The business model is to collect more funds through premiums and investment income than they have to pay out in losses, while also offering competitive prices which consumers will accept.
Insurance companies make money by underwriting or investing the money collected from premiums.
The most intricate aspect of the insurance business may be the actuarial science of rate-making policies, which uses statistics and probability to estimate the rate of future claims based on the given risks. After producing the rates, the insurance company will accept or reject risks at their discretion through the underwriting process.
At the most basic level, rate making includes considering the frequency and severity of the insured losses and the expected average payout resulting from these losses. The insurance company will then collect historical loss data, adjust that data towards present value, and compare these previous losses to the premium collected in order to assess rate adequacy properly. Loss ratios and expense loads are also utilized by companies.
At its most basic level, rating for different risk characteristics involves comparing the losses with “loss relativities”– a policy with twice as many losses shall therefore charge twice as much.
Insurance companies sometimes use more complex multivariate analyses in cases where multiple characteristics are involved, and a univariate analysis may be used to produce confounded results. Other statistical analysis methods may also be employed for assessing the probability of future losses.
Upon the termination of a given policy, the amount of the premium collected minus whatever amount is paid out in claims is the insurance company’s underwriting profit on that said policy.
Insurers measure underwriting using the “combined ratio,” which is the ratio of their expenses and losses to premiums. A combined ratio of less than a hundred percent shows an underwriting profit, while anything over 100% indicates an underwriting loss. An insurance company with a mixed ratio of over 100% may remain profitable through its investment earnings.
Insurers earn their investment profits on “float.” Float, or accessible reserve, is the amount of money that the insurance company has on hand at any given moment. This is the money it has collected in insurance premiums and has not paid out yet in claims.
Insurance companies start investing insurance premiums as soon as they are paid by the insured and start earning interest on them until claims are paid out. For example, in the United States, the underwriting loss of property and casualty insurance for the five years ending 2003 was $142.3 billion. For that same period, the overall profit was $68.4 billion as a result of float.
Some insurance business insiders believe that it is impossible to forever sustain a profit from float without an underwriting profit. Some companies’ reliance on float for profit has led some industry experts to call these companies “investment companies that produce the money for their investments by selling insurance.”
In an economically depressed period, the float method is complicated to carry out. Bear markets cause insurers to move away from investments and instead toughen up their underwriting standards, so a low economy generally means higher insurance premiums. This inclination to swing between profitable and unprofitable periods is called the underwriting cycle.
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