How an insurer makes money

Ten thousand households each pay 400 a year to insure a home worth 300,000. Four million comes in. In an ordinary year eleven houses burn, flood or fall down, and about 2.4 million goes out.

That is the whole product, and the arithmetic is not the clever part. The clever part is that eleven is knowable and which eleven is not.

The two ratios

Everything about underwriting performance compresses into two numbers, both expressed as a share of premiums.

The loss ratio is claims divided by premiums. What share of what came in went straight back out to policyholders.

The expense ratio is everything else it costs to write the business: commission to brokers, staff, claims handling, advertising, the software.

Add them and you get the combined ratio. Below 100, the insurer made money purely on the insurance. Above 100, the insurance itself lost money.

Predict

Of every 100 in premium a typical home or motor insurer takes, roughly how much comes back out as claims?

Choose one answer

Around 20 — insurers refuse most claimsAround 60 to 75Around 95 — insurers barely break even on claims aloneIt varies too much between insurers to generalise

Lock in answer

Run the underwriting

The model below has the investment side deliberately switched off. Returns are pinned at zero, so what you are looking at is the insurance business and nothing else. Only the two ratios move.

Insurance float

≈ Hypothetical model, not a forecast

Premiums in, claims and expenses out, and the money held in between put to work.

It assumes

• The return on money held is pinned at zero here, so only underwriting is visible.
• Claims and expenses are steady shares of the premiums written that year.
• Premiums grow at one constant rate, with no hard or soft market cycle.
• No catastrophe year, which is the thing that actually destroys insurers.

It ignores

• Reserve development, where yesterday's claims turn out to cost more
• Reinsurance, which changes both the claims and the float
• Any year in which the investments themselves lose money
• Capital requirements, and the cost of holding that capital
• Catastrophe years, which is when insurers actually fail

The combined ratio starts at 93 and the insurer is comfortably profitable. Move the two ratios until the combined ratio is above 100 — and see how small a change it takes.

Claims, as a share of premiums6,000%

Expenses, as a share of premiums3,300%

Commission, administration and everything else it costs to write the business.

Combined ratio

9,300%

Premiums in the final year

1,304,773

Underwriting result, final year

91,334

Float held, final year

3,914,320

Investment income, final year

0

Total result, final year

91,334

Underwriting result over the period

802,472

Investment income over the period

0

Total result over the period

802,472

What the float costs, as a rate

-233.3%

Return the float must earn to break even

-233.3%

• Premiums
• Claims
• Underwriting result

◷ Not there yet — keep moving the controls.

Seven points. A wet winter, a rise in the cost of repairs, one competitor pricing aggressively enough that you have to follow — any of those is worth seven points.

This is why insurance is not a business you can win by being slightly better at pricing. The margin between comfortable and loss-making is narrower than the year-to-year noise, and the noise is weather.

Check

An insurer prices motor cover using fewer risk factors than its competitors — one flat price for a broad group. What happens?

Choose one answer

It wins market share by being simpler and easier to buyIt attracts the customers its rivals priced highest, and its loss ratio deterioratesNothing much — risk averages out across a large enough bookIts expense ratio falls enough to compensate

Check answer

Who pays, who benefits, who carries the risk

Who pays. Every policyholder, every year. The overwhelming majority of them pay for decades and claim nothing, which is not a failure of the product — it is the product.

Who benefits. The eleven households whose house burned down, who are made whole. Everyone else, who gets to sleep. And the insurer, on a thin and cyclical margin.

Who carries the risk. Formally, the insurer. In the tail, the reinsurer behind it, and behind them the capital markets, and in the largest catastrophes, the state. Risk is not destroyed by insurance. It is moved, sliced and moved again, and the question worth asking of any insurance arrangement is where it finally comes to rest.

Worth remembering

• Insurance pools variance: a rare unbearable loss becomes a regular affordable payment, and that is a genuine service.
• The loss ratio is claims over premiums; the expense ratio is everything else; added together they make the combined ratio.
• A combined ratio below 100 means the underwriting made money, and above 100 means it lost money.
• The gap between comfortable and loss-making underwriting is only a few points, which is less than ordinary year-to-year variation.
• Pricing with fewer risk factors than competitors invites adverse selection: you win the customers everyone else priced highest.