Lesson 2 of 7
Reading an insurer
An insurer earns two ways, underwriting and investing the float, and the combined ratio and reserve development say which one is really working.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- An insurer earns two ways: the underwriting result on the policies it wrote, and the return on the float those policies hand it to invest.
- A combined ratio under 100 means it was paid to hold that money; over 100 means it paid for the privilege.
- Reserves are an estimate of claims not yet settled, and when that estimate is revised, the change lands in the profit of the year it is revised.
The combined ratio says whether underwriting made money. Float says how much money the insurer holds to invest. Reserve development says whether past profits were real.
One insurer's combined ratio, four years
- Year 194
- Year 2101
- Year 397
- Year 4 · underwriting loss108
Break-even underwriting: 100
Two ways to make money
Combined ratio equals Losses + expenses divided by Premiums earned.
Example($700 + $280) ÷ $1,000 = 98%
Below 100, the insurer made an underwriting profit before a single dollar was invested. Above 100, it ran an underwriting loss, and the investment income has to cover that loss before the business made anything at all. Berkshire Hathaway's 1996 shareholder letter puts the two apart plainly: what counts in an insurance business is the amount of float generated and its cost, and an insurer running an underwriting profit has, in effect, been paid to hold other people's money.
Float, money you hold but do not own
The 2007 shareholder letter defines insurance float as money an insurer temporarily holds that does not belong to it, and calls it free as long as underwriting breaks even. Premiums are collected before claims are paid, so an insurer sits on a pool of cash between the two dates. That pool grows with the business written and shrinks as claims are settled, and its size, not the premium alone, is what an insurer actually gets to invest.
Reserve development, the estimate revising itself
A reserve for losses not yet settled is an estimate, not a fact. When claims settle for more or less than reserved, the difference is booked in the year it is found, not restated into the year the policy was written. A run of favourable development, reserves consistently proving too high, can flatter several years of reported combined ratios before a single adverse year gives some of it back. For property and casualty insurers, the notes carry a development table: each accident year's estimated losses, re-estimated every year since, so you can see whether reserves have tended to prove too high or too low.
What float costs
Cost of float equals Underwriting loss divided by Average float.
Example$30 ÷ $1,000 = 3.0%
The 1996 letter compares that cost with the yield on long-term government bonds. Float is worth having when it costs less than borrowing. It is an albatross, in the letter's word, when it costs more. An underwriting profit makes the cost negative.
Do it on a real 10-K
- Open the notes to the financial statements and find the claims development table, sometimes called the reserve roll-forward.
- Compare each accident year's original estimate with what it has been re-estimated to since, reading across the row.
- Find the line for prior-year reserve development in the current year's results, and note whether it added to or subtracted from profit.
- Check the combined ratio with and without that development to see how much of the year's result came from old years, not new ones.
Check yourself
An insurer's combined ratio is 108. What does that mean on its own?
- It made an underwriting profit of 8 percent
- It ran an underwriting loss: losses and expenses exceeded premiums by 8 percent
- Its float shrank by 8 percent
Show the answer
Answer: B.
A combined ratio above 100 means losses and expenses together exceeded premiums earned, so the underwriting side of the business lost money before any investment income is counted.Premiums earned are $1,000, losses $700 and expenses $280. What is the underwriting profit?
- $300
- $20
- $1,000
Show the answer
Answer: B.
1,000 minus 700 minus 280 is 20, matching a combined ratio of 98 percent (980 divided by 1,000).An insurer's reserves for old claims are revised downward this year, because claims are settling for less than expected. What happens to this year's reported profit?
- Nothing: the change is applied to the year the policy was written
- It rises: favourable reserve development is booked in the year it is discovered
- It falls, because reserves are always conservative
Show the answer
Answer: B.
Reserve changes are recognised in the year the re-estimate happens, not restated into the original policy year, so favourable development lifts the current year's reported result.Sources
- Berkshire Hathaway shareholder letter, 1996: the amount and cost of float, and the point that the business is an albatross when float costs more than market rates for money.
- Berkshire Hathaway shareholder letter, 2007: insurance float defined as money held that does not belong to the insurer, and free while underwriting breaks even.
- ASU 2015-09, disclosures about short-duration contracts: the claims development table.
What this leaves out
- The combined ratio leaves out investment results, so an insurer under 100 can still lose money after investment losses, and one over 100 can still earn a profit from its float.
- Reserve development is disclosed with a lag, in the notes rather than on the face of the income statement, and a single year's favourable development does not establish that the insurer reserves conservatively.
- Life insurers and annuity writers are measured under ASU 2018-12, which requires their long-duration assumptions to be updated at least annually; this lesson reads a property and casualty insurer.
- The chart and worked example use round invented figures so the arithmetic can be checked by hand.
- Nothing here is advice about any security.