Meet the only insurer that can never exhaust its capital

Throughout the journey building out the qualitative case for an Insurer of State, the co-convenors have spent many an hour consulting with stakeholders and experts for their views on the Insurer of State concept. Without exception - it is the question of "where the capital comes from?" that trips up understanding and engagement. Here's why the Insurer of State, unlike a private insurance company, can never run out of money.

It's easy to find insurance not at all fun and not really optional - it kind of isn't. It is the Grudge Buy. Besides paying taxes is there anything you'd rather spend on less? There is also a perception of the industry that is very difficult to shake. In a recent viral video that swept across [insurance Linkedin, Slack and X] the internet, insurance was satirised as "sad gambling". The skit tears apart the business model of insurance in seconds and hits just about every grudge buy and behavioural aspect of insurance on the head. It's funny because it's true, as they say.

"Oh, it's a gamble because if nothing bad happens then they're paying you for nothing?" ~ https://www.youtube.com/shorts/UtvM5QXu3Yw

As funny as the joke around sad gambling is, insurance companies really do have a fairly simple business model. The many pay for the sadness of the few. An insurer earns premium, invests as much of it as they can for bigger returns, and then pay valid claims reactively with their cash flow.

Just like a casino, though, they can also lose. Lose it all. Sometimes they do. That's why the sector is so heavily regulated - and backed up by the present FSCS scheme.

In the meantime, the policyholder pays the premium dutifully, hoping nothing too bad happens. Who wants to claim? It means bad luck has struck! Like an inverted bank, the insurer is promising to pay - but only when certain things happen. It relies on both good "gambles" (risk selection and pricing) and luck. Through a mixture of exclusions and limitations in cover, as well as operating as a portfolio play, the ideal insurer attempts to reduce the aggregation of risk so that any one big incident or event can't blast through its balance sheet quicker than a card-counting Harvard undergrad.

So long as the gambles pay off, the insurer is solvent. Yet, even when these risk casinos dodge certain events and claims - the losses don't go away. They're either self-insured or, in some drastic cases, the government will step in. Just as the government is ultimately responsible for all FIAT money so is it ultimately bearing the "downside" of all losses. The loss of assets or capital that was otherwise reasonably engaged in creating value, is by its nature a retraction in economic activity. Money that could have been used to create growth is instead putting humpty dumpty back on the wall. That effects tax receipts - which are inherently correlated to economic growth.

Thriving insurance markets lead to economic growth

In fact, this has been explored by academics - with a causal link being established between the growth of non-life insurance coverage and GDP growth. One can therefore reasonably assume that a lack of coverage, a protection gap borne by government, is a lag on economic growth.

Here we come to the flaw of insurance companies. Their solvency is always tied to both the amount of capital they can quickly liquidate to pay for losses and the amount of exposure (and premium) they take on through normal activities. It's a fine margin where every leap in "capacity" has to be correlated with an increase in underlying capital. That ratio is the equivalent of a bank's deposit to loans ratio. Black Swan (a term popularised by Nassim Taleb's The Black Swan: The Impact of the Highly Improbable) events are the insurance equivalent of a bank run. The more severe the event - the more likely their funds will be exhausted.

The Insurer of State can't run out of money

As long as the economy, in itself, exists in some shape or form - this institution remains viable. Unlike traditional insurers, the Insurer of State does not purely source its capital from insurance activity [premium + investment] income.

Whilst it does indeed collect a fee [the State Insurance Premium or SIP] levied on each and product and class of business - culminating the need for Insurance Premium Tax - it also has the powerful ability to create capital. Those two tools [the SIP and capital creation] work hand in hand. For, one may operate as a pool of coupons for which massive liquidity can be pegged against.

The Insurer of State is, for all intents and purposes, a sibling to the central bank. That means it can create liquidity for losses assumed by the Government, and Black Swan events. It does so by creating loans [to Loss Purpose Vehicles] which can be used to purchase a tied-to-risk form of hypothecated debt. That debt is a Perpetual Bond issued by the DMO (Debt Management Office.)

The bond is not a product in the way a Gilt is. One that can be bought and sold on the secondary market or to private buyers - only LPVs can buy this bond. Its coupon is also dynamically pegged to the State Insurance Premium collected so that the LPV can never become insolvent (which is for all intents and purposes what has happened to the Bank of England's Asset Purchase Facility). The IoS isn't focused on the money supply, inflation or credit markets - it fixes loss - and has as much firepower as it needs to do so.

This creates a stable and instantly deployable source of loss liquidity and removes the jeopardy of coupon-to-face-value volatility. Mr Market is not allowed into this closed loop. Only the Insurer of State, the LPV and the DMO are. Three ledgers, all forming a liquidity well. The IoS base income can also be customised and configured to different classes of insurance, increased where and when risk and loss is incurred.

This is hitherto a power that only the Bank of England possessed. You'll recall the massive in unprecedented "Quantitative Easing" programmes of the West post The Great Recession. Sovereign capital creation is used by the bank to keep financial markets moving. Sadly - as we have previously explored - the Bank's most recent solutions have created economic losses for the state, regardless. The losses can only be paid for by the same tools - gilts, tax or cuts. A forth tool is here.

Insurance doesn't lend to claimants

During covid- when the Government "interrupted" the economy abruptly with lockdowns, a huge debt programme was spun out, underpinned by government and therefore central bank guarantees. This was the equivalent of getting a new mortgage if your house burns down. It didn't make logical sense at the time and it still doesn't now. It created "too much" capital - and "claimants" were allowed to self-assess their financial needs. Something that an insurance company's claims team would simply never consider wise.

Put simply, bifurcation of the sovereign capabilities atop both the risk and financial markets through a "liquidity of last resort" institution makes far more sense than mingling credit with claims. We've seen the outcome of that - it was a contributing factor towards the ongoing Cost of Living Crisis.

Just as an insurance company is only obliged to "pay out" when certain things happen, so is the Insurer of State. That simply isn't the case for a credit institution.

The Well that never runs dry

With this model, the entire insurance market, as well as all the Public-Private "Re" vehicles and even the limited FSCS can now be backed up by a new institution - just as the banking and credit markets are. If there is a loss they weren't covering, or simply didn't properly underwrite [because it was a Black Swan event], the well never runs dry.

The Insurer of State can either pay the government capital for things for which it has assumed liability; or it can partially support the downstream balance sheets of the Re-vehicles (such as Pool and Flood Re), or it can directly inject claim liquidity into the insurance supply to be administered "as a claim" instead of guaranteeing loans as it did with CBILS during covid.

This kind of solution offers economic repair faster. It underpins the industry - which accounts for massive flows of inward investment. It also creates a new behavioural paradigm where the Sad Gamble is underpinned by the might and process of a state - now insurance buyers will know their choices enable access to the well. A new, more stable institution sits at the core of the market - making the casinos look much more like their banking and credit market brethren. (Upon whom they shall no longer rely for a bowl of porridge when the going gets tough.)