Insurance companies base their business models on assuming and diversifying risk. The essential insurance model involves pooling the risk of individual payers and redistributing it across a larger portfolio. Most insurance companies generate income in two ways: by charging premiums in exchange for insurance coverage, and then reinvesting those premiums in other interest-bearing assets. Like all private companies, insurance companies try to market effectively and minimize administrative costs.
Pricing and risk taking
The details of the revenue model vary among health insurance companies, property insurance companies, and financial guarantors. However, the first task for any insurer is to price risk and charge a premium for assuming it.
Suppose the insurance company offers a policy with a conditional payment of $ 100,000. You need to assess the likelihood that a potential buyer will trigger the conditional payment and spread that risk based on the duration of the policy.
This is where underwriting is essential. Without a good underwriting, the insurance company would charge some clients too much and others too little to take the risk. This could discount less risky customers and eventually cause fees to go up even more. If a company assesses its risk effectively, it should generate more premium income than it spends on conditional payments.
In a sense, the real product of an insurer is insurance claims. When a customer files a claim, the company must process it, verify its accuracy, and submit payment. This adjustment process is necessary to filter out fraudulent claims and minimize the risk of loss to the business.
Earnings and interest income
Suppose the insurance company receives $ 1 million in premiums for its policies. You could hold the cash or put it in a savings account, but that’s not very efficient – at the very least, those savings will be exposed to the risk of inflation. Instead, the company can find safe, short-term assets to invest its funds. This generates additional interest income for the business while it awaits potential payments. Common instruments of this type include Treasuries, high-quality corporate bonds, and interest-bearing cash equivalents.
Some companies go into reinsurance to reduce risk. Reinsurance is insurance that insurance companies buy to protect themselves from excessive losses due to high exposure. Reinsurance is an integral component of insurance companies’ efforts to stay solvent and avoid default due to payments, and is required by regulators for companies of a certain size and type.
For example, an insurance company may write too much hurricane insurance, based on models that show little chance of a hurricane affecting a geographic area. If the unthinkable were to happen with a hurricane hitting that region, it could lead to considerable losses for the insurance company. Without reinsurance taking some of the risks off the table, insurance companies could close every time a natural disaster strikes.
Regulators require that an insurance company should only issue a policy capped at 10% of its value unless it is reinsured. Therefore, reinsurance allows insurance companies to be more aggressive in gaining market share as they can transfer risks. In addition, reinsurance smoothes out natural fluctuations for insurance companies, which can experience significant deviations in profit and loss.
For many insurance companies, it is like arbitration. They charge a higher rate for insurance to individual consumers and then obtain cheaper rates by reinsuring these policies on a large scale.
By smoothing out business fluctuations, reinsurance makes the entire insurance industry more suitable for investors.
Companies in the insurance sector, like any other non-financial service, are evaluated based on their profitability, expected growth, payment and risk. But there are also sector-specific issues. Since insurance companies do not invest in fixed assets, there is little depreciation and very little capital expenditure. Also, calculating the insurer’s working capital is a challenging exercise since there are no typical working capital accounts. Analysts do not use metrics that involve company and company values; instead, they focus on stock metrics, such as price-earnings (P / E) and price-book (P / B) ratios. Analysts perform index analysis by calculating specific insurance indexes to evaluate companies.
The P / E ratio tends to be higher for insurance companies that exhibit high expected growth, high payouts, and low risk. Similarly, P / B is higher for insurance companies with high expected earnings growth, a low-risk profile, high pay, and high return on equity. Holding everything constant, return on equity has the biggest effect on the P / B ratio.
When comparing P / E and P / E ratios across the insurance industry, analysts have to deal with additional complicating factors. Insurance companies make estimated provisions for your future claims expenses. If the insurer is too conservative or aggressive in estimating such provisions, the P / U and P / B ratios may be too high or too low.
The degree of diversification also makes comparability difficult in the insurance sector. It is common for insurers to be involved in one or more different insurance businesses, such as life, property and casualty insurance. Depending on the degree of diversification, insurance companies face different risks and returns, making their P / E and P / B ratios different across the industry.