Underwriting and investing

Underwriting and investing

The business model is to collect more in premium and investment income than is paid out in losses, and to also offer a competitive price which consumers will accept. Profit can be reduced to a simple equation: Profit = + investment income - incurred loss - underwriting expenses.

Insurers make money in two ways:

1. Through , the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks;
2. By the premiums they collect from insured parties.

The most complicated aspect of the insurance business is the of ratemaking (price-setting) of policies, which uses and to approximate the rate of future claims based on a given risk. After producing rates, the insurer will use discretion to reject or accept risks through the underwriting process.

At the most basic level, initial ratemaking involves looking at the and of insured perils and the expected average payout resulting from these perils. Thereafter an insurance company will collect historical loss data, bring the loss data to , and comparing these prior losses to the premium collected in order to assess rate adequacy. and expense loads are also used. Rating for different risk characteristics involves at the most basic level comparing the losses with "loss relativities" - a policy with twice as money policies would therefore be charged twice as much. However, more complex through generalized linear modeling are sometimes used when multiple characteristics are involved and a univariate analysis could produce confounded results. Other statistical methods may be used in assessing the probability of future losses.

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 on that policy. An insurer's underwriting performance is measured in its combined ratio which is the ratio of losses and expenses to earned premiums. A combined ratio of less than 100 percent indicates underwriting profitability, while anything over 100 indicates an underwriting loss. A company with a combined ratio over 100% may nevertheless remain profitable due to investment earnings.

Insurance companies earn profits on "float". Float, or available reserve, is the amount of money on hand at any given moment that an insurer has collected in insurance premiums but has not paid out in claims. Insurers start investing insurance premiums as soon as they are collected and continue to earn interest or other income on them until claims are paid out. The (gathering 400 insurance companies and 94% of UK insurance services) 20% of the investments in the .

In the , the underwriting loss of and 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 , 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 period. 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 .