There are two ways that insurance companies today earn revenue. The first way is the most well known. The insurance company charges clients a premium and uses skilled actuaries to accurately estimate the likelihood, timing, and value of claims. By charging a premium greater than the expected value of claims, the company expects to make a profit.
The second way an insurance company can make money is by taking advantage of their unusual position by investing what’s referred to as the “float”. Policyholders pay the insurance company up front and, sometime later, make a claim on the assets of the insurance company. Until policyholders make that claim, the insurance company uses the up-front money (the “float”) to invest and earn a return. Float has become a more importance source of profit than premia. Competition for float has pushed premia down to the point where some areas of insurance underwrite their premiums at a loss (the premiums are greater than the expected value of the claims).
In a strange way, insurance companies can be thought of as banks. They borrow money from creditors—policyholders, depositors, lenders, etc.—and lend money to others, hoping for a higher return. Much like in a bank or other business, creditors and equity holders of the insurance company do not always have the same interests.
Recently, there has been a wave of financiers who have purchased insurance companies for their float, looking to earn a better return on the assets on the insurers books. Because the insurance company has substantial future liabilities, the price of acquiring a company is less than the float it manages. Some commentators have criticized these transactions, arguing that they create opportunities for conflicts of interest. Alternatively, the interests of the insurance company’s shareholders (who now have a source of leverage for their investment ideas) and policyholders diverge, much like how the interests of equity and debtholders of a corporation may diverge.
For example, if the insurance company were presented with an opportunity to triple the value assets managed by the company 50% of the time, but would reduce the value of those assets by half 50% of the time, the shareholders would likely be for it, since 1) the expected value is positive and 2) they probably hold the insurance company as a part of a diversified portfolio. Obviously, policyholders would be against this. Policyholders are not exposed to the upside of these investment decisions, but may be at risk of the company’s assets are not enough to cover future liabilities.
Buyers of insurance concerned about this divergence of interest may consider purchasing “mutual insurance”. Unlike stock insurance companies, which are formed like conventional corporations, mutual insurance companies do not issue shares, and are owned by the policyholders. The policyholders receive dividends and elect the directors of the mutual insurance company. Because the directors are elected by the policyholders, they’re more likely to take actions which are for the benefit of those policyholders.
The disadvantage of mutual insurance companies is their difficulty of raising funds, since they can’t sell equity to generate capital. If mutual insurance companies need cash to pay for expenses, they are forced to rely on loans and premiums.
Additionally, there are benefits to policy holders by having decision-making performed by investors (or for their benefit of shareholders, by their agents, when competition between investors for funds would be expected to reduce premia paid by shareholders). Skilled investors can create great returns by buying insurers and using the float to fund their ideas; Warren Buffet’s Berkshire Hathaway uses this approach. Investors with promising investment theses may be driven away from the mutual structure, since they would capture little of the gains from their investments.
One solution to the diverging interest between policyholders and equity holders is to have the mutual insurance company contract its investment decisions to a third-party skilled investor, with the skilled investor taking a substantial cut of the gains earned from the investment. If the mutual insurer wants to give an excellent incentive for maximizing return, the mutual insurer can offer 100% of the return in excess of a certain amount. On the other hand, if the mutual insurer is worried that the investor will choose a portfolio that is too risky, the insurer can opt to “vertically slice”, and offer to divide returns. Additionally, the insurer can look over the investment strategy chosen, and reject portfolios it deems to be too aggressive.
In corporate governance, there is a common understanding that having an independent board of directors is beneficial for shareholders, and this structure creates something homologous to a board of directors (the mutual insurance company board) being independent from the CEO (the contracted investor.) In fact, it has the additional advantage that the investor need not be a natural person, but could also be another corporation or asset manager. If other investors approach the board with better proposals, the board can effectively switch its entire investment team at once, giving more flexibility and responsiveness.
Much like investment products, the choice of an insurance provider is dependent on factors unique to each purchaser. Some may desire the incentive structure created by mutual insurance, while others do not, and look solely to the premia they are expected to pay. Still, it’s worth considering what the incentive structures are, much less whether they are vulnerable to abuse.