Insurance companies generate revenue by assuming and diversifying risk. The core model involves pooling risk from individual policyholders and redistributing it across a larger portfolio. They primarily earn money through two methods: charging premiums for coverage and reinvesting those premiums into interest-generating assets. Like any business, they aim to market effectively and minimize administrative costs.
.jpg "How Do Insurance Companies Make Money?")
Pricing and Assuming Risk
The revenue models differ among health insurance, property insurance, and financial guarantors. However, the primary task is to assess risk and set a premium for assuming it.
For instance, if an insurance company offers a policy with a $100,000 conditional payout, it must evaluate the likelihood of a customer triggering this payout and extend that risk over the policy duration.
Underwriting is crucial in this process. Without accurate underwriting, the company might overcharge or undercharge customers, potentially driving away the least risky ones and leading to higher overall prices. Accurate risk pricing ensures more revenue from premiums than expenditures on payouts.
An insurer's real product is insurance claims. When a customer files a claim, the company processes it, verifies its accuracy, and issues payment. This adjusting process helps filter out fraudulent claims and minimize losses.
Interest Income and Revenue
If an insurance company collects $1 million in premiums, holding it in cash or a savings account is inefficient and exposes it to inflation risk. Instead, investing in safe, short-term assets generates additional interest income while awaiting potential payouts. Common investments include Treasury bonds, high-grade corporate bonds, and interest-bearing cash equivalents.
Reinsurance
Insurance companies use reinsurance to mitigate risk. Reinsurance is insurance that companies purchase to protect against excessive losses due to high exposure. It is crucial for maintaining solvency and avoiding default due to large payouts, and regulators often require it for companies of certain sizes and types.
For example, a company might write extensive hurricane insurance based on models indicating low probabilities of a hurricane in a specific area. If a hurricane occurs, reinsurance helps the company manage significant losses. Without reinsurance, companies could go out of business when natural disasters strike.
Regulators mandate that companies can issue policies only up to 10% of their value without reinsurance. Reinsurance allows companies to be more competitive by transferring risks and smoothing out profit and loss fluctuations.
Many insurance companies use reinsurance like arbitrage, charging higher rates to individual customers and securing cheaper rates for bulk reinsurance.
Comparing Insurers
Reinsurance stabilizes the insurance sector, making it more appealing to investors by evening out business fluctuations.
Unique issues in the sector include the lack of fixed asset investment, minimal depreciation, and small capital expenses. Calculating operating capital is challenging since there are no regular accounts for it. Analysts focus on equity metrics like price-to-earnings (P/E) and price-to-book (P/B) ratios and use insurance-specific ratios to evaluate companies.
The P/E ratio tends to be higher for companies with high expected growth, high payout, and low risk. Similarly, P/B is higher for companies with high earnings growth, low-risk profiles, high payout, and high return on equity. Return on equity significantly impacts the P/B ratio.
Analysts must consider complicating factors when comparing P/E and P/B ratios across the insurance sector. Estimated provisions for future claims expenses can skew these ratios if the insurer is too conservative or aggressive.
Diversification also complicates comparisons. Insurers often engage in various insurance businesses, such as life, property, and casualty insurance. The degree of diversification affects the risks and returns, making P/E and P/B ratios vary globally.