In many ways, the basics of operating an insurance company seem pretty straightforward. You underwrite risk, not all of those risks generate claims, and the premiums you collect more than offset the losses you incur. If the equation works out as expected, you should make a profit. While that seems simple, a lot more factors are involved and you would be surprised at how thin the underwriting profit margin really is for most insurance companies.
The insurance business can be very competitive, particularly when it comes to conventional risks such as home insurance. When the risk of being insured is generally similar and there is a tremendous amount of it, the underwriting becomes more precise. For example, there are millions of households in the U.S. and most of them have home insurance. Therefore, that’s a great deal of similar risk being underwritten by various insurance companies. Over time, statisticians that work for the insurance companies (known as actuaries) can analyze the history of losses and determine the probability of losses in the future with a fair amount of precision. This helps the insurance company set the premiums for the new business they write. On the other hand, insurance companies that provide coverage for very unusual or unique risks (say, tourist submarines in open waters off the coast of California) do not have the benefit of a great deal of history for similar risks. Those risks are much more difficult to predict and insurance companies tend to charge more and hedge their bets.
With home insurance, the relative consistency of the risk means that most insurance companies also charge similar prices. It’s difficult for insurers to charge a wide-varying premium from the others because they will lose market share. In the insurance business, a large pool means less volatility of results and losses can be more easily absorbed without significant negative financial impact. However, in the very competitive home insurance industry, the constant competition means the marketplace tends to move to the median, with some companies trying to gain market share or increase premium by writing more business at lower rates.
What all of this means is that insurance companies sometimes write coverage at very low levels of profit. The profit can be very minor or, in many cases, non-existent. That’s right — insurance companies sometimes will write coverage at an underwriting loss, meaning they take in less premium than the losses they pay out. In addition to that basic underwriting loss, you need to consider all the expenses they incur in generating your business (such as commissions to the agents) and managing your claims. After combining all of these costs, you might wonder how they do this and stay in business!
In most cases, the premiums they collect will not be paid out immediately in claims. Instead, they might sit on the premiums for a year or more before any claims are paid. During this period of time, they are investing your premiums and earning interest and returns on the investment. What throws the insurance company off its course is when the overall market takes a dive and the investment returns are not what they expected. That, in turn, causes them to raise rates overall in the future to make up for the losses they sustained in prior years.
You might wonder why they can’t just charge enough to make always make an underwriting profit. After all, that seems like the simplest principle of insurance. If they did, you would be paying a lot more in premium for your coverage and that’s not something most consumers will embrace. Therefore, it’s a fairly delicate balancing act for insurance companies in the amount of premium they can charge and still eke out a slight profit. You should consider that difficulty the next time you wonder about the premium you are being charged for your policy. After all, not every policyholder can get their premium dollars back in claims each policy year. If they did, the insurance company would be out of business very quickly.