September 22, 2023

Insurance Float's Underappreciated Value

It is no longer a secret that upfront premiums collected by insurance companies, called float, help their profitability. The additional investment income adds to the earnings. But the degree to which an insurance company's worth increases during a high-interest rate period, like now, is still imperfectly understood.

Insurance companies represent a combination of insurance underwriting business and investment management business. In the past ten calendar years, the US property and casualty insurance industry has generated less than 1% underwriting returns on average equity capital. Thus the combined ratio, the inverse of the profit margin, has rarely reached high levels. The ratio has been around 100, a level indicating operating expenses have barely covered the revenue generated through premiums. This depressing situation usually gets offset by investment income.


Source: National Association of Insurance Commissioners

Assessing underwriting effectiveness is essential but it is a separate analysis from the one we are discussing here. The value of the float capital is based on risk-free interest rates and evaluated on the profitability of the underwriting operations. In order to examine this phenomenon, we need to first understand how float works. An insurance business receives the premiums in advance (float). They pay out later when the claims are filed after the mishappening and it usually takes time to settle claims. In the interim period, these funds are invested, typically, in high-quality fixed-income instruments. In addition to float capital, insurance companies also have equity capital available for investments. 

Generally speaking, for every dollar of equity capital, insurance companies can underwrite about a dollar of premium. Thus, these enterprises, typically, have double the equity capital to invest. Consequently, for every one percentage point increase in investment yield, the return on equity could increase by two percentage points.

A simple example will illustrate this pronounced impact of interest rates: Consider an insurance operation with $100 million of equity capital. This capital would allow the company to write policies with $100 million in premiums. In effect, the company has $200 million at its disposal to invest before any claims are paid out. Suppose the company is breakeven in its underwriting operations and invests all the $200 million in a 2-year treasury note. If we consider pre-covid year of 2019, this enterprise would have made $4 million pre-tax using a 2% going rate at the time. This is a 4% return on equity. Currently, the 2-year treasury is at 5%+. Thus, the same company will generate a $10 million pre-tax profit. This is a 10% return on equity which is 6% higher for a 3% increase in yield of invested assets.

The foregoing example shows that the earning power of the business improved considerably from the rise of interest rates. As the company's earning power substantially governs its intrinsic value, the value of float increases with higher interest rates. In effect, a company writing at the same combined ratio in a high-interest rate period today has a far higher attractive business than it did pre-covid.

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