Property/Casualty Insurance Accounting 101
INCOME STATEMENT
UNDERWRITING PROFIT/LOSS
Premium revenue is used to fund claim payments, sales commissions for insurance agents and operating expenses.
Insurers typically express each of these expenses as ratios to earned premiums.
Claim expenses, for example, typically consume 75% of an insurer's net revenues.
Adding together these three ratios produces the combined ratio.
Combined ratio is an insurance company's key underwriting profit measure.
A combined ratio under 100 indicates an underwriting profit.
For example, a combined ratio of 95 means that the insurer paid out 95% of its premium revenue for losses. The 5% remaining is the underwriting profit.
A combined ratio exceeding 100 indicates an underwriting loss.
For example, an insurer with a combined ratio of 105 paid out 105% of its premium revenue to cover losses, meaning that it had an underwriting loss equal to 5% of revenues.
Companies with combined ratios exceeding 105 for more than a short time have a difficult time recouping their losses via investment earnings, and this type of poor underwriting track record suggests that an insurer's competitive position is unusually weak.
Insurers unable to earn even the occasional underwriting profit will produce the industry's poorest returns and may be tempted to accept large investment risks to boost profitability.
INVESTMENT INCOME
Insurers also make money from investment income, which they often report as a ratio of premiums.
Adding the investment ratio to the combined ratio yields the operating profit ratio.
In many instances, investment income is a key profit determinant because it offsets underwriting losses.
BALANCE SHEET.
ASSETS
INVESTMENTS
The key asset for most insurers is investments.
In addition to float, most insurers invest a large portion of their own retained earnings as well.
The investments account reveals the size of an insurer's investments relative to its asset base and details the asset allocation employed.
As a starting point, look for insurers with no more than 30 percent invested in equities (unless the company is run by Warren Buffett).
UNEARNED PREMIUMS
Unearned premiums represent premiums received but not yet considered revenue.
When an insurer receives a premium, it is deemed to earn it gradually across the year.
After all, if a customer cancels a policy, the insurer must refund that portion of the coverage not consumed.
After six months, an annual auto policy would be 50% earned, and half the premium would be considered revenue.
Before this occurs, the premiums are held in the unearned premium account, and the insurer is free to invest them.
WHAT DO YOU WISH FOR.
Look for an insurer who is able to consistently earn underwriting profits on a large, growing customer base.
In effect, this insurer would be getting paid to profit from investing other people's money and could retain this float indefinitely (as long as it grows).
Unfortunately, for investors, these situations rarely occur.
FLOAT
Insurers enjoy a peculiar business advantage.
Premiums are received well in advance of the firm's requirement to pay claims.
This money is often referred to as float.
An insurer enjoys the use of this money between the time it receives a premium and the time it has to pay a claim.
Insurers exploit this by investing these premiums and keeping the money they make from the investments.
How much money they can make this way depends on market performance, the insurer's asset allocation, and how long the insurer holds premiums before making claim payments.
Insurers writing long-tail insurance hold premiums longer and, hence, can invest more in equities.
(The length of an insurance policy's tail refers to the time it takes for damages to become apparent.
Short-tail policies are those where damages incurred during the insured period become known quickly, such as a car accident.
Long-tail policies cover damages that may not become apparent for many years, such as an asbestos injury_
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