Understanding Revenue Sources and Profitability in Insurance Companies (Full Transcript)

Speaker 1: There are two revenue sources for insurance companies, underwriting income from customer premiums and investment income, where insurers invest some of that money to generate a return. Let's look at investment income first. For companies which sell physical products, costs are incurred before revenue comes in. For insurance, it works the other way around. Insurers collect premium revenues up front, while claims, which make up most of the costs, come months or years later. In the meantime, insurers invest this excess cash. Underwriting income is more complicated. Imagine you're starting your own P&C insurer. Let's see how underwriting income works on your P&L. In year one, you take in $150 million in revenue from premiums. This is referred to as your gross written premium, or GWP. You pay out $100 million in claims and the cost of handling them, such as claims staff. The other costs of running your business, known as underwriting expenses, are $30 million. They include distribution costs, like sales commissions, and overheads such as staff, buildings, and IT. This gives you underwriting income of $20 million. This is what your P&L would look like if you kept all of the risk on your books. But you reduced your exposure by paying or ceding a third of the premiums to a reinsurer, and in return, they pay a third of the claims. The $100 million remaining in the business is known as net written premiums, or NWP, because it is net of reinsurance. How do you know if your business is doing well? In P&C, three metrics are commonly used to measure performance. The loss ratio measures what proportion of the premiums go to claims. Here it is 67%. Next, the expense ratio is the proportion of premiums that goes to cover the underwriting expenses, 30% in this case. The combined ratio looks at both cost items as a share of total premiums, which is 97%. A combined ratio of above 100% means you are losing money on the underwriting side, and below 100% means you are making money. In this example, the insurer has a 3% underwriting profit. But remember that you have another income stream – $2 million from investments takes your operating income to $5 million. It is possible for insurers to be profitable even if costs exceed premium revenue, because investment income makes up for the underwriting losses. The time gap between premiums coming in and costs going out is called the tail. Generally, in P&C, that gap is short, while life insurance has a long tail – it can be decades before the insured person dies. With longer to invest, investment income makes up a large proportion of revenue for life insurance. P&C has little investment income, so profitability depends almost entirely on accurate pricing of risk through underwriting.