It’s hard for most companies to ignore the cost of capital, which is how much it costs to borrow from lenders and how much it promises to shareholders. But there’s one kind of company that may not incur costs when “raising” capital: insurance companies.
Insurance companies are paid to hold your money. They are paid to take on “loans”. And at the heart of this fascinating world lies the concept: float.
Float: Interest free loan
Float is the money insurers collect in premiums but don’t immediately pay out in claims. It’s like an interest-free loan, except better. Even if an insurer only breaks even after expenses and claims, they get to invest the premiums until a claim hits and keep the earnings. That’s like your bank paying you to borrow money.
Let’s take car insurance, where claims are usually processed quickly. Even so, the constant renewal of policies allows insurers to hold onto the float, creating a consistent supply of interest-free capital.
It’s important for insurers to follow strict rules so they can meet all their obligations. The capital doesn’t go into high-risk investments. It’s mostly invested in a mix of corporate bonds, equities, or real estate.
Combined ratio: How to tell if they are getting paid to “borrow”
The “combined ratio” is an essential gauge of an insurance company’s health. This tells you whether the company is underwriting consistently and profitably. It’s the ratio of premiums to operating expenses and claims paid.
It’s quite easy to read this:
If the combined ratio is below 100, it means underwriting profit.
If the combined ratio is above 100, it means underwriting loss.
Earnings can be manipulated by estimates
Here’s the thing, insurance companies’ income statements will be heavily influenced by how aggressive or conservative management is.
When an insurance company collects a premium, it’ll estimate how much they’d potentially “lose” (or pay out for claims) based on historical data. After that, they set aside funds for these potential payouts.
Overestimating future losses depresses earnings in the short-term, but they’ll have a positive surprise when they readjust reserves when claims don’t come in.
Underestimating future losses inflate earnings in the short term, but they’ll have a negative surprise when claims are in excess of what was estimated, this shortfall will hit its earnings.
Therefore, we want to ensure that they have a good track record of estimating future losses along with a healthy combined ratio.
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