General Insurance business makes money largely the same way as a traditional bank.
Sounds weird, right? But, it’s true. Read on please!
A bank gives us an interest on our deposits, which the bank uses to give out loans at a higher interest rate. The bank makes money on the interest rate differential.
A well-run general insurer is able to raise money many a time at a lower interest rate than a bank (at times even at 0% or -ve interest rate). Much like a bank, the insurer then invests that money at higher interest rate and earns on the differential.
But, where do the insurance premiums and claims go?
Let’s use a very simple 𝗲𝘅𝗮𝗺𝗽𝗹𝗲 to understand a general insurer’s business model –
Remember, premiums are received upfront and claim payments come at a later point in time.
Let’s say premiums received in a year are $110.
𝗔 𝗽𝗮𝗿𝘁 𝗼𝗳 𝗽𝗿𝗲𝗺𝗶𝘂𝗺𝘀 𝗲𝘃𝗲𝗿𝘆 𝘆𝗲𝗮𝗿 𝗮𝗿𝗲 𝘀𝗲𝘁 𝗮𝘀𝗶𝗱𝗲 — let’s call this “𝗳𝗹𝗼𝗮𝘁” — to cover future claims (Insurer invests this reserve money and earns an interest).
Let’s say $10 is reserved for future claims, leaving the insurer with $100 net premium in that year.
The net premium money i.e., $100 goes towards $32 worth of expenses (agent commissions, policy underwriting, etc.) and $70 worth of claims payments of that year.
So this insurer makes a $2 loss on the net premium in that year — this is called 𝘂𝗻𝗱𝗲𝗿𝘄𝗿𝗶𝘁𝗶𝗻𝗴 𝗹𝗼𝘀𝘀.
Put simply, this UW loss of $2 is akin to the 𝗰𝗼𝘀𝘁 𝗼𝗳 𝗿𝗮𝗶𝘀𝗶𝗻𝗴 𝗺𝗼𝗻𝗲𝘆 or the 𝗰𝗼𝘀𝘁 𝗼𝗳 𝗳𝗹𝗼𝗮𝘁 — as Buffett calls it.
Like, previously stated, 𝗶𝗻𝘀𝘂𝗿𝗲𝗿 𝗲𝗮𝗿𝗻𝘀 𝗶𝗻𝘁𝗲𝗿𝗲𝘀𝘁 𝗼𝗻 𝘁𝗵𝗶𝘀 𝗳𝗹𝗼𝗮𝘁
Let’s say the “accumulated” float overtime (including the $10 set aside this year) is $100, so the cost of float this year is $2/$100 = 2%
i.e., cost of float 2% this year < market rate of raising money
Like a bank, an insurer makes money on the differential between investment returns (say 8%) and the cost of float 2%
Return = 8% – 2% = 6%
But, 𝒊𝒇 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒇𝒍𝒐𝒂𝒕 “𝒐𝒗𝒆𝒓𝒕𝒊𝒎𝒆” 𝒊𝒔 > 𝒎𝒂𝒓𝒌𝒆𝒕 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒎𝒐𝒏𝒆𝒚 𝒕𝒉𝒆𝒏 — 𝒊𝒏 𝒕𝒉𝒆 𝒍𝒂𝒏𝒈𝒖𝒂𝒈𝒆 𝒐𝒇 𝑾𝒂𝒓𝒓𝒆𝒏 𝑩𝒖𝒇𝒇𝒆𝒕𝒕 — 𝒕𝒉𝒆 𝒊𝒏𝒔𝒖𝒓𝒆𝒓 𝒊𝒔 𝒘𝒐𝒓𝒕𝒉 🍋
Only handful of Indian insurers have a -ve cost of float i.e., they are paid to acquire float.
Hope this helped!
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If you want to understand WarrenBuffett method of evaluating a general insurer in detail, then I’d suggest you to watch this linked video:
Decoding a general / non-/ property & casualty insurance business model

Gautam is the passionate equity researcher and instructor at Invest and Rise
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