Not a lot of people know this about insurance

It's generally true that we expect, in a competitive market, insurers to lose money by writing insurance. That's something which not a lot of people know nor realise. But understanding the point will aid in understanding what the latest complaint about the market is for car insurance.

Motorists are facing higher insurance premiums even though the industry is saving millions of pounds thanks to Government imposing curbs on whiplash claims.

Drivers have seen the cost of insuring their cars rise by up to 20 per cent - adding £115 to the cost of a policy.

But at the same time the insurance industry has saved around £520 million because of a dramatic drop in personal injury claims, The Times reported.

The changes which led to it being more difficult to claim for whiplash were supposed to have saved everyone £90 a year on their premiums. Whiplash has become more difficult to claim for yet premiums are rising. Cue capitalist rip offs and so on.

However, now add in that we expect insurers to lose on their underwriting books, the actual process of writing insurance, the difference between premiums paid in and claims paid out.

The reason for this is that there's a timing difference between the two. That gives the insurance company a large pile of money to play with. And play with it they do. The go and invest it in nice, safe, and short term, investments in The City. This brings them an income, of course.

As these things happen in competitive markets that second income is important. Because there's always going to be one or another insurance company which notes that they can gain more of that cash pile to invest by cutting premiums. And so the general return to capital in the business reverts to the general return, risk adjusted, across all business. That means that the investment returns subsidise the insurance premiums. 

Another way to say the same thing is that the two income streams must, in a competitive market, end up as amounting to that general return on capital, so one of the two will subsidise the other.

We can and do use this as a measure of whether an insurance market is competitive (and also some other businesses which get such a cash float, like futures broking, possibly retail banking). If the underwriting, the provision of the basic service, isn't loss making in the face of the investment returns then it's not a competitive market.

Now change what those investment returns are. Safe, short term, investments in the City now yield pretty much nothing. Thus the float isn't making a great profit, thus the losses on underwriting are not being subsidised as they were. Thus prices across the market are rising to consumers.

It is, of course, possible that they really are collaborating to rip off the consumer. But it's almost impossible, from prices alone, to tell the difference between a perfectly functioning and competitive market and a perfectly operating collusion. Prices will still move in lockstep. When we see this happening we thus need to really investigate said market.

And here with car insurance the test will be. Are the insurers making more than the general return on capital, adjusted for risk? If not then the likely explanation is that fall in investment yields, reducing the subsidy to premiums.

We'll leave to those with the further interest the task of going and reading the financial results of the insurers. But that is where the answer will be found. Only if that return on capital is out of step would further investigation be warranted.