by elmads

An industry that financially protects people from disasters that may or may not happen in our lives. This itself gives certainty from the uncertainties of life, a sense of comfort, and stability. It bestows peace of mind and a goodnight sleep that no matter what happens to us or our belongings, our loved ones will always be financially protected. No one would certainly want to impart financial burdens to their loved ones.

This is the importance of insurance in the point of view of individuals, corporations and government as clients. But how about as a business and shareholder? how does it become an effective business model other than just selling their services through insuring people and/or tangible/intangible products? and how do they actually make more money?

The Insurance Premium

People who are financially protected via their insurance plans will always need to pay a premium. It usually comes as a monthly expense on the side of the person who has the insurance policy. In return, if the unfortunate event does happen, the insurer will need to pay an equal monetary amount as stated in the policy.

The insurance Premium is what you call the revenue that Insurance companies get from their customers. A top line income as a service of promising someone and/or something, financial protection. Insurance can be both life (health and death coverage) and non-life (auto, travel and home).

The question here is, how do insurance companies make a decision on how much they place in their premiums?

Underwriters & Actuaries

Insurance has evolved over time, since its usage from the ancient Babylonian laws (The Code of Hammurabi), to the bottomry in times of the Greeks then the Romans, to the medieval times of guilds. To the rise of a strong Mediterranean trade, then to the formation of the modern insurance due to a single coffee shop, which created the jobs that we now have such as underwriting and insurance brokers. This is all thanks to the centuries of people wanting to always have a better protection for themselves, their treasured belongings and their families.

When we talk about insurance in the eyes of the insurer, we’re talking always about risk. Remember that insurance companies are also businesses, which means that they definitely need revenue to; firstly, continue to survive and operate their business so they could forever carry forward on protecting the people who are still not financially protected (the uninsured), and secondly, to grow the company more than they are now.

No company in their right mind would give all of their products and services for free, not unless they are a non-profit organization.

This in mind, insurance companies make more money from the premiums they get from their policy holders only if they have a good team, like any other businesses in the world. But most people think that it only boils down to skilled insurance brokers, when in fact they are only a part of the team. Insurance companies also need wonderful Underwriters and Actuaries.

• Underwriters – they are the ones responsible for issuing the insurance policy. They essentially decide which policies their insurance company should offer to their potential clients. This means that if you’ve applied for an insurance coverage, the underwriter will be the one digging deeper into your own personal circumstances such as age, location, job, income, medical details, and etc. This is their way of assessing the risk you potentially hold.
  
  For what reason, you asked? let’s just say that this is how underwriters think in a nutshell “How likely will we pay the claim to this person in the long run?” Why? well if the risk doesn’t materialize, then that’s free money given by the policy holder to the insurance company. But, if the risk does happen, then they would need to shell out and pay the money to their policy holder as promised.

• Actuaries – One of their jobs is to determine the appropriate premium to charge on top of the base premium on different individual characteristics such as gender, age, income and geographical location. This is called the “Rating Factors”. It is a table that they make, where the characteristics of an individual has a corresponding additional premium that they charge. These characteristics are based from their research and analysis either or both outsourced or insourced methods. Actuaries are great problem solvers.

Basically, Actuaries are macro scale researchers making decisions for the premium that needs to be paid depending on a specific characteristic of a group, while underwriters are micro scale assessors who looks specifically on individuals who are applying for an insurance policy. If the underwriters deem a person insurable based on their assessment, they will then place a premium based from the table made by Actuaries. That’s the simple gist and relationship of the two.

Insurance is a Business

So yes, insurance is a business. A great insurance company is the one who seldom pays claims to their customers, not because they’re without integrity to their policy contract, but because their underwriters are good assessors of individuals risks while actuaries are great problem solvers of macro scale risks. They get a lot of premiums from customers without needing to pay claims because they are able to make a good risk calculation. That an unfortunate event will not happen to the majority of their approved policy holders, hence no claims that they need to pay, which translates to more income for the company.

To give you context, I’ll make an OVERSIMPLIFIED scenario. We have persons A and B, who both applied for life insurance. The insurance policy they applied for states the following;

• They need to pay for a monthly base premium worth ₱1,000 for 30 years. This totals ₱360,000. (₱1,000 amount of money x 12 months x 30 years).

• On the event of their death, the insurer will pay let’s say ₱2,000,000 to their listed dependent(s).

Person A is 30 y/o, Asian, lives in the Philippines, works night shifts permanently, has a good yearly income, no current to medical condition, physically active, non-smoker, occasional drinker, BMI is within normal range (18.5 to 24.9), Family medical history of Type 2 Diabetes, Hypertension and Cancer (not specified).

Person B is 30 y/o, Asian, lives in the Philippines, works day shifts permanently, has a good yearly income, not physically active, has borderline Diabetes and Hypertension, a smoker, occasional drinker, BMI is overweight (25 to 29.9) , with Family medical history of Type 2 Diabetes, Hypertension and Cancer (not specified).

After being reviewed by the underwriters, both are approved but the premiums differ based from the table done by actuaries. Which person do you think will have a higher premium????

Yep you’re right, Person B will. This is not a matter of being unfair, because remember they are a business who are also taking risk in insuring someone. 

The riskier a person or item they will cover, the higher the premium they will require. Or, if they deem that a person or item possess substantial risk, then they’ll most likely decline to cover him/her or it.

Just imagine the scenario above again, then let’s say they approved 100,000 people with the same base premium of ₱1,000 monthly for 30 years.

Then after 30 years, the policy has been completed and no one actually claimed the money because no one in the 100,000 people approved 30 years ago, passed away. So what will happen to the premium collected by the company over the years? That becomes an income to the insurance company.

That’s (₱1,000 amount of money x 12 months x 30 years x 100,000 individuals approved = ₱36 Billion!! worth of premium for the insurance company), this is only in the consideration that no one died, but if someone did actually pass away during the policy period then the insurance company will have only less than that ₱36 billion. The more policy claimed the lower will be their possible revenue overtime.

Insurance Brokers

Some of you might be thinking that I talked more about Underwriters and Actuaries. How about the Insurance brokers? I didn’t focus on them too much because most of us know what they do.

They are the ones responsible for looking clients or items to insure, they are the direct contact to the customers, and bridge them to the proper insurance policy. Without them, insurance companies will not thrive, because who would market the company’s insurance policies? No matter how good the insurance policy is, if there’s no one to advertise, market and find people that will be best suitable for it, then no one will know if it is indeed a good insurance policy and company.

It’s just the same as, even if you’re the best cook in town, if no one knows and has tasted your cooking, then you’re just dreaming.

Insurance brokers are the bridge between the insurance policies of a company and the clients. Insurance brokers, Underwriters and Actuaries are the sum of its parts of a great insurance company, but wait there’s still one part missing. The capital allocator, the investment division of an insurance company.

Investment Company

If an insurance company has good insurance brokers, underwriters and actuaries, then that means that they have a great insurance business, isn’t it? well, sort of, because that’s only one part of the story.

It’s true that if they have a good team then that insurance company is a cash cow, meaning money keeps on flowing to their company consistently. Unfortunately, having a lot of money is also a problem for them. Why? it’s because money stored in a bank devalues overtime due to inflation, this is where it becomes a liability for insurance companies. This was one of the problems of insurance companies centuries ago.

Don’t worry, they already found a solution, and that’s through investing the excess cash on other assets to make it productive. This is how Insurance companies also became an investment company, which also helped them to create the popular product that they are offering now to everyone, the Variable Life Insurance (VUL).

But, they can’t invest all of their cash because they are still an insurance company who has the responsibility to pay claims to their policy holders, when the policy meets its requirements.

In general, a good insurance company should also be a good capital allocator in which they can make a good call on how much or what percentage of their premium they can invest (Float) and what needs to be liquid for paying possible claims in the future (Claim Reserves). Additionally, the invested float should, as much as possible equal, or better exceed inflation.

On an individual level analogy, we can think of this as money saved for emergency purposes, 3-12 months of our essential living expenses, which may or may not happen but at least we’re covered when it does actually pan out (This is the CLAIM RESERVE of an insurance company). Then our Residual Income, the excess money after paying our month’s essential expenses, debt and other financial responsibilities, which we could use for investments so that our money can grow overtime (This is the INSURACE FLOAT).

Insurance Float and Warren Buffett

Warren Buffett, who is also known as the “Oracle of Omaha” because he lives in Omaha Nebraska US and most especially due to his investment selection prowess that made him into one of the bests, if not the best investor of this generation.

He is the Chairman and CEO of Berkshire Hathaway, a conglomerate company consisting of several insurance and reinsurance, utilities and energy, freight rail transportation, manufacturing, and retailing businesses. Plus, his various marketable securities holdings such Apple, Bank of America, Coca-Cola, American Express, and Kraft Heinz, which are their top 5 holdings as of their 2021 annual report.

Berkshire Hathaway is also considered an insurance company as they have approximately 11 wholly owned insurance businesses. Their most popular and largest insurance business is GEICO (Government Employees Insurance Company), an auto insurance company and the second largest in the US after State Farm.

When we think about it, Berkshire Hathaway has the best capital allocator of this generation has ever seen, plus it has massive amounts of cash due to the insurance floats being produced by its multiple insurance businesses, other businesses and marketable securities investments.

A Great Capital Allocator plus a lot of money to invest = OVERKILL!! That’s Warren Buffett and His Berkshire Hathaway Empire.

No wonder how Warren Buffet massively and exponentially increased his company’s growth including his net worth. He doesn’t need to have his own investment fund, because he gets multiple times more money from the insurance business model through its float, and invest portions of that money to other businesses and marketable securities. whew!

Here’s Warren Buffet talking about Insurance Float, which was taken from Berkshire Hathaway’s 2009 annual report. (https://www.berkshirehathaway.com/2009ar/2009ar.pdf) page 6.

Insurers receive premiums upfront and pay claims later. ... This collect-now, pay-later model leaves us holding large sums -- money we call "float" -- that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit. ...

If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money -- and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the Property/Casualty (P/C) industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float. ...

Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most -- though certainly not all -- future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.

Let me emphasize again that cost-free float is not a result to be expected for the property/casualty (P/C) insurance industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry's overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses.

To sum it up

The insurance industry is an important part of our lives, without it, financial protection would not even be possible for us ordinary citizens of this world. Some may seem to not want to be insured as they do not see its importance, or that it is not a priority, or they deem the probability of such catastrophic events happening to their lives are less likely to happen. As long as this person is comfortable with his/her decision, and takes accountability and responsibility of its outcomes, whether it’ll be good or bad, then whatever choice that person takes is absolutely fine.

There is no such thing as the perfect financial protection plan for everyone, but there is a financial plan that best fit each and our own circumstances. What makes us sleep well at night and have the peace of mind are the most important things in personal finance and also investing.

I cannot see a world where the insurance industry will cease to exist. As long as there are chances of catastrophic events happening, debilitating diseases & illnesses befalling human kind, and the uncertainties in life, then this industry will always thrive along with the human race.

Knowledge is my sword, and patience is my shield

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.