Insurance as Conditional Debt Creation – Modelled

Over the last week I have been having something of an intellectual headache. Should the ‘I’ in the ‘FIRE’ sector be considered as an endogenous money provider, creating debt, and whether it is an extractive ‘rentier’ sector which drags down the real economy?

My thinking was promoted by reading a paper from the ever excellent Dirk Bezemer and Michael Hudson’s ‘Incorporating the Rentier Sectors into a Financial Model’

The FIRE sector is today’s form that the rentier class takes. Rentiers are those who benefit from control over assets that the economy needs to function, and who, therefore, grow disproportionately rich as the economy develops.

Should the insurance industry be included? Insurance is a sector which economics has neglected in recent years even more than banking, it is almost entirely absent in text books and with only a small number of exceptions it was neglected by classical writers too.

Over the last few months we have gradually built up here a double entry stock-flow consistent model of banking and interest which has demonstrated that lending of money is in effect the renting of money over a period and a form of rentier income, the capturing over a period of time of the benefits of productive combinations of capital and labour. The greater the monopoly power or concentration of money in fewer hands the greater the productivity that can be captured by the few at the expense of the many.

But including insurance?

Certainly the history of insurance suggests strong connections with the debt creation process. If someone’s income is close to their expenditure, they work alone and they do not carry debt than any unfortunate loss to them does not become a loss of profit to others. Once debt is included however the risk of disaster becomes a potential loss. That debt must be insured. The Code of Hammurabi, includes the maritime loan, a loan which was not paid if the ship sank. The higher cost of such loans, the cost of which varied by season and route, included a risk premium. Insurance then can be seen as a loan the cost of which is equal to the risk covered (plus expenses). It appears that the ability to take out insurance unbundled from a specific loan did not emerge until the emergence of mercantile capitalism in the  Mediterranean in the C13th. There is also the ancient Chinese practice of splitting up cargo between various merchants’ boats. Imagine a merchant with 20 boats with a lifespan of 20 years, with a 1:20 chance of a boat being lost each year. To maintain capital stock and profitability the merchant would have to expand any loan for the 20 boats (plus depreciation) to 21 boats (plus depreciation). So we can see the close connection between loans and insurance, with insurance being a form of loan to reduce risk, in the modern world now separated out as a discreet product.

Yes insurance is a form of debt creation. Whereas a conventional loan is an agreement to create an amount of money in your account at a specified time and in return you will pay premium + interest, in an insurance contract the loan is conditional on the triggering of some triggering event and for the duration of the ‘policy’ (contract) you will pay your ‘premium’ (premium + interest in economic terminology).

Verbally the cost to the insurer of the policy is:

(Cost of payout X probability of payout) + faux fres expenses : discounted to net present value

The faux fres expenses being the administrative overhead of the insurer plus any frictional capital cost and regulatory capital cost. So we have a business model of insurance in parallel to the business model of banking where:

Cost of Policy +Markup – Revenues =Profit

If you are sceptical that Insurance can be considered as a specialised form of loan consider this document from Swiss Re that states that insurance companies issue debt in the form of insurance policies to policy holders that pay out in circumstances of a specified uncertain event.

Insurers are liability driven financial intermediaries: They originate contracts: i.e. insurance policies, and use financial markets to bridge the gap between today’s premiums and tomorrow’s claims[1].

One key difference with loans is that the debt is not amortized, rather the policy holder is under an obligation to continue with a payment stream they can be adjusted. In a bank loan the payment to the debtor is made up front and steady payments of interest + premium reduce the level of payments in a non linear manner. This income stream is an asset to the bank. With insurance contracts however we do not know when the payment will be made so there is no amortization, and even when a policy pays out the policy may allow future payments of the same category (for example you might have your replacement car stolen also), though you are likely to lose a new claims bonus as your risk is reassessed or the insurer may refuse to renew the policy. So insurance policies either have a one off payment- if the cover is low value/low risk/short term – like travel insurance – or a steady long term stream of payments that do not amortize – like life insurance – but may be periodically reassessed according to circumstances. This income stream is also an asset to the insurance company.

I have in places seen it stated that insurance companies effectively borrow from their insurers, but this is asset liability confusion. There is no concept of reserves or idle reserves in insurance, the only liability to the policy holder is payout of policy and all cash flows from the policy holder to the insurance company are assets that the insurance company will invest to cover the longer term liabilities of payout – the intermediary role bridging the durability gap. Part of the confusion on this point comes from the interesting role that interest payments play in insurance. Who is paying interest to whom, policy holder to insurance company or vice versa? Interest is interesting here it is the discount rate necessary to restore the pay out at the point the payout is triggered to net present value. So for a ‘loss’ policy on average they will be triggered halfway through the policy term (for simplicity we assume that the insurer does not assume renewal), for life insurance it is paid out at the point of policy maturation and the interest cost is the cost to that point. This needs to be added to the anticipated liability payout. In order to cover this liability and generate a profit the insurance company needs to generate a matching asset portfolio. This needs to be able to transform the maturity of a steady income stream into that of the anticipated liability stream. Hence the major role that insurance companies have in investment. Overall interest rate generated costs on the liability side should be balanced by the interest attracted from investments on the liability side. Premiums attract no interest component so again it is not meaningful to speak of policy holders lending to insurance companies, rather vice versa, insurance companies lend, conditionally triggered, loans to policy holders with premiums invested and attracting interest to cover these liabilities of the insurance company.

Insurance companies generally trade at a premium to their economic net worth. This premium, or franchise power, reflects the present value of investors’ expectations regarding the value created by future business. It is a reminder that shareholders expect insurers to create value[1].

Here we have an exact equivalent to the concept of ‘lending power’ we have found with banks. ‘Insuring Power’ we can call it.

We are now at the point where we can confidently double entry model the insurance process.


Insurer
Assets Liabilities Equity
Operation Insurance Power Value Replicating Portfolio (Investment Fund) Risk Capital Policy Liabilities
Operating & Frictional Capital Costs Finance
Capitalists’ Deposits
Clients’ Deposits Safe
Make Investment -Equity +Equity
Increase Insurance Power +Equity
-Faux Frais
+Faux Frais -Equity
Record Premium +Premium -Premium
Record Risk Capital -Risk Capital +Risk Capital
Record Policy Liability -(Policy Value*Payout Risk)+interest +(Policy Value*Payout Risk)+interest
Invest Idle Insurance Accounts -Investment +Investment
Make Claim Payout -Payout +Payout
Record Investment Returns +Investment Return -Investment Return
Retain Proportion of Profits +(-(Premium+ investment return) -(policy Value*payout Risk))/β -(-(Premium + investment return) -(policy Value*payout Risk))/β
Payout Dividends -(-(Premium+ investment return) -(policy Value*payout Risk))/(1-β) +(-(Premium+ investment return) -(policy Value* payout Risk))/(1-β)

Where

β=proportion of profits retained within firm – the equivalent of the Bankers surplus we had before, the insurers surplus.

For reasons of simplicity we have not recorded the complex treasury function within insurance firms which allocate investment and insurance returns between various accounts

The investment fund held by insurers is generally called the replicating portfolio. This is designed in term structure to replicate the future cost of liabilities – it is a hedge – producing finance through investment to match expected claims. By the law of large numbers in this way most risk to insurers is removed from the balance sheet as it is balanced by the replicating portfolio. In general insurance firms need to be relatively conservative investors as if they are not instead of hedging risk off the balance sheet they are adding to it. Of course the lead up to the global financial crisis saw some insurance firms like AIG take highly risky investments.

Of course there will be some exceptional high cost claims that might not be hedgable. In past times many companies exempted these as ‘acts of god’ but today provision will be made in the form of risk capital.

It is useful to compare the efficiency of insurance companies as credit creating institutions with banks. Insurance companies require little initial finance capital compared to banks, they receive an initial income stream before they have to make payouts. However they are forced to invest more conservatively than banks and make provision for risk capital. Insurance companies are also subject to double taxation, on their earnings and investments – which led to Warren Buffett spotting a huge arbitrarge opportunity by using the huge positive cash flow of insurance companies to make investments which are low taxed.

Of course a whole discipline has emerged to estimate the probability of payouts at particular points in time – Actuarial Science – There is little space to explore that here however s strict stock flow model of banking with its consequent equations offers a window whereby the insights of this science in terms of risk and demographics can inform economics

actuaries did not circulate actuarial discoveries to other professions simply because actuarial profession created its own language which was ignored by wider world journals.[2]

One final issue is to what extent insurance created debt is included in national flow of funds data. My interpretation of the Fed data is that insurance payouts are treated as business saving rather than loans – as a consequence perhaps this sector has a huge inter sectoral corrections row.

1.    SwissRe, The Economics of Insurance How insurers create value for shareholders.

2.    Adelakun, J.S.A.a.O.J., Controversy between Financial Economics and Traditional Actuarial

Approach to Pension Funding. Journal of Emerging Trends in Economics and Management Sciences (JETEMS), 2010. 1(1): p. 1-5.