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Inside this Article
Insurer’s
Business Model
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Profit = earned premium + investment income - incurred loss -
underwriting expenses. Insurers make money in two ways:
(1) through underwriting, the
process by which insurers select the risks to insure and decide how much
in premiums to charge for accepting those risks
(2) by investing the
premiums they collect from insures.
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Insurer’s
Business Model
The most difficult aspect of the insurance
business is the underwriting of policies. Using a
wide assortment of data, insurers predict the
likelihood that a claim will be made against their
policies and price products accordingly. To this end,
insurers use actuarial science to quantify the risks
they are willing to assume and the premium they will
charge to assume them. Data is analyzed to fairly
accurately project the rate of future claims based on
a given risk. Actuarial science uses statistics and
probability to analyze the risks associated with the
range of perils covered, and these scientific
principles are used to determine an insurer's overall
exposure.
Upon termination of a given policy, the amount of
premium collected and the investment gains thereon
minus the amount paid out in claims is the insurer's
underwriting profit on that policy. Of course, from
the insurer's perspective, some policies are winners
(i.e., the insurer pays out less in claims and
expenses than it receives in premiums and investment
income) and some are losers (i.e., the insurer pays
out more in claims and expenses than it receives in
premiums and investment income).
An insurer's underwriting performance is measured
in its combined ratio. The loss ratio (incurred losses
and loss-adjustment expenses divided by net earned
premium) is added to the expense ratio (underwriting
expenses divided by net premium written) to determine
the company's combined ratio. The combined ratio is a
reflection of the company's overall underwriting
profitability. A combined ratio of less than 100
percent indicates profitability, while anything over
100 indicates a loss.
Insurance companies also earn investment
profits on “float”. “Float” or available
reserve is the amount of money, at hand at any given
moment, that an insurer has collected in insurance
premiums but has not been paid out in claims.
Insurers start investing insurance premiums as
soon as they are collected and continue to earn
interest on them until claims are paid out.
In the United States, the underwriting loss of
property and casualty insurance companies was
$142.3 billion in the five years ending 2003. But
overall profit for the same period was $68.4 billion,
as the result of float. Some insurance industry
insiders, most notably Hank Greenberg, do not believe
that it is forever possible to sustain a profit from
float without an underwriting profit as well, but this
opinion is not universally held. Naturally, the
“float” method is difficult to carry out in an
economically depressed period. Bear markets do cause
insurers to shift away from investments and to toughen
up their underwriting standards. So a poor economy
generally means high insurance premiums. This
tendency to swing between profitable and unprofitable
periods over time is commonly known as the
"underwriting" or "insurance"
cycle.
Property and casualty insurers currently make the
most money from their auto insurance line of business.
Generally better statistics are available on auto
losses and underwriting on this line of business has
benefited greatly from advances in computing.
Additionally, property losses in the US, due to
natural catastrophes, have exacerbated this trend.
Finally, claims and loss handling is the
materialized utility of insurance. In managing the
claims-handling function, insurers seek to balance the
elements of customer satisfaction, administrative
handling expenses, and claims overpayment leakages. As
part of this balancing act, insurance fraud is a major
business risk that must be managed and overcome.
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