An insurance company work on a policy, which is a contract between the insurer and insured,whereby the insurer (insurance company) agrees to pay for any loss or damage suffered by the insured on a particular asset (or life, in terms of life insurance) for a fixed amount of premium the insured has to pay at regular intervals to the insurer for taking up the responsibility to pay for his loss or damage.
The premiums which the insurance company receives at regular intervals from the insured serves as their income. Like any other business, these insurance companies also make a profit, which is mainly of two types: 1. Underwriting income 2. Investing Income.
- Underwriting income: Underwriting income is obtained from the difference between how much money is collected for all policies sold (in terms of premium) and how much money is paid out in insurance claims (final settlement) for those policies in any given time period. Example: If an insurance company ‘XYZ’ collects a premium of Rs. 100 every year for 10 years and the insured suffers a loss due to an accident at the beginning of the 11th If the claim the insurance company has to pay is more than the accumulated premium collected (100* 10) then it suffers loss. If it has to pay for the claim less than the premium collected (100*10) then, the difference amount becomes their profit.
- Investment income: Insurance companies can invest the premium money collected while they are idly kept until a claim needs to be settled. They can invest this money in stocks, bonds, other business or even other insurance company to earn returns on the idle man. But these should be investments made only for short termsince the claim can occur any time. Investing in the stock market involves risk,though the returns are high. The insurance company may raise the insurance rates that are the premiums in case they anticipate a loss.
The insurance companies can estimate the ultimate claim ratio for the year that is the loss ratio using various statistical tools. Loss ratio is the ratio of the total losses incurred (paid and reserved) in claims plus adjustment expenses divided by the total premiums earned.
Example: If an insurance company pays Rs. 55 in a claim for every Rs. 100 collected in premium, then the loss ratio is 55% and the gross margin or profit ratio is 45%. Some portion of this 45% will cover all the expenses incurred (operating cost) and the remaining is the net profit.
Using the above principle the price of an insurance contract can be determined and the premium to be paid by the insured. The insurance company makes an estimate of all possible losses, and the estimated management, cost and distribution costs and keeps a margin of minimum 2 to 5%. Using statistical tools the premium amount to a specific risk is calculated.
At the end of the year, the insurance companies sets aside some amount of money to cover all the anticipated loss and claims and some amount for margin (for more than the estimate)into an accounting reserve.They can later compare the actual payout with the original expectations and adjust the reserve up or down.
Thus, it is seen that these insurance companies collect premium from the investors and invest the amount in short- term securities to earn returns and to pay claims or make settlements to the insured to make good his loss.