Have you ever been curious about how insurance companies make money? Maybe you think that any money comes from the price you pay for your policy. Well, that’s only part of the story. In fact, many believe that an insurance company is able to generate a profit even when it sustains a direct loss from that activity. But how? Let’s find out!
Insurers’ ultimate goal is to collect more in premiums and investment income than they pay out in losses. The secondary purpose, which is as vital, is to give a competitive price that consumers will accept in order to put themselves ahead of the competition. Profit can be calculated using a simple equation:
Profit = Earned Premium + Investment Income – Incurred Loss – Underwriting Expenses
Insurance companies make money in two ways:
- Underwriting profits: Underwriting is the process by which insurers select the risks to insure and determine how much to charge in premiums for accepting those risks and bearing the weight of the risk should it occur.
- Investment profits: They are generated by investing the premiums collected from insured parties.
The actuarial science of ratemaking (price-setting) of policies, which uses statistics and probability to approximate the rate of future claims based on a particular risk, is the most sophisticated aspect of insurance. Following the generation of rates, the insurer will exercise its discretion to reject or accept risks through the underwriting process.
At its most basic, initial rate-making entails considering the frequency and severity of insured hazards, as well as the estimated average payout from these risks. Following that, an insurance firm will collect historical loss data, convert it to present values, and compare it to the premium collected to determine rate adequacy. Loss ratios and expense loads are employed too.
The loss ratio is a mathematical calculation that divides the total claims reported to the carrier, plus the carrier’s expenditures for claim administration, by the total premiums generated.
Expense loading covers costs associated with the purchase of new policy contracts, the collecting of insurance premiums, and the maintenance and management of policy contracts throughout the insured period.
At its most essential, rating for various risk characteristics is comparing losses to “loss relativities.” As a result, a policy with twice as many losses would be charged twice as much. When numerous characteristics are involved and a univariate analysis might generate muddled results, more complicated multivariate studies are utilized. Other statistical methods may be employed to estimate the likelihood of future losses.
When a policy is terminated, the insurer’s underwriting profit on that policy is the amount of premium collected minus the amount paid out in claims. The “combined ratio,” which is the ratio of expenses/losses to premiums, is used to assess underwriting effectiveness. Anything less than 100% suggests an underwriting profit, whereas anything greater than 100% indicates an underwriting loss. A corporation with a combined ratio greater than 100% may nonetheless be successful thanks to investment earnings.
Insurance companies profit from “float” investments. The amount of money on hand at any given time that an insurer has collected in insurance premiums but has not paid out in claims is known as float. Insurance premiums are invested by insurers as soon as they are collected and continue to produce interest or other income until claims are paid out.
For example, The Association of British Insurers (which represents 400 insurance businesses and 94% of UK insurance services) owns over 20% of the London Stock Exchange. Profits from float in the United States totaled $58 billion in 2007. Warren Buffett stated in a 2009 letter to investors, “We were paid $2.8 billion to hold our float in 2008”.
In the five years ending in 2003, the underwriting loss of property and casualty insurance carriers in the United States was $142.3 billion. However, as a result of floats, the overall profit for the same time was $68.4 billion. Some insurance industry insiders, most notably Hank Greenberg, feel that it is impossible to sustain a profit through float indefinitely without also making an underwriting profit, but this is not widely agreed upon. Because of their reliance on floats for profit, insurance companies have been dubbed “investment companies that raise money for their investments by selling insurance” by certain industry analysts.
Naturally, the float method is difficult to implement during an economic downturn. Because bear markets force insurers to shift away from investments and tighten their underwriting rules, a bad economy often equals high insurance premiums. The underwriting, or insurance, cycle refers to this tendency to alternate between profitable and unproductive periods throughout time.