Insurance companies: Investing the float to create a stream of revenue
Posted on Feb 08, 2022 by Rachel Klein, CPA | Tags: Accounting
What if I told you that a significant portion of revenue for insurance companies came from investment income and a concept called “investing the float”? Surprised? Curious?... Let me explain why this strategy is not only smart, but effective for insurance companies!
First, let’s briefly talk about how insurance companies make money. The obvious answer is collecting money from insurance premiums from customers. The excess in premiums collected over the amount of claims paid out and operating expenses is the resulting net income for the insurance company. We aren’t here to talk about insurance premiums and claim payments…Today, I want to draw your attention to the second circle in the image below—the investment of premiums.
Investment-related income is typically the second largest revenue source for insurers! Both invest the float. Investment-related income was the second largest source of revenue in 2020 for Progressive, New York Life, Liberty Mutual, State Farm, Northwestern Mutual, Allstate, Travelers, AIG, and Zurich!
How does this work?
Insurance contract premiums are collected from policyholders; however, the insurance company does not recognize claims until a loss event has been incurred (P&C contracts) and does not pay until the claim is settled. Due to the timing between the collection of premiums and the settlement of claims, insurance companies invest these premiums, known as “the float,” to earn income via interest, dividends, and/or appreciation. This concept is referred to as “investing the float.”
Some insurance products have “long tails” which means the time from incurred loss to claim settlement could be quite long, therefore, the insurer has more time to invest and earn a return. Furthermore, for P&C contracts, it’s possible a loss event may never occur during the policy period!
Strategic investments
While this sounds like it may be too good to be true, it’s not! This concept of “investing the float” isn’t new, and it definitely works – Warren Buffet frequently cites Berkshire Hathaway’s use of “the float” in his annual shareholder letters.
Insurers earn significant amounts of interest and dividends on the investments they are purchasing with this “idle cash,” however, they must be strategic in the investments they make. Insurers must balance the goal of earning returns on invested funds with the ability to meet the claims of their policyholders when they occur. When choosing investments, insurers will try to match the maturities of their investment portfolios to match their claims payment patterns. This concept is known as asset liability management, or ALM. Additionally, insurance entity regulators require insurers to maintain specific levels of capital and liquid funds to ensure entities remain solvent and reduce risky investment decisions.
Common invstments
Insurers typically invest in instruments that are highly rated and easily marketable. This investment strategy allows for a steady, reliable source of interest and dividend income and, if necessary, a quick sale if liquidity needs arise.
Common investments held by insurance entities include:
- Debt securities: bonds, notes, and redeemable preferred stock
- Equity securities: common stock, mutual fund shares, and non-redeemable preferred stock
- Short-term investments: commercial paper, certificates of deposit, mutual funds, and money market funds
- Securities lending and repurchase agreements (repos)
- Derivatives: swaps, options, futures, and forwards
- Other: limited partnership interests and joint ventures
Insurance industry trainings and offerings
Accounting for insurance companies is no easy task and we’re here to help! Curious how we make insurance training fun and engaging? Check out the video below from our Insurance Industry Fundamentals: Industry Overview course to see for yourself!
The GAAP Dynamics team has been teaching insurance accounting fundamentals courses and annual updates around the world (for both U.S. GAAP and IFRS ) for years.
We recently released our online insurance training program – Insurance Industry Fundamentals. This collection of eLearning courses begins with an overview of the industry before diving into the details and accounting for property and casualty (P&C) contracts and reinsurance contracts. Fair value, investments, derivatives, and credit losses are also included in our collection to ensure all your bases are covered!
Have questions about insurance? Let's talk!
About GAAP Dynamics
We’re a DIFFERENT type of accounting training firm. We don’t think of training as a “tick the box” exercise, but rather an opportunity to empower your people to help them make the right decisions at the right time. Whether it’s U.S. GAAP training, IFRS training, or audit training, we’ve helped thousands of professionals since 2001. Our clients include some of the largest accounting firms and companies in the world. As lifelong learners, we believe training is important. As CPAs, we believe great training is vital to doing your job well and maintaining the public trust. We want to help you understand complex accounting matters and we believe you deserve the best training in the world, regardless of whether you work for a large, multinational company or a small, regional accounting firm. We passionately create high-quality training that we would want to take. This means it is accurate, relevant, engaging, visually appealing, and fun. That’s our brand promise. Want to learn more about how GAAP Dynamics can help you? Let’s talk!
Disclaimer
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