Insurance is a business with long history and plays an important role in modern finance world as the industry controls large amount of capital and investments. For example, Berkshire Hathaway, one of the largest corporations in US, is a conglomerate with insurance business as its core that invests broadly on business and securities.
What is insurance? Simply speaking, It is a transfer of the risk of a loss from one entity to another in exchange for a payment (premium). An insurer, the major participant in insurance business, sells insurance policies to policyholder (underwrites).
Whether a risk can be insured depends on various factors, including the calculability of the loss, exposure unit, loss trigger, etc. There are many types of insurance: life, health, casualty, property, liability, credit and more, each regarding one or more specific risks. Insurance companies are generally divided into two groups: life insurance companies and non-life/property/casualty insurance companies. The two groups are usually subject to different regulations and rules in most countries, mainly due to the difference of time-length of the policies.
So how does Insurance business makes money?
An insurer receives premium from underwriting risks and invests the money seeking investment income. It pays policyholders in the case of losses, maturity or other specified events. Therefore, the profit of an insurer can be expressed as:
Profit = Premium Earned + Investment Income – Payment – Operating Expenses
Insurer can only make profit when the premium it receives plus the investment incomes exceeds the payment. Determining the proper premium is not an easy job. It should be high enough to cover the expected payout but also low enough to offer a competitive price to its customers. It is all about properly pricing risks. This is mostly the job of actuaries, who use statistics and probabilities to estimate the potential claims based on the risks (See Actuarial Science).
The capital insurer collected is called “float”. It is the amount of premium collected but not yet paid out for claims. The insurer then invest the float to earn interest or other income. The investment is mainly on fixed income securities such as treasury or municipal bonds while a portion of it is on equities in order to enhance yields. Insurers also incur costs on operations, marketing and other overheads. When a policy matures or terminates, the amount of premium minus the payout is booked as profit for insurer.
While some insurers sell policies to customers directly, most insurers distribute their policies via brokers, agents and banks. These channels earn commissions on the premium received by the insurers.
Details and more aspects on competition, regulation, financials and regulation will be discussed in future posts. Follow the tag #insurance for more posts.