Sunday, 2 October 2016

Understanding An Insurance Company's Revenue Model

The revenue models of insurance companies are based on premiums collected from policyholders.

Premiums are the starting point for revenues earned by all types of.

This includes

  • life insurance companies, 
  • auto insurance companies, 
  • companies that sell homeowner’s insurance and 
  • even companies that sell annuities.

Pricing of Risk by an Insurance Company

The revenue model starts with the pricing of risk and the sale of an insurance policy. 

The insurance policy’s benefit amount represents the amount that the insurance company is willing to pay should a loss occur. 

For life insurance, that loss is death.

With property and casualty insurance such as auto and homeowner’s insurance, the loss is damage, theft or destruction of property, such as a home or auto.

Risk Pooling and Premium Pricing

The willingness to accept this risk comes at a price to the policy owner.

This price is the premium amount and is based on the common occurrence of risk, as distributed among a large class of people.

This process is known as risk pooling and is performed by actuaries hired by the insurance company.

The risk pools determine the likelihood of a loss occurring for a class and the price for that risk, which becomes the premium amount.

Net Premiums

When the premium is paid, the insurance company nets out its expenses associated with keeping the coverage in force.

This includes commissions paid to agents and brokers of the insurance company.

It also includes the administrative and operational costs of the insurer such as overhead, salaries and other business related expenses.

The net amount of the premium represents the revenue amount that the insurer has to invest.

General Account versus Separate Account Assets

For life insurance companies, 2 accounts are maintained in order to address the risks associated with their products.

These accounts are the general account and separate account of the insurance company.

 In the general account, net premiums from fixed products issued by the life insurance company such as fixed annuities, term life, whole life and universal life products are deposited.

 These net premiums are invested in fixed income securities such as municipal and treasury bonds in order to back the insurer’s promise to pay.

Separate Account

The separate account is backed with net premiums from variable insurance products such as variable annuities and variable life insurance.

These product’s premiums must be segregated or maintained in a separate account by law since it is the policy owner that determines how the premiums are invested, not the insurer. 

This investment control means that the policy owner is subject to a greater risk because those premiums are in the stock market and other equity securities.

Interest Earnings and Revenue

The interest earned by the investment of assets in either the general account for life insurance and property and casualty insurance companies or separate account for the life insurer is a component of overall revenue for the insurer. 

Savings realized by lowered expenses and less than expected risk losses (i.e. deaths, illness, disability, auto accidents) leads to higher revenues for an insurance company.

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