How insurance risk is transformed into investable assets

Summary

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 CollateralizedThis 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 DistributedThe 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...