Insurance companies primarily make money in two ways: from investments and by generating an underwriting profit—that is, collecting premiums that exceed insured losses and related expenses.
It all begins with underwriting. Insurers, whether life or nonlife, must assess the risk and gauge the likelihood of claims and the value of those claims.
Insurance companies invest assets that are set aside to pay claims brought by policyholders. The insurance “float” represents the available reserve, or the funds available for investment once the insurer has collected premiums but is not yet obligated to pay out in claims. If an insurer has predominantly short-term obligations—for example, homeowners’ policies which pay out in a relatively short period— the float is usually invested in short-term liquid instruments to enable the insurers to pay out on claims as they happen.
If the needs are long term, a portfolio containing fixed income securities, such as bonds and mortgage loans, may also include preferred and common stocks, real estate and a variety of alternative asset classes. Life insurers also establish separate accounts for nonguaranteed insurance products, such as variable life insurance or annuities, which provide for investment decisions by policyholders.
Property/casualty insurers traditionally have been more conservative with the asset side of their balance sheets, primarily due to the high levels of risk on the liability side. For example, catastrophe losses can wipe out years of accumulated premiums in some lines. The global recession of the previous decade hurt nearly all aspects of the insurance industry, as many companies experienced declining revenues and investment losses. Companies with risky asset portfolios such as an outsized exposure to mortgagebacked securities, equities and high yield bonds suffered disproportionately.
Life insurers who offered variable annuity products with rich guarantees to their policyholders also suffered, as they used options to hedge these guarantees. During a time of peak stock market volatility, these options became very expensive, resulting in losses. Few winners emerged. However, the mutual insurance sector managed to remain somewhat unscathed by the downturn. Ater the recession, meanwhile, the Federal Reserve’s attempts to battle the economic weakness by lowering the fed funds rate resulted in a chronic low interest rate environment limited the ability of life and other insurers to benefit from fixed investments such as bonds. That may change, depending on economic conditions that could spur higher inflation.
Most industries work as follows:
• Build product.
• Incur costs.
• Price product.
• Sell product.
• Generate revenue.
But insurance works largely in reverse:
• Build product.
• Price product.
• Sell product.
• Generate revenue.
• Incur costs.
The significance of this reversed revenue/cost cycle is that the product is priced and sold based on an estimate of future costs to be incurred. These estimates can be wrong for any number of reasons, including catastrophes, claim cost inflation, changes in legal climate, newly identified exposures not known at the time the insurance policy was sold, social changes, investment market fluctuations and other factors.
This also means that insurers must be very good at predicting the future and very prudent in administering their business over the long term. This strategy directly results in what are known as underwriting cycles and is why insurance insolvencies sometimes spike in periods following catastrophes or market disruptions.
The insurance industry is less tangible in that the actual cost of its product isn’t precisely known at the time of sale. The true cost is determined at a later point, often much later. Yet risk is taken on along with unpredictable, exogenous factors that ultimately determine profit or loss. While insurers gauge the probability of a large catastrophic event or some latent liability, these scenarios still cause a supply shock. A simplified explanation is that the insurance cycle is driven by supply and demand. If capacity is lacking, the price of risk transfer goes up.
Source: AM Bests Guide to Understanding the Insurance Industry