Insurance Companies
As a commercial product, insurance is provided as a service by organizations that manage the transactions: determine probability of loss (and premiums), write the insurance policies, sell them to customers, confirm and pay for losses, and manage the funds. These "organizations" may be nonprofit organizations (who seek to collect premiums sufficient to pay losses and cover their operating expenses) or for-profit companies (who add to their premiums to generate profit).
Insurer's Business Model
The basic business model for insurance can be expressed as an equation:
premiums - losses - expenses = profit
An insurer can also invest the collected premiums until they are needed to pay losses and add investment earnings (or deduct investment losses) in the equation. This "investment profit" is common in the industry, though it tends to be a "bonus" profit (made by happenstance rather than anything the insurer can address through business practices, with the exception of delaying payment on claims).
The term "float" refers to the amount of time money is held in the firm - premiums collected in advance of having to pay out claims. At the very least, most companies earn bank interest on the float - and for large companies that insure billions in assets, the investment earnings can be significant.
However, a "float" may work against insurers: if there are a high number of claims in the early part of an accounting period, the insurer may be required to pay settlements now and collect premiums later, and actually go into debt to obtain the capital they need (if they have managed their resources poorly).
Ignoring expenses, the difference of premiums collected less claims paid is referred to as the "underwriting profit" on a policy. Some policies are losers, in that claims paid exceed premiums collected, and others are winners - but if the underwriting is sound, they should balance out.
Another way of hashing the numbers is to develop a loss ratio (losses/premiums) and an expense ration (expenses/premiums) and add the two together for a combined ratio. The combined ratio shows a profit or loss, and the two component ratios help to identify a more specific cause (underwriting or expenses).
Finally, it's worth noting that the profits of insurance companies are a matter of some discomfort: insurers who regularly charge more in premiums than is required to pay claims and expenses are often targeted by consumer advocacy groups or politicians who seek to curry favor by administering the industry to ensure that they are being "fair" with customers, particularly for forms of insurance that citizens are required by law to obtain.
Cash Flow Analysis
A closer look at cash flows for an insurance business:
The most fundamental cash flows into an insurance firm are premiums collected from the customers it insures and investment earnings on the float; and the most fundamental flows out of the firm are indemnity payments to settle claims and business expenses.
However, there are other cash flows that merit consideration:
- Investment Losses - While investment companies typically manage their cash reserves carefully, the potential to take a loss, rather than earn a profit, remains
- Salvage Recoveries - Depending on the terms of the policy, an insurance company may take possession of damaged property (most commonly, when a vehicle is totaled, the insurer takes possession of the wreckage) and sell it, in its damaged condition, to recover costs
- Subrogation Recoveries - In instances where two insured parties are involve in an incident (most commonly, an automobile accident), one company may pay its own customer and later discover that the "fault" lies with the other party. The insurer will then attempt to collect from the other insurance company the monies it has paid to its own customer.
Types of Insurance Companies
There are various taxonomies for classifying insurance companies - however, note that there are very few pure players by any definition. A single insurance company may fall into all of the categories listed below, often by having subsidiary companies under the same parent company.
Life and Non-Life
Life insurance companies are generally split off from non-life insurance companies because of the differences in tax and accounting requirements between life insurance products and other forms of insurance.
Property insurance policies have fixed terms, typically six months to one year. While it is possible to have coverage for many years, the policyholder actually holds a series of separate policies, one renewing immediately after the previous one expires. Also, these policies do not accrue value: the insurer pockets the premiums and pays claims (which are treated as income and expenses for tax purposes) and policies do not accrue cash value.
By contrast, life insurance is an ongoing policy that may last quite a long time (it's possible to buy a policy for an infant that will be kept until they day they die). And except in the case of term life insurance, a life insurance policy is a type of investment instrument that accrues value over the years, so a life insurance company manages a large pool of funds over a long period of time on behalf of its policyholders. Premiums are treated as assets under management, not revenues.
Standard and Excess Lines
Companies are also referred to as "standard line" and "excess line" insurers.
A standard-line insurer typically provides the most common forms of insurance policy (home, auto, business) and use a standard format for all of their customers.
Excess line companies cover risks that the standard line does not (for example, boiler insurance may be a separate policy from the standard homeowners' policy).
Mutual and Stock
Mutual insurance companies are owned by the policyholders, whereas stock companies are owed by shareholders (corporation). It is worth noting that mutual insurance companies are a dying breed: they are either going out of business or "demutualizing" and becoming stock companies. The distinction has nothing to do with the insurance they provide, merely the structure of the company.
The Insurance Cycle
The "insurance cycle" is a phenomenon that affects the industry at large, as a result of competition and economics. On the surface, the price of insurance tends to decrease over time, until a major catastrophe occurs and precipitates is a "claims burst."
The first effect of a claims burst is the bankruptcy of smaller and weaker firms, leaving their policyholders in the lurch.
The second effect is that even companies that have sufficient financial strength realize that they have been too lax in their underwriting standards and tighten their underwriting criteria.
The third effect is that new competitors, wary of the recent catastrophe and its effect of smaller and weaker firms, are reluctant to enter the market to drive cost down through competition.
The fourth effect is that individuals and businesses are acutely aware of their exposure, and will be willing to pay a higher price for policies they may not need, or amounts of coverage they may not need.
The net effect is a dramatic decrease in the elasticity of both supply and demand, resulting in a price spike.
Unless/until a second disaster occurs, customers "relax" their perception of the need for the insurance coverage, and may drop their policies. Insurers must then decrease the cost of their coverage to achieve a tenable market position. However, insurers will react more slowly than customers, earning high profits, which attracts new competition to the market, at which point the cycle will repeat until the next disaster occurs.
This same cycle has been noticed several times in recent years, from various disasters (wildfires, earthquakes, tornadoes, hurricanes, and floods), and the pattern seems to be similar in each instance.
Some sources argue that it should be mitigated because it is harmful: consumers may carry more or less insurance than they really need; insurance companies' premiums are influenced by market forces rather than sound underwriting and their solvency (particularly that of smaller players who enter the market).
However, given that the cycle is the result of free market forces and irrational consumer behavior, the only method for "mitigating" the problem is government intervention, which tends to cause more pain than it relieves.
Insurance Company Ratings
There are a wide array of "ratings" agencies, but the recognized standard in the Insurance industry is the A. M. Best Company, which uses grades (A+, B, etc.) to reflect the solidity of companies (how likely it is the company will be financially solvent and capable of paying claims).
Consumer advice: companies with poor ratings often offer lower premiums to attract customers - so when offered a low rate, be sure to check the insurer's rating. Otherwise, they may not be in business when you need them to pay a claim.
Other Insurance Businesses
Much of the present document deals with a simple model of insurance in which the insured and insurer do business directly with one another, and the insurer performs all tasks necessary to provision and service the product. Naturally, this seldom occurs.
Franchises, Brokers, and Resellers
The business from which an insured purchases a policy may and contacts to report a claim may not be the actual insurer.
An insurance "agency" is an independent business (not a branch office that's owned by the parent corporation), much like a franchise restaurant. The office operates under the brand of a national firm, which is the de facto insurer, but the office is an independent company. While business models vary, such franchisees are generally paid on commission.
Alternately, an independent "broker" may sell the policies of a variety of insurance companies, without having an exclusive agreement with any individual insurer. As with the franchisee, these brokers are strictly salesmen, working on commission, but a broker does not market under one company's brand.
There are also companies that resell insurance in bulk. Most commonly, these resellers provide benefits packages to their own customers (small businesses and organization), and the benefits include insurance from various insurance companies.
Outsourcing and Contracting
The fad of outsourcing has struck the insurance business, much like any other. Supporting services (accounting, call centers, etc.) are being shopped out, and even certain core services (adjusting and investigation) may be outsourced.
Reinsurance Companies
Reinsurance companies insure insurers - such that policyholders can still be paid of the claims exceed the assets of their original insurance company. This may occur when an insurance company serves a large number of customers in the same area, and disaster strikes.
There are two methods for reinsurance:
- Facultative reinsurance is the practice by which a reinsurer covers policies individually, receiving a portion of the premium from the primary insurer in exchange for providing remuneration for claims above a specific amount on each policy.
- Treaty reinsurance provides a payout to the original insurer if the total claims paid during a given period exceed a predetermined amount
In some cases, a reinsurance company's own requirements of the kinds of policies they will reinsure become industry-standard clauses of the policy offered to the consumer by original insurers.
The benefit of reinsurance is that it enables insurance companies to moderate their own costs - they do not need to maintain a large financial reserve to pay claims in "bad" years, can maintain a leaner capital structure, and moderate the premiums they charge to their own customers.
Supporting Services
There are a myriad of businesses that support, and are supported by, insurance firms. For example, an auto insurance company will make use of other firms to serve their customers (repair shops, dealerships, car rental agencies, etc.) and enter into agreements with national chains.
One reference mentioned the beginnings of "in-sourcing" - where an insurance company in a metropolitan area will provide a service itself (for example, providing rental or loaner automobiles to customers whose vehicles are damaged) in order to save cost (as opposed to paying a vendor). However, the source that mentioned this "growing trend" did not mention any specific examples, or cite any hard data to substantiate this claim, so I suspect it may be largely speculation.
Types of Insurance Coverage
This section discusses various types of insurance coverage, which should be differentiated from insurance policies in that a policy document may provide various types of coverage.
For example, auto insurance provides property coverage (protecting loss to the vehicle as an asset), liability coverage (protecting the insured against claims of damage by others), and health coverage (protecting the insured against the cost of medical treatments for injuries sustained).
Property Coverage
Property coverage applies to a specific physical asset, such as a house, an automobile, or a painting. The coverage compensates the policyholder for the value of the item (or the amount of damage done to the item) with the goal of replacing the item or restoring it to its original value.
Typically, property coverage provides for the immediate cause of loss as well as any consequential damages - if a bird flies through your window (insured loss) and broken glass impales your beagle (consequential damage), the property coverage extends to both. However, the second loss must be directly related and there must have been no action that the claimant could have reasonably taken to prevent the consequential damage (if it rains the next week and the water ruins your carpet because you failed to adequately board up the window, that's probably not covered).
Also, coverage may be for specific named risks or all risks - though even an "all risks" policy generally names specific events that are excluded from its coverage.
Loss of Use
"Loss of use" is a separate coverage that may be bundled with property coverage to compensate the insured for the income that they would have derived from the use of the asset had it not been damaged.
Examples of loss-of-use coverage would be payments for lost wages of an injured individual, or a monetary settlement for lost profits if a retail establishment is damaged.
The specific amount owed to an insured due to opportunity cost is highly theoretical: if a specific amount is not stated in the policy, it may be a matter of some argument to determine how much money the insured might reasonably have been expected to make, were the asset not damaged.
It is possible, though rare in practice, for loss-of-use coverage to be purchased without property coverage for the corresponding asset, and therefore receive a loss-of-use settlement without a property damage settlement.
Consequential Expenses
Coverage for consequential expenses is similar to loss-of-use, though it covers actual costs an insured must undertake instead of opportunity costs of lost revenue as a result of the loss of an asset. A "consequential" expense is any cost other than that necessary to repair or replace the insured asset.
An example of consequential expense coverage is reimbursement for a temporary lodging during a period when one's residence is untenable due to damage from a covered loss.
Consequential expense coverage is more common than loss-of-use coverage, as it deals with actual cash outlays that can be assessed objectively (how much was actually paid).
Casualty Coverage
Casualty coverage protects the insured against losses due to accidents. It may not be tied to any specific property. The loss may be to the policy holder, another person named in the policy, or even a third party.
Liability Coverage
Liability coverage, a kind of casualty coverage, pays claims made by others against the policyholder for injuries, property damage, and other losses they have incurred that can be blamed on the policyholder. Said another way, liability coverage insures against the loss a policyholder would suffer when the legal system awarded damages to another party - though these insurance settlements often preempt lawsuits.
It is possible to obtain limited liability coverage to pay only certain types of claims, such as bodily injury, property damage, or both (comprehensive general liability), but in practice, most insurance policies provide for all forms of liability.
Health and Life Coverage
Health and life coverage pertain to the injury or death of persons who are insured by the policy, whether such persons are a named insured or provisions of the policy cover them, even though they are not mentioned by name in the policy.
Health and life insurance are generally categorized as being "other than" property and casualty - but if you drop pretensions and consider the human body as an asset, it's roughly the same: these forms of insurance provide funds to restore the body when it is damaged, or compensation for the benefits the beneficiary will lose if the insured body ceases to operate permanently.
In most instances, health insurance provides for the cost of medical treatment to restore bodily health as a result of injury or illness. In other instances (such as accidental dismemberment), a fixed sum is paid directly to the insured, regardless of how it is spent. Life insurance provides a benefit to the beneficiaries of an insured in the case of their death to compensate them for the loss of financial support.
In most insurance policies (auto insurance, for example), the injury must be the result of a covered event. In pure health insurance policies, all risks are covered (with specific exceptions - like self-inflicted wounds or injuries sustained from participating in dangerous activities).
Injury or death to other parties is not covered by health insurance. However, such parties may have a legal claim against the insured, and liability coverage indemnifies the insured against that (financial) loss.