How insurance works

Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.

If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money – and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float.

That's from Warren Buffet's letter to Berkshire Hathaway shareholders for 2009.

There seem to be two reasonable conclusions to this fact of reality, but I don't have any data so I reserve the right to amend these. The first is that investment income helps to keep premiums lower than they would be without it. Second, if that is in fact the case, then when investment income suffers, premiums will have to increase faster than they do under periods of normal, or above normal investment income.

I think the current debate would be helped if this aspect of how the insurance industry works was more widely understood.