In the insurance world, there is so much to learn and explore, which can be a very big deal. Today, at Insurance Reassurance, we are going to break down the business model of an insurance company. The information will cover several topics, including the risks of running an insurance company, how interest earnings and revenue operate, reinsurance, how assessing insurers takes place, and the PE and PB ratios of an insurance company. These are all very important components of an insurance company, and we know this is information we may have been wondering about at one point or another. With that being said, let’s jump straight into the video.
The Core of Insurance Companies’ Business Models
Insurance companies base their business models around assuming and diversifying risk. The fundamental insurance model includes pooling risk from individual payers and redistributing it across a bigger portfolio. Most insurance companies produce income in two ways: charging premiums in return for insurance coverage and reinvesting those premiums into interest-generating assets like every private business. Insurance companies also attempt to advertise effectively and limit administrative costs.
Estimating and Assuming Risk
When estimating and assuming risk, we must keep in mind that revenue model specifics differ among health insurance companies, property insurance companies, and financial guarantors. The first assignment of any insurer is to value risk and charge a premium for accepting that risk. Let’s assume an insurance company is offering a policy with a $100,000 conditional payout for the insured. It needs to evaluate how likely a prospective buyer is to trigger the conditional payment and extend that risk based on the length of the policy. This is where insurance underwriting becomes essential. Without good underwriting, the insurance company would charge some clients too much and others very little, which could result in pricing out the least risky clients. Ultimately, this could increase rates further.
Insurance as the Real Product
An insurer’s real product is insurance claims. When a client files a claim, the company must deal with the claim, check it for accuracy, and submit the payment. This adjusting process is crucial in filtering out fraudulent claims and minimizing the risk of loss to the company.
Interest Earnings and Revenue
Interest earnings and revenue are significant income streams for an insurance company. For instance, if an insurance company collects $1 million in premiums, it could hold on to the money in cash or place it in a savings account. However, that would not be very efficient. The company can invest its funds in safe short-term assets, which generates extra interest revenue while it waits for possible payouts. Common investment instruments include treasury bonds, high-grade corporate bonds, and interest-bearing cash equivalents.
Reinsurance: Spreading the Risk
Some companies participate in reinsurance to reduce risk. Reinsurance is essentially insurance that insurance companies purchase to protect themselves from excessive losses due to high exposure. It is an essential part of an insurance company’s efforts to remain solvent and avoid default due to payouts. Regulators mandate reinsurance for companies of a specific size and type. For example, an insurance company may offer hurricane insurance based on models showing low odds of a hurricane in a specific area. If a hurricane were to hit, the company could face significant losses. Without reinsurance, the company could go out of business.
Reinsurance and Market Share
Reinsurance allows insurance companies to be more aggressive in winning market share by transferring risks to other companies. It also smooths out fluctuations in profits and losses. For some companies, reinsurance is like arbitrage, as they charge higher rates to individual consumers and then reinsure those policies at a lower rate on a large scale.
Assessing Insurers
Before assessing insurers and smoothing out fluctuations in the business, reinsurance makes the entire insurance sector more appropriate for investors. Insurance sector companies are evaluated based on their profitability, expected growth, payout, and risk. However, there are unique challenges in the insurance sector. For example, insurance companies do not make investments in fixed assets, resulting in little depreciation and minimal capital expenditures. Consequently, analysts focus on equity measurements, such as price to earnings (PE) and price to book (PB) ratios.
PE and PB Ratios
The PE ratio tends to be higher for insurance companies that show high expected growth, high payout, and low risk. Similarly, the PB ratio is higher for insurance companies with high anticipated earnings growth, a low-risk profile, high payout, and high return on equity. Return on equity (ROE) has the most significant impact on the PB ratio. When comparing PE and PB ratios across the insurance sector, analysts need to account for more complex factors.
The Complexity of Comparing Insurance Companies
Insurance companies make estimated provisions for future claims expenses. If an insurer is too conservative or too aggressive in estimating these provisions, the PE and PB ratios may be excessively high or low. Additionally, the level of diversification hampers comparability across the sector. Many insurers are engaged in different types of insurance, such as life, property, and casualty insurance. Depending on the level of diversification, insurance companies face different risks and returns, which can make their PE and PB ratios vary across the sector.
Conclusion
That brings us to the end of this video. Thanks for joining us today. If you enjoyed the video, please hit the like button—it really helps us out here and allows us to continue making the content that you crave. If you haven’t already, hit the subscribe button so you can be alerted when our next video goes up. We’ll see you next time, right here on Insurance Reassurance.
