The Capital Advantage – How Capital Requirements Put Small Insurers Behind The 8-Ball

This article originally published on

Insurance is the most capital-intensive of all U.S. industries, according to our estimates, and building up market share requires substantial investment. The amount of capital required to compete also pushes the industry toward fewer and larger firms


It is commonly said that insurance is a capital intensive business. As I talk to people in the industry and professionals coming into insurance from outside the industry, such as technologists looking to disrupt the business model, I get the sense that they don’t really understand how crucial financial capital is to insurance. I’d like to try to explain why capital is the backbone of insurance and why disruption of the industry won’t be so easy for new entrants.

A Thought Experiment

Let’s do a thought experiment. You own a home with a replacement value of $250,000. You decide to insure your home with one of these new-fangled, fancy startup insurance companies. You are their first customer (for simplicity, assume no reinsurance…I’ll get to that shortly)

Question: how much capital would you desire they have on hand in case of a fire or claim?

If your answer isn’t $250,000 OR MORE, you are a playing blackjack with your home! You should expect that your insurer has enough capital to back you up and make you whole should a full loss occur. Once policyholders 2,3,4 and 5 sign up, YOU ALL should expect that your insurer has enough capital to back you all should you all experience full losses.

Doing some simple arithmetic shows that 20 homes with an average value of $250,000, means that $5 million of capital would be required to support those 20 homes. $5 million also happens to be the minimum surplus of capital required to start an insurance company in some states.

Stay with me for a little bit more arithmetic…let’s assume that those 20 policies average $1,000 in premium, for a total of $20,000. And also let’s assume that this insurer is a great underwriter and achieves a combined ratio of 50% on those policies, meaning an $10,000 underwriting profit. $10,000 divided by $5 million is 0.2%.


That insurer took all that risk for a measly 20 policies and 0.2% return on capital when it could have gotten 2%-plus (as of this writing) parking it in risk-free treasuries.

To quote Julia Roberts in Pretty Woman:

Why would anyone take risk to get 0.2% when they can get 2% risk-free?? The answer is no one would. So why the heck would anyone ever form an insurance company from scratch?

The On The Ground Realities

Now let me step out of the hyperbole of my imaginary thought experiment. In the real world, two very important realities come to the rescue of small startup insurers.

First, as a startup grows, the likelihood of all policies realizing a full loss diminishes. This diminution of loss likelihood makes it possible for an insurance company to hold much (MUCH) less capital than the full sum of all of their collective policy limits combined. The biggest global insurance companies have literally trillions of dollars in aggregate insurance policies in force.Those trillions are being supported by capital bases in the billions. You heard that right. A large global insurer may have 1,000 times more exposure than capital! So why aren’t the regulators stepping in to stop this? Because while the total exposure to capital ratio may be very high, all insurers use sophisticated catastrophe and capital models to put the frequency and severity of loss in a framework that is mutually acceptable to regulators, rating agencies and the companies themselves. There is some science and a lot of art to this process, but the results is that growing big and spreading risk around in non-correlated ways such as diversifying by geography and product line is the best way for an small insurer to become a big insurer.

Second, small insurers are rescued from this capital dilemma by reinsurance. Reinsurance is insurance for insurance companies and is essentially a cheaper form of capital that insurers use to help manage the capital structure of their companies. No small insurer can survive without reinsurance; the return on capital without reinsurance is too small to justify the risks. But with reinsurance, small insurers can grow and diversify without exposing their precious capital to flukes of nature.

But here is a very key point. Reinsurance is NOT free. Sometimes reinsurance expenses can be downright expensive (think, the period of time after a major hurricane season). Small insurers need a big dose of reinsurance and the side effects of that medicine is that they become dependent on it. Thus, small insurers do not have total control over their operations. Due to capital pressures, small insurers can face situations where capital concerns dictate terms to operational execution.

Put another way, sometimes capital is so darn expensive, that small insurers must completely alter their business plans in order to survive. This is why large insurers have such a mighty advantage over smaller insurers, even if the startups have slicker web sites or pay claims faster. Larger insurers have the capital surplus to brand themselves as long-term, safe establishments for you to get peace of mind. They also have the capital structure to always be the low-cost provider. This is one of the major reasons I declared over a year ago that insurance would NOT be disrupted. How do you unseat a GEICO, Allstate, State Farm or a Liberty Mutual to name just a few of giant insurers who collectively have hundreds of billions of dollars in surplus capital?

The answer I believe is that you can’t. For as much as I appreciate the simplistic, digital interfacing with these small insurers and their well intentioned business models, what they need most of all is capital! For now, that means reinsurance. But for these small insurers to decrease their dependence on reinsurance they need to grow big and wide. Lemonade has already started this move. Others small insurers will follow this model.

State Farm is not too worried. Shouldn’t they be concerned about being disrupted? Well…they lost $SEVEN BILLION in underwriting losses in 2016 and STILL ended the year with a $400 million profit overall. It will be very hard to disrupt an insurer that has so much capital that it can lose billions bungling their underwriting and still turn a profit, isn’t it?

That is the advantage of capital in insurance.

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