A Brief Introduction to Insurance
On the face of it, the concept of an insurance business is pretty straightforward. An insurance firm pools together premiums that customers pay to offset the risk of loss. This risk of loss can apply to many different areas, which explains why health, life, property and casualty (P&C) and specialty line (more unusual insurance where risks are more difficult to evaluate) insurers exist. The difficult part of being an insurer is properly estimating what future insurance claims will be and setting premiums at a level that will cover these claims, as well as leave an ample profit for shareholders. Beyond the above core insurance operations, insurers run and manage investment portfolios. The funds for these portfolios come from reinvesting profits (such as earned premiums, where the premium is kept because no claim occurred during the policy's duration) and from premiums before they get paid out as claims. This second category is a concept known as float and is important to understand. Warren Buffett frequently explains what float is in Berkshire Hathaway’s annual shareholder letters. Back in 2000 he wrote: "To begin with, float is money we hold but don't own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an "underwriting loss", which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money." Buffett