Underwriting and investing

Underwriting and investing

The business model can be reduced to a simple equation: Profit = earned premium +

investment income - incurred loss - underwriting expenses.

Insurers make money in two ways:

1. Through underwriting, the process by which insurers select the risks to insure and

decide how much in premiums to charge for accepting those risks;
2. By investing the premiums they collect from insured parties.

The most complicated aspect of the insurance business is the underwriting of policies.

Using a wide assortment of data, insurers predict the likelihood that a claim will be

made against their policies and price products accordingly. To this end, insurers use

actuarial science to quantify the risks they are willing to assume and the premium they

will charge to assume them. Data is analyzed to fairly accurately project the rate of

future claims based on a given risk. Actuarial science uses statistics and probability to

analyze the risks associated with the range of perils covered, and these scientific

principles are used to determine an insurer's overall exposure. Upon termination of a

given policy, the amount of premium collected and the investment gains thereon minus

the amount paid out in claims is the insurer's underwriting profit on that policy. Of

course, from the insurer's perspective, some policies are "winners" (i.e., the insurer

pays out less in claims and expenses than it receives in premiums and investment

income) and some are "losers" (i.e., the insurer pays out more in claims and expenses

than it receives in premiums and investment income); insurance companies essentially

use actuarial science to attempt to underwrite enough "winning" policies to pay out on

the "losers" while still maintaining profitability.

An insurer's underwriting performance is measured in its combined ratio. The loss ratio

(incurred losses and loss-adjustment expenses divided by net earned premium) is

added to the expense ratio (underwriting expenses divided by net premium written) to

determine the company's combined ratio. The combined ratio is a reflection of the

company's overall underwriting profitability. A combined ratio of less than 100 percent

indicates underwriting profitability, while anything over 100 indicates an underwriting

loss.

Insurance companies also earn investment profits on “float”. “Float” or available

reserve is the amount of money, at hand at any given moment, that an insurer has

collected in insurance premiums but has not been paid out in claims. Insurers start

investing insurance premiums as soon as they are collected and continue to earn

interest on them until claims are paid out. The Association of British Insurers (gathering

400 insurance companies and 94% of UK insurance services) has almost 20% of the

investments in the London Stock Exchange.[6]

In the United States, the underwriting loss of property and casualty insurance

companies was $142.3 billion in the five years ending 2003. But overall profit for the

same period was $68.4 billion, as the result of float. Some insurance industry insiders,

most notably Hank Greenberg, do not believe that it is forever possible to sustain a

profit from float without an underwriting profit as well, but this opinion is not universally

held. Naturally, the “float” method is difficult to carry out in an economically depressed

period. Bear markets do cause insurers to shift away from investments and to toughen

up their underwriting standards. So a poor economy generally means high insurance

premiums. This tendency to swing between profitable and unprofitable periods over

time is commonly known as the "underwriting" or insurance cycle. [7]

Property and casualty insurers currently make the most money from their auto

insurance line of business. Generally better statistics are available on auto losses and

underwriting on this line of business has benefited greatly from advances in computing.

Additionally, property losses in the United States, due to unpredictable natural

catastrophes, have exacerbated this trend.