Capacity – How Much Risk Insurers Can Take On
Insurance companies make money by taking on risk for a price. They agree to pay if something bad happens, like a car crash, fire, or lawsuit. The insurer charges a premium and hopes the bad thing won’t occur. If it does, they pay the claim using the premiums collected from many customers.
This process is called underwriting. But insurers can’t underwrite an endless amount of risk, or they might go bankrupt if too many bad things happen at once. They have to stay within their capacity, which means the most risk they can safely take on. Let’s dig into what determines an insurer’s capacity and how they can increase it.
Insurer Financial Health Limits Capacity
It Comes Down to Capital and Earnings
An insurance company’s capacity mainly depends on how much extra money it has on hand. There are two key sources of money that influence capacity:
Retained earnings: This is profit the insurer made in the past and didn’t pay out to owners. It’s like an emergency fund. The more retained earnings, the bigger risks it can underwrite.
Capital: Shareholders put up capital to start or expand the company. This also acts as a cushion against unexpectedly high claims. More capital allows more capacity.
Think of retained earnings and capital as an insurer’s rainy day fund and rich uncle. The fatter these accounts, the more storms the insurer can weather without going broke. That’s capacity in a nutshell.
How Insurers Increase Capacity
Insurers always want more capacity so they can sell more policies and make more money. But increasing retained earnings and capital is a slow process. And shareholders want their investment back at some point.
Reinsurance to the Rescue
The answer for many insurers is reinsurance. It’s insurance for insurance companies. For a fee, reinsurers agree to pay part of an insurer’s claims once they exceed a certain amount. This takes some risk off the insurer’s shoulders.
Here’s how reinsurance quickly boosts capacity: Remember those unearned premium reserves? Those are premiums the insurer collected but hasn’t fully earned yet, since some of the policy period is still in the future. The insurer has to hold that money because it might turn into claims later.
But with reinsurance, the insurer can release some of those reserves right away and count that money as retained earnings instead. Voila – more capacity! The insurer still has money if claims come in, but now from the reinsurer. It’s like a weight was lifted.
The Dangers of Too Much or Too Little Capacity
Thin Ice for Small Insurers
If an insurer has too little capacity, it’s skating on thin ice. One bad winter with a lot of claims could crack that ice and make the insurer fall right through into bankruptcy. No one wants to buy from an insurer that might not be around to pay claims.
That’s why you see many small insurers specialize in covering very specific things, like weddings or pets. The claims are usually small, so not much capacity is needed. And they can charge high premiums since few competitors dare skate on that same thin ice.
The Pitfalls of Too Much Capacity
Now, having too much capacity is definitely better than too little. But it’s not perfect either. Insurers with lots of retained earnings and capital tend to get reckless. They lower their underwriting standards and cut premiums to bring in more business and put all that capacity to work.
This works great when times are good. But all underwriting mistakes get revealed eventually. Insurers that grew too aggressively hit a wall when their claims catch up with them. Suddenly they have to slam on the brakes and jack up prices. Not a good look.
The biggest insurers are like huge ocean liners with plenty of capacity below deck. They can sail through stormy seas without sinking. But if they take on too much water, even that huge capacity can get overwhelmed, and the good ship U.S.S. Too Big to Fail starts to list.
Striking the Capacity Balance
The best insurers walk a tightrope between having too little and too much capacity. They diligently monitor their capital and retained earnings. They use reinsurance strategically to boost capacity without overextending. And they resist the temptation to write every piece of business that comes along.
Capacity is like Goldilocks’ porridge – you want it not too hot, not too cold, but just right. Insurers that keep their capacity lukewarm can pay claims even in bad times and live to insure another day.
