New on FinoLib · Volume III: Finance Encyclopedia
I have added a new article to FinoLib, my finance education website: Insurance Float Explained: Balance Sheet and Investment Income, part of Volume III: Finance Encyclopedia. This page gives you the core of the topic in expert but plain language; the full article goes much deeper.
The idea in plain words
An insurer collects premiums first and pays claims later. The money it holds in between is called float, and it earns investment income. The cost of the float is the underwriting result: if claims and expenses exceed premiums, that is the price paid for holding the money. Whether rising or falling interest rates help an insurer or a pension plan depends on whether its assets or its liabilities are more sensitive to rates. Leveraged hedges can add a cash-shortage risk, which 2022 exposed.
Key points
■Cost of float = underwriting loss ÷ float: losing $3 million on $150 million of float is borrowing at 2%.
■With $1,100m of duration-6 assets against $1,000m of duration-10 liabilities, a 1-point rate rise lifts surplus by $34m; the flip point is asset duration 9.09.
■In 2022 the 100 largest US corporate pension plans saw liabilities fall 28.2% and funded status rise from 96.3% to 99.3%.
■The UK’s September 2022 gilt crisis was a collateral (liquidity) problem, not a solvency one.
A closer look
Because an insurer collects premiums today but pays claims later — sometimes decades later for life insurance — it holds a large pool of collected-but-not-yet-paid-out cash called float. This float is invested (introduced conceptually in Capital Markets Part 5’s portfolio theory, and Part 3: Sovereign Debt & Public Finance’s bond mathematics), and the investment income earned on it is frequently as important to an insurer’s overall profitability as the underwriting result itself — sometimes more so, particularly for life insurers with very long-duration liabilities.
A worked example
Worked Example — Compare the Scenarios: An Insurer’s Surplus When Rates Move
An insurer holds assets of $1,100 million with a duration of 6 against liabilities with a present value of $1,000 million and a duration of 10, so surplus is $100 million. Using the duration approximation (change ≈ −value × duration × rate change, ignoring convexity): Scenario Assets Liabilities Surplus Change in surplus Rates fall 1 point $1,100m + $1,100m × 6 × 1% = $1,166m $1,000m + $1,000m × 10 × 1% = $1,100m $66m −$34m Rates unchanged $1,100m $1,000m $100m $0 Rates rise 1 point $1,100m − $66m = $1,034m $1,000m − $100m = $900m $134m +$34m Because the liabilities carry more dollar duration ($1,000m × 10 = $10,000m) than the assets ($1,100m × 6 = $6,600m), this insurer…
Decision rule
Match dollar durations, then fund the hedge’s liquidity. Set asset dollar duration close to liability dollar duration (an asset duration near 9.09 in the example above) unless the board has chosen and sized a rate view. If the hedge is leveraged, then hold liquid collateral of at least exposure × duration × the stress move you must survive, which caps leverage at 1 ÷ (duration × stress): for a 20-duration hedge, 1 ÷ (20 × 1.6%) = 3.1 times to survive 160 basis points, and 1 ÷ (20 × 2.5%)…
The costliest mistake
Hedging solvency risk with leverage and forgetting liquidity risk. A pooled LDI fund with $100 million of capital supporting $400 million of long-bond exposure (4 times leverage, duration 20) loses about $400m × 20 × 1.6% = $128 million on a 160-basis-point rise, more than all its capital. The scheme behind it is better off on paper, because its liabilities fell further, but unless it can wire cash within days the hedge is closed out at the worst moment. That is the spiral the Bank of England interrupted in 2022.
Analogy
Float is functionally similar to a bank’s deposits (Volume I’s Part 3) — money that belongs to someone else (policyholders, eventually), but that the institution can invest and earn a return on in the meantime. The crucial discipline, exactly as with an insurer’s actuarial reserves, is investing this float in assets whose duration reasonably matches when the money will actually be needed to pay claims — a serious mismatch here is precisely the vulnerability Capital Markets Part 3 warned about…
Recap
Float, the money held between premium and claim, costs the insurer its underwriting loss and earns investment income; strong underwriters hold it at no cost or better. Whether rate moves help depends on dollar duration: liabilities longer than assets gain when rates rise, as US pension plans did in 2022, while leveraged hedges, as in the UK gilt crisis, turn a solvency gain into a liquidity emergency.
What the full article covers
The full article includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, Insurance Float Explained: Balance Sheet and Investment Income, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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