What is the main business model for insurance companies?: Insurance companies build their business models around diversifying and assuming risk. The core insurance model is to pool risk from different payers and distribute it across a larger portfolio. Two ways are common for insurance companies to generate revenue:
They charge premiums in return for insurance coverage and then invest those premiums in other interest-generating assets. Insurance companies, like all private businesses, try to market efficiently and reduce administrative costs.
Pricing and Assuming the Risk
The revenue model details for financial guarantors, property insurance companies, and health insurance companies vary. However, the first task for any insurer is to price risk and then charge a premium for taking it on.
Let’s say that an insurance company offers a policy with a conditional payout of $100,000. It must assess the likelihood of a buyer to trigger the conditional payout and increase that risk based on the policy’s length.
Insurance underwriting is crucial. If there is no underwriting, insurance companies will charge customers too much for taking on risk. This could lead to rates rising even more by pricing out customers who are least likely to be at risk. A company that prices its risk accurately should generate more revenue from premiums than it does on conditional payments.
An insurer’s true product is in fact insurance claims. The company must receive a claim from a customer, process it, and verify its accuracy before it can be paid. This is essential to eliminate fraudulent claims and reduce the chance of the company being sued.
Interest Earnings and Revenue
Let’s say that the insurance company receives $1,000,000 in premiums for its policies. The company could keep the money in cash, or put it into savings, but this isn’t very efficient. At the very minimum, these savings will be exposed to inflation risk. The company should instead find short-term, safe assets to invest its funds.
The company can then generate additional interest revenue while waiting for potential payouts. These instruments include Treasury bonds and high-grade corporate bonds.
Reinsurance can be used by companies to lower their risk. Insurance companies purchase reinsurance to reduce their exposure and protect themselves against excessive losses. Reinsurance is an essential part of the insurance company’s efforts to stay solvent and avoid default due to payments. It is mandated by regulators for companies of certain sizes and types.
An insurance company might write too many hurricane insurance policies if it bases its hurricane forecasts on the low likelihood of a hurricane affecting a particular area. The insurance company could suffer huge losses if a hurricane struck that area. Insurance companies could lose their business if they don’t have reinsurance to take some of the risks off the table in the event of a natural catastrophe.
The regulations require that insurance companies only issue policies with a maximum of 10% of their value unless they are reinsured. Reinsurance gives insurance companies the ability to transfer risk and allows them to win more market share. Reinsurance also helps to smoothen out fluctuations in profit and loss, which can cause significant deviations for insurance companies.
It is akin to arbitrage for many insurance companies. They charge higher rates for insurance to individuals, but then they can get lower rates when reinsuring policies on a larger scale.
Evaluation of Insurers
Reinsurance helps to smoothen fluctuations in the business and makes the whole insurance industry more attractive to investors.
Like any other non-financial service they are assessed on their profitability, expected growth, and payouts. There are specific issues that the sector faces. Insurance companies don’t invest in fixed assets so there are very little capital expenditures and depreciation. It is difficult to calculate the working capital of an insurer because there are no typical working capital accounts.
Analysts don’t use metrics that involve firm and enterprise value; instead, they focus on equity metrics such as price/earnings and price/book ratios. Analysts use ratio analysis to determine the company’s insurance-specific ratios.
Insurance companies with high expected growth, high payouts, and low risk tend to have a higher P/E ratio. The P/B ratio is also higher for companies that have high expected earnings growth, low-risk profiles, high payouts, and high returns on equity. The largest influence on the P/B ratio is the return on equity, even if everything else remains constant.
Analysts have to consider additional factors when comparing the P/E and B ratios in different insurance sectors. Insurance companies prepare estimates for future claims expenses. The P/E or P/B ratios could be too high or low if the insurer is too conservative, or too aggressive when estimating these provisions.
Comparability within the insurance industry is also affected by diversification. Insurers are often involved in multiple insurance businesses such as property, life, or casualty. Insurance companies are exposed to different risks and return depending on how diversification is done. This can make their P/E or P/B ratios vary across sectors.
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