Let's take a look at a very simple version of a P&C balance sheet. We'll start with the reserves, which are the main liability for an insurance company. Now, this has two components. Firstly, the unknown premium reserve, which reflects the premiums received from policy holders, but where the insurance cover hasn't yet been provided. Secondly is the claims reserves, which shows the amounts owing to policy holders as a result of claims that have been incurred. The reserves are therefore the sum of the unearned premiums and the claims reserves. Now, when an insurance company receives some premiums, it's gonna invest those to generate a nice return for themselves until the claims are paid out. So the dominant number on the asset side of the balance sheet is the investments and cash. Now, clearly, as for any company, there'll also be some equity reflecting the share capital and any retained profits in the business. However, an important difference for insurance compared with a corporate, is that the amount of equity is subject to regulation, which sets the minimum amount of equity that the company must have. Now, let's understand how this balance sheet will change over time for a typical policy. And let's take the example of a policy with 100 of premium and an 80% loss ratio. So the expected claims here are 80. Now, initially that premium of 100 will be recorded as unearned premium, so it will increase reserves by 100, but there will also be 100 of cash to invest on the asset side of the balance sheet. Importantly at this point, the claims reserves are nil, because no claims have been incurred at this point in time. Now, let's roll forward six months. Half of the premium will now be earned. So the unearned premium reserve reduces by 50 and that 50 is recorded in earnings, so it increases equity by 50, but also half of the expected claims have been incurred by this time, and that's 40. And we'll assume that these claims haven't yet been paid out. So it will increase the claims reserve by 40 and increase the claims expense by 40. So reducing equity.

Now, let's assume that the insurance company decides to settle 20 of the claims. This will clearly reduce the claims reserved by 20, but will also reduce the investments in cash available. Finally, we must remember that the investments will generate an investment return for the company. So this will increase the amount of cash investments, let's assume by 10. This will also increase equity by 10 as it will be recorded as profits for the insurance company. Now, taking a step back from all of this, hopefully you can see that the flow here is that the policy starts off in reserves as unearned premium and then gradually, over time, that unearned premium is released, firstly to the claims reserves when claims are incurred, but also to equity as the profits from the policy are earned. So you can start to think of a premium on an insurance policy as consisting of two elements. Firstly, the compensation for future claims and also the future profits from the policy.