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How property and casualty insurance works
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By Andreas Schwartze

Insurance can be a dull topic and most of our clients know the fundamental issues that drive the cost of their insurance. Or do they? Let’s find out right here how this business really works, as it is not always what it seems to be.

Property and casualty insurers really don’t like being in the insurance business. How can one possibly predict the level of claims that are to be expected in a given year, or for that matter claims that surface much later and are traceable to years for which the accounting books have long since been closed? I certainly would not want to give someone long term access to my bank account, in exchange for a few dollars of premium...a risky business deal, at best. Better to take one’s chances with oil...

 

 

 

Insurance companies are really in the investment business. They want our insurance premiums today, so that they can invest them tomorrow morning and not have to sell the investment until you and I present a claim. The time delay, from premium collection to payment of claim, creates a large pool of capital, temporary though it may be, that generates investment returns for the insurer. A robust investment climate helps keep premiums lower and at times even promotes some serious competition for your insurance dollar. But this is only one half of the story.

The other is the regulation of insurance capital by the Federal Superintendant of Insurance. On a very simple scale, an insurer must have $40 of safely invested capital for every hundred dollars of premium that it wishes to take in. Note that the relationship is between capital and premium. Using somewhat higher numbers, this means that a capital base of $400 thousand will allow an insurer to take in a million dollars of premium. The trick is to make certain that the million dollars of premium covers all of the claims arising from that pool of clients. Claims that amount to less than the premium billed will grow the capital pool, and where they exceed the premiums taken in they shrink the capital pool. How an insurer picks its clients, so as to ensure this works to its benefit, is another issue entirely.

At the end of the year, our small insurer may have made money in underwriting. Let’s assume the million dollars of premium taken in left it with a $100 thousand underwriting profit. Add that $100 thousand to the $400 thousand of safe capital already in hand and, in the next year, the insurer can take in $1,250,000. We call this “capacity” to write business. $1 of capital allows $2.50 of premium income.

Of greater concern is where the underwriting operation posts a loss of $100 thousand. This claims deficit must come from its safe capital. Suddenly our little insurance company has only $300 thousand of that pool remaining. In the following year, therefore, it must trim its premium intake to a mere $750 thousand. When insurers make money they roar ahead, sometimes foolishly, and do what they must to grow the premium income.

But when they lose money, not only do they have to pare their premium levels, they have to do so by closing out accounts and re-pricing what they can keep. It’s an exponential collapse of market “capacity” that makes life very difficult for many insurance buyers, with some being entirely pushed out of the system.

The impact that investment and underwriting results have on property and casualty insurers result in this sector’s pricing being subject to some serious mood swings. As is to be expected, each carrier watches the others carefully and thus the entire industry goes in the same direction at once. When times are good, clients benefit significantly, but when times go bad hold on to your hat. Fortunately it doesn’t happen too often.

It’s a cycle that never fails to repeat itself.

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