The business model is to collect more in premium and investment income
than is paid out in losses, and to also offer a competitive price which
consumers will accept. Profit can be reduced to a simple equation:
Profit = earned premium + investment income – incurred loss – underwriting expenses.
Insurers make money in two ways:
Through underwriting, the process by which insurers select the risks to
insure and decide how much in premiums to charge for accepting those
risks.
By investing the premiums they collect from insured parties
The most complicated aspect of the insurance business is the actuarial
science of ratemaking (price-setting) of policies, which uses statistics
and probability to approximate the rate of future claims based on a
given risk. After producing rates, the insurer will use discretion to
reject or accept risks through the underwriting process.
At the most basic level, initial ratemaking involves looking at the
frequency and severity of insured perils and the expected average payout
resulting from these perils. Thereafter an insurance company will
collect historical loss data, bring the loss data to present value, and
compare these prior losses to the premium collected in order to assess
rate adequacy. Loss ratios and expense loads are also used. Rating for
different risk characteristics involves at the most basic level
comparing the losses with "loss relativities"—a policy with twice as
many losses would therefore be charged twice as much. More complex
multivariate analyses are sometimes used when multiple characteristics
are involved and a univariate analysis could produce confounded results.
Other statistical methods may be used in assessing the probability of
future losses.
Upon termination of a given policy, the amount of premium collected
minus the amount paid out in claims is the insurer's underwriting profit
on that policy. Underwriting performance is measured by something
called the "combined ratio", which is the ratio of expenses/losses to
premiums. A combined ratio of less than 100% indicates an underwriting
profit, while anything over 100 indicates an underwriting loss. A
company with a combined ratio over 100% may nevertheless remain
profitable due to investment earnings.
Insurance companies earn investment profits on "float". Float, or
available reserve, is the amount of money on hand at any given moment
that an insurer has collected in insurance premiums but has not paid out
in claims. Insurers start investing insurance premiums as soon as they
are collected and continue to earn interest or other income on them
until claims are paid out. The Association of British Insurers
(gathering 400 insurance companies and 94% of UK insurance services) has
almost 20% of the investments in the London Stock Exchange.
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.
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