Welcome to post #2 of my AINS 101 notes. In case you somehow found your way here without reading my previous post, you should know that I am in the process of obtaining the Associate of Insurance (AINS) certification, of which the first step is to complete the AINS 101 course that covers the core basics of insurance. We previously went over the question of Why Do We Have Insurance? Today, we look at how the insurance business succeeds.
1. Why Insurance Operations Are Regulated
Insurance is regulated to make it fair for both insurers and policy holders. The three primary reasons are to:
- Protect consumers by
- verifying that insurance policies truly benefit customers.
- requiring insurers to pay legitimate claims and honestly represent the benefits of their policy.
- guaranteeing that insurance is available and accessible to all who require it.
- Maintain insurer solvency, making sure insurers are financially able to pay out claims.
- Insurers that cannot pay for all of the losses they insured are insolvent.
- Regulations make sure insurers have enough cash on hand to pay for future claims made on the policies they issue, including ones from long ago in which they have already collected the premium.
- Insurers must be able to pay off multiple affected insured at once due to some catastrophe.
- Regulations prevent insurers from making bad investments or engaging in fraudulent activities that can jeopardize its reserves.
- Prevent destructive competition, such as when one insurer prices its policies so low that it drives another to bankruptcy.
- This prevention helps insurers maintain their financial health and protect their consumers.
- Charging an inadequate premium could leave the insurer without enough cash to pay out claims.
- Charging low rates may be an attempt to drive out the competition.
2. Deciphering Insurer Financial Statements
Insurance companies need to manage assets, liabilities, revenue, and expenses to stay profitable. We can analyze financial statements to see how well an insurer is doing.
An Insurer’s Income Statement
This statement is used to show total revenue, expenses, and net income for a particular time period.
- Revenue – Gained primarily from premiums
- Expenses – Incurred losses from claims and the costs associated with them, as well as the cost of underwriting
- Net income – Calculated income from underwriting and investments. Net income before taxes is called bottom-line.
The Importance of Earned Premiums
Insurers calculate revenue from premiums by totaling premiums charged from all policies written with the effective date of a calendar year from January 1st to December 31st. There is a differentiation between earned and unearned premiums.
- Earned premiums – Portion of written premiums applied to part of a policy period that has already occurred
- Unearned premiums – Remaining portion of written premiums applied to a policy period that has not yet occurred and coverage is yet to be provided.
For instance, if it is December 31st and we are at the end of one policy period, the premiums are considered earned prior to this date. For the period of January 1st and beyond of the following year, the premiums are considered unearned as coverage has not been provided yet.
An Insurer’s Balance Sheet
The balance sheet gives a snapshot of an insurer’s financial position at a specific point in time through their assets, liabilities, and surplus.
- Assets – Admitted assets are assets that can easily be turned into cash, such as short-term investments, bonds, and common stock. Non-admitted assets are not as liquid and cannot be easily converted into cash, such as overdue premiums.
- Liabilities – This represents an insurer’s responsibility to pay policyholders’ claims.
- Policyholders’ surplus – This represents the difference between the value of a company’s assets minus its liabilities, and is the best indication of how well the company is doing.
3. Breaking Down the Combined Ratio
Measuring Underwriting Results
Underwriting results are a key indicator of an insurer’s profitability. The combined ratio is the most common financial measure of underwriting results over a specific period of time.
Determining an Insurer’s Profitability
You can analyze your own insurer’s financial statements over several quarters or years to see what is trending over time. These performance trends can be compared between multiple insurers to see how the industry is doing as a whole, and you can make calculations to see the potential effects of changing underwriting strategies or expanding into new lines of business.
The Combined Ratio
As mentioned earlier, the combined ratio is used to measure the financial results of underwriting. It is measured by adding the loss ratio to the expense ratio. So,
Loss Ratio + Expense Ratio = Combined Ratio
- Loss ratio – What percentage of a premium dollar is used to pay losses and loss adjustment expenses.
- Expense ratio – What percentage of a premium dollar is used to pay insurer’s expenses, such as marketing costs and employee wages.
Understanding the Results
To give an example, an insurer may have a loss ratio of 65 and expense ratio of 25. This means that 65 cents per premium dollar earned is spent on losses and loss adjustment, and 25 cents per premium dollar is spent on insurer expenses. The combined ratio is 65 + 25 = 90. With a combined ratio of 90%, this indicates that the company keeps 10% of its total premium earned, thus a turning a profit.
Combined ratio < 100 = Profit!
To give a more tangible example, let’s look at the following financial report.
- Earned premiums $4,000,000
- Written premiums $5,000,000
- Net investment income $1,000,000
- Incurred Losses $3,000,000
- Incurred underwriting expense $2,000,000
To determine the loss ratio, we calculate
Loss ratio = Incurred losses / Earned premiums
Thus, in our case, our loss ratio is 3 / 4 = 0.75 = 75%
To determine the expense ratio, we calculate
Expense ratio = Incurred underwriting expense / Written premiums
So our expense ratio is 2 / 5 = 0.40 = 40%
The combined ratio is then 75 + 40 = 115%, meaning this company was not profitable this year!
4. How Is Insurance Marketed?
Like other businesses, insurance is marketed based on customer needs and preferences. Here are some of the common ways insurance is marketed and sold:
- Independent agents and brokers
- Exclusive agency
- Direct writer
- Distribution channels
Who Are Independent Agents and Brokers?
Agents and brokers sell insurance products to individuals and businesses as well as provide policy services. While similar, they are two different entities.
- Agents – Legally represent one or more insurers
- Brokers – Represent customers, and unlike agents, cannot commit an insurer to write a policy as they are not their legal representatives.
Independent agents and brokers are not employees of an insurer and are free to work with as many insurers as they wish. They own their expiration lists, which are lists that contain policyholder information and policy expiration dates. This is a significant advantage for them because insurers do not have a right to independently solicit those policyholders.
What Is an Exclusive Agency?
An exclusive agency is contracted to sell insurance for one insurer or a group of insurers. They are not employees of the insurers and are only allowed to sell policies from contracted insurers, and the insurers handle administrative functions, such as issuing policies, collecting premiums, and processing claims themselves. Unlike independent brokers and agents, they do not own the expiration lists and thus cannot take policyholders along should they contract with another insurer.
What Is a Direct Writer System?
A direct writer system is when an insurer uses its own employees as producers. Their agents are similar to exclusive agents as who they represent is restricted to just their own insurer. The insurer owns the expiration lists and its other staff does most of the administrative work.
An Evolving Market
Now in the digital age, many customers looking for personal policies prefer to get a quote online. However, there are many insurance distribution channels:
- Digital – Apps and websites
- Call centers – Talk to customer representatives or chatbots
- Direct response – Social media, email blasts, website ads, or direct mail
- Group marketing – Marketing to members of the same personal or professional group
- Financial institutions – Marketing through banks and financial services
5. Conclusion
Now we know how insurers succeed in their business. In this post, you have read a bit about underwriting, but do even know what underwriting is? Tune in for my next post on How Does Underwriting Work?