repayment delay. This doesnt make sense to me if the payout is >100% and the average time delay converges to 0.
No, that's not accurate. The time delay doesn't converge to 0 just because payouts match incoming premiums. Here's why:
Think of it like a water tank:
- The tank contains 66B gallons (total liabilities)
- 30B gallons flow in annually (new premiums)
- 30B gallons flow out annually (claim payments)
- The tank stays at 66B gallons (stable liability pool)
Even though the annual inflow equals the outflow (30B), it would still take about 2.2 years to drain the entire tank (66B/30B = 2.2) if you stopped adding new water. This is the average time delay.
The matching of annual inflows and outflows just means the system is in steady state; it doesn't affect the average duration of how long money stays in the system. That duration is determined by:
- Total liability pool ($66B) divided by
- Annual payout rate ($30B)
Another way to think about it:
- Each premium dollar collected today is promised against future claims
- Those future claims are spread out over the next several years
- Even as old claims are paid, new premiums create new future obligations
- The ratio of total obligations to annual payments (66/30) determines the average delay
So while the annual cash flows may match, the time delay is a structural feature of how insurance obligations are spread out over time. The matching of annual inflows and outflows maintains the system's stability but doesn't eliminate the time delay inherent in the insurance model.
It is intrinsic to the nature of insurance that there is a time delay. Even if the insured were to suffer a loss on the same day that they paid their premium, there will still be a delay. Even the most efficient, benevolent insurance operation cannot process a claim, value a loss, and settle the claim within a day.
I get how you can have a profitable steady state in with equal inflow and outflows given a surplus tank.
I get how even an immediate claim takes time to settle.
Would you agree that this puts an upper limit on the loss they can run? If more aggregate auto claims are submitted than premiums paid in a day, you can only make interest on they delay duration. If payout delay is say 3 months, annual interest is 4%, you break even at a 1% loss on premiums, right?
If you are consistently drawing down your float to pay claims instead of adding to it, you are better off leaving the auto insurance industry and simply operating an equity investment firm.
> Would you agree that this puts an upper limit on the loss they can run? If more aggregate auto claims are submitted than premiums paid in a day, you can only make interest on they delay duration. If payout delay is say 3 months, annual interest is 4%, you break even at a 1% loss on premiums, right?
Of course there is an upper limit on losses they can run. The upper limit is base on their investment returns and the time frame. The time frame is longer than you think. Based on a quick run of the numbers it is measured in years.
> If you are consistently drawing down your float to pay claims instead of adding to it, you are better off leaving the auto insurance industry and simply operating an equity investment firm.
They are continually replenishing the float at the same time. The whole point is that they are operating an equity investment firm, except the investment capital comes from a revolving pool of insurance premiums instead of some other pool of money.
There's something I'm still not getting. Car insurance should not have a significant lag because the probability of claim is not related to the date of policy. I'm just as likely to get in an accident on day 1 of my policy as day 1,000.
If daily claims meet or exceed the daily premium, the only time available to earn interest is between premium receipt and claim payment.
Imagine founding an insurance company and on day one you receive $100 in premiums and $100 in claims.
Let's use an example: If an insurance company has $66 billion in premiums collected, they know they'll likely need to pay out about $66 billion in claims over the coming years. Instead of letting this money sit idle in a bank account, they invest it.
This is where the two sides of an insurance company come into play:
- The underwriting side (selling insurance policies) collects premiums
- The investment side uses these premiums as capital to make investments
It's similar to a loan system, but with a twist. When customers pay premiums, they're essentially "lending" money to the insurance company. This "loan" only gets "repaid" when the customer files a claim. Meanwhile, the insurance company invests the premium money. While they eventually have to pay out claims (repay the "loan"), they get to keep all the investment profits they made.
This explains why insurance companies often continue selling insurance even if they lose a small amount on the underwriting side - it's like getting a very cheap loan. Historical data shows insurance companies lose about 1.5% per year on underwriting. That's their effective borrowing cost, which is much cheaper than other forms of borrowing.
Why don't they just raise prices to make both underwriting and investments profitable? Because insurance is highly price-competitive. Customers will quickly switch companies for a better rate. If Company A tries to make a 2.5% profit on underwriting, while Company B is willing to lose 2.5%, Company B's prices will be 5% lower - and they'll attract more customers, giving them more premium money to invest.