Now that we understand the accounting for premiums and reserves, it's really important to understand the link between reserves and profits.

This is a crucial part of insurance accounting.

Let's use an example of an insurance company writing a portfolio of one-year insurance policies with written premium of $100 million and an 80% loss ratio. If the premium is received upfront, the balance sheet at the start of the coverage period looks something like this.

All the premium is unearned. It's effectively deferred revenue.

So we have an unearned premium reserve of 100 million, and that's a liability on the balance sheet.

We also have 100 million of cash and investments which the insurance company invests to generate an investment return, and these are assets on the balance sheet.

If we now roll forward on the timeline by six months, the balance sheet will have changed slightly. Half the premium has now been earned, so we still have $50 million of unearned premium on the balance sheet in the unearned premiums reserve.

If claims experience is in line with expectations, then the claims incurred are 80% of the premiums earned.

So the claims incurred are $40 million.

Assuming that these are not yet paid, we now have a claims reserve of $40 million, and that's also a liability in the balance sheet.

But what about profit? Well, if the insurance company has earned half the premiums, that means $50 million of premiums have been recorded as revenue in the income statement.

At the same time, we know that $40 million of claims have also been incurred, and that will be shown as claims expense in the income statement. So that means we have $10 million of profit recorded in the income statement, and this is also recorded in equity within retained earnings.

If we connect the linkages here, we can think of the premium of $100 million, which is initially recorded as a liability, reflecting the future claims of $80 million plus the future profit of $20 million.

This is a really important link that we will keep revisiting, and we can refer to this as our insurance equation.

Premiums equal future claims plus future profits.

So effectively, the unearned premium reserve is gradually transferred to the claims reserve to reflect the claims incurred, and also equity to reflect the profits released to equity.

One final point is that we sometimes refer to insurance reserves or insurance liabilities. These are typically referring to the unearned premiums and claims reserves together.

Early on in the insurance contract, most of the insurance reserves are unearned premiums, and towards the end of the insurance contract, insurance reserves are mostly claims reserves.