So in my previous post I wrote about insurance pricing and underwriting performance, usually indicated by loss and combined loss ratios.
Today I want to share how an insurer can actually still be profitable when they have a combined loss ratio of more than 100%!
Sounds counter-intuitive isn't it? How can an insurer suffer a loss on its primary business and still be profitable? So let me explain...
When you (and everyone else) pay your policy premiums, the insurer actually gather all the funds and plough them into the investment field, either through their internal investment department or an external fund manager. Bottom line is that the insurer doesn't not waste time letting the money sit idle and instead will set to let the premiums earn investment yield asap.
And since one isn't going to make a claim the day after (or maybe not even in the policy year - that is, the accident is incurred in the policy year but maybe the insured suffers in delay in reporting to insurer) the insurer thus has a runway to earn interest on the premiums. Theoretically, the longer the runway, the higher the yield earned.
So on a net basis, it's possible for an insurer to be profitable if its investment income outweighs its underwriting losses! And this is actually one big reason why insurance claims tend to be "not fast", it is in the insurers' interest to prolong the investment runway or to wear the insured out such that he/she settles for a lower claim amount or even drop the claim altogether (yes such people exists).
Not to mention, the surplus funds from any earlier years of underwriting profits continue to earn yield for the insurer in the financial markets and the snowball effect will only get larger.
So one can actually see how profitable an insurance company can be if it is disciplined in:
Office cost management.
The underlying idea behind this article is the concept of "float" that legendary investor Warren Buffett mentions in his annual letter without fail.
I will try to explore this "float" concept in the next few articles.