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| How Do Insurance Companies Profit |
Insurance companies' business models are based on assuming and diversifying risk. The fundamental insurance model entails aggregating risk from individual payers and redistributing it across a larger portfolio.
The majority of insurance companies generate revenue in two ways: they charge premiums in exchange for insurance coverage and then reinvest those premiums in other interest-generating assets. Insurance companies, like all private businesses, strive to market effectively while minimizing administrative costs.
Pricing and Risk Assumption
The revenue models used by health insurance companies, property insurance companies, and financial guarantors differ. However, the first task of any insurer is to price risk and charge a premium for assuming it.
Assume the insurance company is offering a policy with a conditional payout of $100,000. It must determine how likely it is for a prospective buyer to trigger the conditional payment and then extend that risk based on the length of the policy.
This is where insurance underwriting comes into play. Without proper underwriting, the insurance company would charge some customers too much for risk and others too little. This may price out the least risky customers, causing rates to rise even further. If a company effectively prices its risk, it should generate more revenue in premiums than it spends on conditional payouts.
In some ways, the real product of an insurer is insurance claims. When a customer submits a claim, the company must process it, verify its accuracy, and make payment. This adjusting process is required to screen out fraudulent claims and reduce the company's risk of loss.
Revenue and Interest Earnings
Assume the insurance company receives $1 million in policy premiums. It could keep the money in cash or put it in a savings account, but that is inefficient: At the very least, those savings will be subject to inflation risk. Instead, the company can invest its funds in safe, short-term assets. While the company waits for possible payouts, this generates additional interest revenue. Treasury bonds, high-grade corporate bonds, and interest-bearing cash equivalents are examples of common instruments of this type.
Reinsurance
Some businesses use reinsurance to reduce risk. Insurance companies purchase reinsurance to protect themselves from excessive losses due to high exposure. Reinsurance is an essential component of insurance companies' efforts to stay solvent and avoid payout default, and regulators require it for companies of a certain size and type.
For example, an insurance company may issue too much hurricane insurance based on models that predict a low probability of a hurricane striking a specific geographic area. If the unthinkable happened and a hurricane hit that area, the insurance company could suffer significant losses. Insurance companies may go out of business if natural disasters do not take some of the risks off the table through reinsurance.
Regulators require that an insurance company only issue a policy with a 10% cap unless it is reinsured. As a result of the ability to transfer risks, reinsurance allows insurance companies to be more aggressive in gaining market share. Furthermore, reinsurance smoothes out the natural fluctuations of insurance companies, which can result in significant variations in profits and losses.
It is similar to arbitrage for many insurance companies. They charge a higher rate for insurance to individual consumers and then receive lower rates when reinsuring these policies on a large scale.
Insurer Evaluation
Reinsurance makes the entire insurance sector more appealing to investors by smoothing out business fluctuations.
Companies in the insurance sector, like any other non-financial service, are evaluated based on profitability, expected growth, payout, and risk. However, there are some issues that are unique to the industry. Because insurance companies do not invest in fixed assets, there is little depreciation and very little capital expenditures recorded. Furthermore, calculating the insurer's working capital is a difficult task because there are no standard working capital accounts.
Analysts do not use firm and enterprise value metrics; instead, they concentrate on equity metrics such as price-to-earnings (P/E) and price-to-book (P/B) ratios. Analysts use ratio analysis to evaluate companies by calculating insurance-specific ratios.
Insurance companies with high expected growth, high payout, and low risk have a higher P/E ratio. Similarly, insurance companies with high expected earnings growth, a low risk profile, a high payout, and a high return on equity have a higher P/B. Return on equity has the greatest impact on the P/B ratio when all else is constant.
Analysts must contend with additional complicating factors when comparing P/E and P/B ratios across the insurance industry. Insurance companies make provision for potential claims expenses. If the insurer estimates such provisions too conservatively or aggressively, the P/E and P/B ratios may be too high or too low.
The degree of diversification also makes it difficult to compare insurance companies. Insurers are frequently involved in multiple insurance businesses, such as life, property, and casualty insurance. Insurance companies face different risks and returns depending on their level of diversification, so their P/E and P/B ratios vary across the industry.
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