Central banks helping to increase your insurance premium

April 15th, 2009

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Insurance is one of the easiest businesses to understand. Basically, it earns money this way:

  1. Collect insurance premiums
  2. Invest the collected premiums (in insurance jargon, this invested money is known as floats)
  3. Pay out insurance claims

Where are the areas that can go wrong with this kind of business?

One possibility is that it may miscalculate the probability of mishaps and mispriced the insurance premiums charged to customers. As a result, claims on the insurance company overwhelms its ability to pay. The Australian government’s guarantee of bank deposits and funding is akin to providing insurance to the Australian financial system. But as we said before in Australian government?s contingent liability to exceed AU$1 trillion, if the mishaps in the financial system are correlated with each other, the Australian government may find that it has burned a big hole in its pocket. For insurance companies, at least they can buy re-insurance to insure itself from such fiascos. The Australian government, on the other hand, have no re-insurance to insure itself other than the monetary printing press.

The other possibility of what can go wrong can occur when it suffer severe losses in its investment endeavours. That can happen when the investment divisions of insurance companies decide to become cowboys and get involved in sexy derivatives, as in the case of AIG. The more prudent ones keep a substantial portion of its investment portfolio in safe bonds and other fixed interest securities. That’s where central bankers are not helping. By cutting interest rates to below price inflation rate, the investment returns of insurance companies get eroded. Along with rising value of claims due to price inflation (e.g. rising health care costs for health insurance), their profit margins get squeezed, sometimes so severely that they can suffer losses.

So, guess what insurance companies will do in that case? They raise the premiums that all of us pay. Cutting interest rates may be good for borrowers, but as everything else in life, there is no such thing as a free lunch.

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