Insurance companies receive premiums for a policy before, often long before, they have to pay out the corresponding claims. A dollar of premium received today can be invested, yielding substantially more than a dollar by the time it must be paid out as claims. Thus an insurance company can pay out more dollars in claims than it takes in in premiums, and still make a profit--because the interest they receive more than makes up the difference.

While interest income is important to people running insurance companies, it is an irrelevant distraction for our purpose, which is to analyse the economics of the allocation of risk, so I have ignored it in this chapter. Readers who find this disturbing are free to assume either that the real interest rate is zero, so that a dollar today exchanges for a dollar next year, or that all numbers represent present values calculated to the same date. For more information on how present value calculations can be used to deal with this sort of complication, see chapter 12 of my webbed Price Theory.