Funding Cover

Funding cover refers to insurance premiums held in an account in conjunction with an excess-of-loss reinsurance, which is used to pay insurance claims. Funding covers act as a resource pool that can be drawn down to pay for claims, with unused funds returned to either policyholders or ceding insurers.

Funding cover can be used to generate investment income. When an insurance company underwrites a new policy it is agreeing to indemnify the policyholder from covered losses. In exchange for taking on this risk the insurer is paid a premium. The premium is used to pay claims, as well as generate investment income. Insurers have to balance the mechanisms they use to manage funding for future claims with their desire to generate profits by investing premiums.

One approach to funding claims is to use an alternative risk transfer (ART) transaction, such as a funding cover. In a funding cover, an insurer pays premiums into a fund designed to cover a finite risk. For example, an insurer wants to finance a $50 million cover over a five year period. The insurer transfers premiums to the fund, and the premiums are used to make investments that earn the insurer interest. If no claims are filed, and thus no losses experienced, the funding cover could earn the insurer a profit that could be greater than 100%. A reinsurer or other company that manages the funding cover typically charges a fee for this service.

Funding covers can also be used to provide an insurer with access to additional financing. For example, the insurer could deposit $20 million into a funding cover to gain access to $100 million in bridge financing. If no losses are incurred then the $20 million, plus any interest generated from investment activities, is returned to the insurer. If losses do occur they are first drawn against the $20 million, with any losses between $20 million and $100 million covered by a supplemental default policy. Using a funding cover allows the insurer to earn income on funds that would otherwise be inactive, with the income used to self-fund against claims.

A funding cover is usually a safe strategy for how an insurance company might handle an insurance float, but while the risks are low, so are the potential for returns. What an insurance company does with its insurance float is a huge factor in determining how successful they ultimately are. An insurance company has many options with what to do with their float, some more profitable than others. As Warren Buffet puts it, "an insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money."