Insurance risk involves the sale of insurance policies to policyholders, the receipt of premium and the payment of claims. If claims & associated expenses are less than premium received, an Underwriting Profit is made. If claims are greater than premium, an Underwriting Loss occurs. In essence, investing in insurance risk is like partnering with an insurer — you share in the results of the portfolio, keeping a slice of the underwriting profit if claims come in below premiums, or sustaining a loss if they come in above.
Most Insurance Is Not Fully Collateralized
This brings us to the concept of collateralization. An everyday example of collateral involves your mortgage. When you take out a loan from the bank to buy a house, you're putting up the house itself as collateral for the loan to secure it - meaning, if you fail to pay back the loan, the bank can foreclose and sell the house to cover the loan.
The key observation about insurance risk is the possibility for insurers to pay out more money in claims than they take in via policy premiums. When you purchase a policy from an insurance company, you’re implicitly trusting that the insurance company will be able to pay you out in the event of a claim, even if it means they’re operating at a loss. Insurance companies have a balance sheet (basically, an amount of assets or money) which acts as collateral against the chance that they must pay out more than they take in.
The amount of money held by the insurance company for this purpose is known as insurance capital & surplus. Since this amount of capital is less than the total sum of all policy limits, we can say the policies are partially collateralized.
Visualizing How Insurance Losses Are Distributed
The chart below illustrates this concept with a probability distribution. The blue curve shows the likelihood of different loss levels. It peaks around 60-70% of premium but has a long tail extending to extreme scenarios.
The insurance company in this example holds capital equal to 175% of premium collected, giving them total resources of 275% of premium (100% premium + 175% capital) to pay claims in extreme years.
The green dashed line shows the return on capital from underwriting activities. When losses are less than premium collected (green zone), the insurer keeps the difference as profit. Once losses exceed the break-even point at 100%, the insurer must use their capital reserves to pay claims (red zone). Think of it like making an "investment" with the premium you collected, but getting such a negative return that you have to reach into your wallet to cover the losses (red line).
Chart Legend: Blue Curve: Probability of different loss levels Orange Line: Premium remaining (profit zone) Red Line: Capital required (loss zone) Green Line: Return on capital at loss level Green Zone: Profit (Loss < Premium) Red Zone: Loss (Loss > Premium) Purple Zone: Insolvency (Loss > Capital) Key Insight Notice how potential returns can fall well below -100%, meaning losses can exceed the original premium collected. In the purple insolvency zone beyond 275%, even the capital reserves are exhausted - this is why insurers need substantial capital cushions and why regulators closely monitor capital adequacy.
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