How Insurance Risk is Transformed Into Investable Assets

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.

This 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.

The 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 to 175% of premium collected, giving them total resources of 275% of premium (100% premium + 175% capital) to pay claims in extreme years.

The green dashed line shows the return on capital from underwriting activities. When losses are less than premium collected (green zone), the insurer keeps the difference as profit. Once losses exceed the break-even point at 100%, the insurer must use their capital reserves to pay claims (red zone). Think of it like making an "investment" with the premium you collected, but getting such a negative return that you have to reach into your wallet to cover the losses (red line).

Retail brokerages offer margin accounts to those customers that have sufficient assets to support it - much like the insurance company capital - and reserve the right to make a margin call if those trader’s reserves fall below minimum requirements. In extreme cases, it’s even possible for a trader to end up in a position where the brokerage could not sell collateral quickly enough and they’re left with a negative balance which must be filled with assets from elsewhere.

In the same way, insurers must maintain capital to meet extreme claims. Both systems rely on partial collateralization: enough to cover most outcomes, but not the absolute maximum.

Therein lies a critical implication: The entire balance sheet of the insurance company is available and backing each individual policy. This is similar to your margin account, as if your account balance (collateral) goes below zero, you'll have to pull from assets outside to cover the debt.

This is one of the fundamental reasons why regulators restrict retail investors from direct insurance risk investments. A strong knowledge base of how the risk works is needed to understand you're not just exposed to losing your investment, but other assets as well. For history buffs, I recommend reading Andrew Duguld's On the Brink: How a Crisis Transformed Lloyd's of London1for a fascinating first-hand account of the Names at Lloyd's. These individuals once pledged their entire personal wealth to back insurance syndicates, sometimes with catastrophic consequences.

So what have we learned from this comparison? Three points stand out:

The challenge, then, is clear: how can retail investors access insurance risk without facing the danger of unlimited losses? The solution has been to design fully collateralized structures as vehicles that capture underwriting profits while capping potential losses at your invested amount. One of the most intuitive examples comes from adapting reinsurance structures into a format investors can access.

Catastrophe Bonds, or "CAT Bonds", are the most widely known form of investable insurance risk. If we ignore the insurance implications of it for a second, CAT Bonds are just like any other corporate bond: they are issued by a firm, pay a coupon, have a maturity date and have an associated risk of default (not being paid back principal).

The difference here is the risk of default of a CAT bond is tied in someway to insurance losses. If a qualifying insurance event happens, the principal is kept by the insurance company to pay those claims, effectively defaulting the bond. They are referred to as "Catastrophe" bonds simply because they are most often tied to large, catastrophic events such as Hurricanes, Earthquakes, or even Cyber events.

CAT Bonds can be thought of as an insurance policy bought by the insurance company itself. They are, in fact, usually a compliment to the insurance company's full reinsurance program. Here, however, the insurance company isn't buying a policy from another insurance company, but rather outside capital markets on a fully collateralized basis.

Let's form our own very basic CAT bond. We're Risksure - a Florida based insurance company - and we write a lot of homeowners policies in the sunshine state. We'd like to take out the following CAT bond:

To issue this Bond, Risksure Re would collect $100M of principal from outside investors, thus fully collateralizing the insurance risk. In return, Risksure Re would pay $9M of premium for the bond, and should no hurricane event occur, pay back the $100M of principal at maturity.

This type of structure is common in reinsurance and known as an excess of loss structure. The layer of coverage can be visualized as follows:

There are two components of return for the investors in our CAT Bond:

It's clear that we this structure, the investors are taking on insurance risk exposure. However, in this case, the "buyer" of the insurance policy (the insurance company itself) does not need to worry that the insurer (the outside investors) will not be able pay claims if the large event happens, because the entire value of the policy limit ($100M limit) is set aside and can't be touched.

We can now examine and visualize a few potential outcomes for the buyers of the CAT bond:

Keen observers will notice that we've successfully transformed the insurance risk into a limited liability product - you can no longer owe additional capital beyond your original investment. However, it's clear that investing in insurance risk in this manner should be treated as a compliment to other investment strategies. Bear markets for equities might return -30% to -50%, but crucially, they retain the potential to recover those losses over time. CAT bonds offer no such recovery potential - once triggered, that capital is permanently lost. That said, the stated probability of default for these bonds is typically 1-3%, meaning the 5-9% excess returns above risk-free rates are designed to compensate for this low-probability but high-severity risk.

A natural question arises through this analysis: why aren't insurance companies forced to hold enough money to cover all potential loss scenarios? The short answer is efficiency. The less capital you have to hold, the larger your returns on capital will be. This can be illustrated with simple math. Say you hold $10M in capital and expect a profit of $500K on underwriting business. Expected return is $500K/$10M = 5%. But let's say now you only have to hold $5M in capital - your return on capital has now jumped to $500K/$5M = 10%. By holding fully collateralized layers, CAT bonds are trading capital efficiency for payment certainty.

Referring back to the chart at the beginning of the article, those extremely remote loss scenarios have exceedingly low likelihood of happening for a sufficiently large and diverse insurance company. Each insurance company has a team of actuaries and risk modelers dedicated to ensuring the ongoing solvency of the company. Regulators setup frameworks to validate and set guidelines for the amount of capital a company needs to hold. With all that said, insurance companies can and do fail, at which point regulators can swoop in to protect policyholders.

This is why under collateralized insurance "works" - there are many checks and balances along the way to align incentives. It's also why giving outside investors access to insurance risk is such a challenge; with out those protections in place, guardrails (such as full collateralization) have to be setup such that insurance policies can be sure their claims will be paid.