Insurers: life and non-life · RiskAtoms Academy

By the end you will be able to

1Explain how premiums, reserves and investments fit together in an insurer.
2Tell life insurance apart from non-life insurance, and say why their investments differ.
3Calculate the loss, expense and combined ratios, and an insurer's operating result.
4Explain how pooling makes many uncertain risks predictable.

Why it matters

Most businesses know what their product costs before they sell it. An insurer does not. It takes your money today and finds out the cost months or decades later, when the claims come in.

Core explanation

Paid first, tested later

An insurer sells promises. You pay a premium; in return it promises to pay if something goes wrong: a car crash, a house fire, a death, or simply living longer than your savings. The whole business rests on three linked pieces: premiums come in first, reserves record what is owed, and investments hold the money until it is paid out.

Why it works: pooling. No one can say whether you will crash your car this year. But across a million drivers, the number of crashes is steady from year to year. This is pooling, and it rests on the law of large numbers. Here is life cover as an example. Suppose 2 in every 1,000 people of a certain age die in a year, and each policy pays $200,000. The expected cost per policy is 0.002 × $200,000 = $400. With a 25% loading for costs and profit, the premium is $500.

Policies in the pool	Expected deaths	Typical swing (±)	Swing as % of expected
100	0.2	0.4	223.4%
10,000	20.0	4.5	22.3%
1,000,000	2,000.0	44.7	2.2%

The swing is one standard deviation of the number of deaths. A small pool is a gamble; a large one is close to a sure thing. That is why size matters so much in insurance.

ExploreHow the money moves through an insurer

Click a box to see what happens there.

Premiums

Policyholders pay at the start of the cover. A one-year home policy bought in July is only half-used by December, so the insurer has “earned” only half of that premium. The unearned part is held as a reserve.

Life and non-life. Insurers split into two families, and in many countries the law keeps them in separate companies.

Life (and pensions)

Pays on death, or pays an income for as long as you live. Contracts run for decades, and many include savings. Main risks: mortality (people die sooner than expected), longevity (they live longer) and interest rates, because the promises are long and the bonds backing them must match.

Non-life (property and casualty, or general)

Covers things and liabilities: cars, homes, ships, businesses, lawsuits. Contracts mostly run for a year. Main risks: underwriting (pricing too low), catastrophes (many claims at once) and reserving (claims costing more than estimated, especially when inflation rises).

Sort itLife or non-life?

A 20-year term policy that pays out on death
A lifetime annuity bought with a pension pot
Comprehensive cover on a car
Directors' liability cover for a listed company
Cover for cargo on a container ship

The formal version

Non-life results are summed up by a few ratios, all measured against earned premiums: the part of the premium for cover already given. They extend the “income minus costs” arithmetic of L1.2.01, so here they are on a few lines.

\text{Loss ratio} = \frac{\text{claims incurred}}{\text{earned premiums}}

\text{Expense ratio} = \frac{\text{expenses}}{\text{earned premiums}}

\text{Combined ratio} = \text{loss ratio} + \text{expense ratio}

\text{Underwriting result} = \text{earned premiums} \times (1 - \text{combined ratio})

\text{Operating result} = \text{underwriting result} + \text{investment income}

Conventions

“Claims incurred” means claims for events in the period, paid or not, including the change in reserves. Some markets, such as US statutory reporting, divide expenses by written premiums instead. Always check which one a report uses.

Try it

A non-life insurer writes £1,000m of premiums. At the starting settings the combined ratio is 98%, so the insurance itself makes £20.0m. Claims are paid 2 years later on average, so it holds a float of £1,360m and earns £54.4m on it at 4%. It would still break even with a combined ratio of 105.4%. Push the loss ratio up, then switch to long-tail liability business.

Try itAn insurer's year on £1,000m of premiums

Loss ratio (claims)68%

Expense ratio30%

Years until claims are paid2.00

Investment yield4.00%

Or pick a line of business

Combined ratio98%

Underwriting result£20.0m

Float held£1,360.0m

Investment income£54.4m

Operating result£74.4m

Break-even combined ratio: 105.4%

Where the profit comes fromLong-tail business holds the float for longer, so investment income can carry an underwriting loss.

Worked example

Southern Cross Insurance's year

Southern Cross is a made-up Australian non-life insurer. Amounts are in A$ millions for one financial year. Its investment portfolio, which backs its reserves and capital, averages A$1,500.0m and earns 3.5%.

From premiums to operating result

Step 1 of 6

1
Loss ratio
Claims incurred A$560.0m ÷ earned premiums A$800.0m = 70%

Regulatory lens

Insurance regulation has one main aim: that the promises are kept, even in a bad year. So rules look at both reserves (are they enough for the expected cost?) and capital (is there a buffer for the unexpected?).

European Union: Solvency II, in force since 2016. Reserves are a best estimate plus a risk margin. Capital must cover losses that would only be exceeded once in 200 years (a 99.5% level over one year). The UK now runs its own version, Solvency UK.
United States: insurers are regulated by the states, coordinated through the National Association of Insurance Commissioners (NAIC), which sets risk-based capital (RBC) formulas.
Asia-Pacific: regulators have moved to risk-based capital too, for example China's C-ROSS regime, while Australia's APRA supervises insurers alongside banks.
Global: the International Association of Insurance Supervisors (IAIS, L1.2.09) sets core principles and an Insurance Capital Standard for large international groups.
Accounting: IFRS 17, in force since 2023, sets how insurers outside the US report contracts and profits.

An insurer's balance sheet and income statement are read in L1.8.04 and L1.8.05. Solvency II and IFRS 17 return in later levels.

Sparks

SparkInsurance born in a coffee house

Lloyd's of London began in Edward Lloyd's coffee house in the late 1600s, where merchants and ship owners met to share news and insure voyages. Underwriters wrote their names under the risk they agreed to take, which is where the word “underwriter” comes from.

SparkMoney we hold but don't own

Warren Buffett built much of Berkshire Hathaway on insurance float. In his letters to shareholders he has called float money the company holds but does not own, and argued that it is worth most when the insurance itself breaks even or better, so the money costs nothing to hold.

Key takeaways

Insurers collect premiums first, hold reserves for what they owe, and invest the money until claims are paid.
Pooling many similar risks makes the total predictable: the swing shrinks as the pool grows.
Combined ratio = loss ratio + expense ratio. Below 100% means an underwriting profit.
Investment income on the float can turn an underwriting loss into an overall profit, especially for long-tail business.
Life insurers hold long promises and long bonds; non-life insurers hold shorter, more liquid assets.

Reaction

Check what stuck

Glossary

Premium: The price a policyholder pays for cover, usually in advance.
Pooling: Combining many similar risks so that the total becomes predictable, even though each one on its own is not.
Reserves: Money an insurer sets aside on its balance sheet for claims and benefits it still owes. Also called technical provisions.
IBNR: Incurred but not reported: claims for events that have already happened but have not yet been reported to the insurer.
Float: Premiums collected but not yet paid out as claims. The insurer invests it in the meantime.
Loss ratio: Claims incurred divided by earned premiums.
Expense ratio: Running costs, including commissions, divided by premiums.
Combined ratio: Loss ratio plus expense ratio. Below 100% means the insurance itself made a profit.
Tail: How long it takes, on average, for claims to be reported and paid. Motor is short-tail; liability is long-tail.
Annuity: A product that pays an income, often for life, in exchange for a lump sum.
Reinsurance: Insurance for insurers: an insurer passes part of its risk to a reinsurer for a premium.
Asset-liability management: Asset-liability management: choosing investments whose cash flows and risks match the promises the insurer owes.

Deep Dives & Origins

Deep Dives

Saunders and Cornett, Financial Institutions Management: A Risk Management Approach (McGraw-Hill), the chapter on insurance companies. Beginner.
Swiss Re Institute, sigma reports on world insurance markets (published regularly). Beginner.
Hull, Risk Management and Financial Institutions (Wiley), the chapter on insurance companies and pension plans. Intermediate.

Origins

Directive 2009/138/EC (Solvency II).
IASB, IFRS 17 Insurance Contracts, issued 2017, effective 1 January 2023.
IAIS, Insurance Core Principles and Common Framework for the Supervision of IAIGs.
NAIC, Risk-Based Capital overview.
Berkshire Hathaway, letters to shareholders (on insurance float).

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