We can now construct a simple insurance balance sheet to demonstrate the economics of insurance business.

Let's start with the premium received.

This initially represents a liability for the insurance company, as they receive this upfront without having provided anything to the customer.

So we can think of it as being very similar to a customer deposit in the banking world.

Now, this premium reflects two things.

Firstly, future underwriting profit on the insurance contract, and secondly, the future claims on the insurance contract.

Although this is just a rearrangement of the formula that underwriting profit is premiums less claims, the more we can think of insurance premiums as future profit and future claims, the more comfortable we will feel with how the insurance balance sheet and income statement interact.

Now let's focus on the asset side of the balance sheet.

This reflects all the cash and investments of the insurance company.

This includes the premiums invested to generate an investment return.

Finally, we have equity at the bottom of the balance sheet.

Note that this is a regulatory requirement, as without this, the insurance company wouldn't actually need any equity at all.

In theory, it could take the premiums received each year, invest them in the market to generate investment returns, and at the end of each year, pay out all of its profits to shareholders.

However, this would be an extremely risky way to run an insurance company.

As if claims in a certain year exceeded the expected amount, or if there was a sudden fall in the value of their investments, there wouldn't be any spare cash and investments to settle those claims.

So regulators require insurance companies to have a minimum level of equity to act as a shock absorber in case there is a shock in the financial markets or in the level of claims received.