Premiums and Claims
When an individual pays their insurance premiums, they are essentially investing in a policy that promises recourse should an incident occur. For instance, if a person pays $2000 annually in premiums, they expect to receive compensation if they file a claim. However, the process is more complex than it appears.
Insurance companies operate based on a metric known as the Pure Loss Ratio. This ratio indicates the amount paid out in claims for every dollar collected in premiums. For example, if the Pure Loss Ratio is 56, it means the company pays out 56 cents for every dollar received.
Operational Costs
Beyond the Pure Loss Ratio, insurance companies incur additional expenses, such as Loss Adjustment Expenses. These include costs related to engineers, adjusters, third-party administrators, and legal fees. Hypothetically, if these expenses amount to 25 cents per dollar, the company has a significant incentive to minimize these costs.
Insurance companies also have operational overheads, including office buildings, TV commercials, commissions, and executive salaries. These overheads typically account for about 14% of their expenses.
Combined Ratio
The Combined Ratio is a critical metric that sums the pure loss ratio and operational expenses. For instance, if the pure loss ratio is 56 and operational expenses are 25 and 14, the combined ratio would be 95. This ratio helps compare insurance companies to other financial institutions, such as banks, which operate on different profit margins.
Investment of Premiums
Unlike banks, insurance companies invest the premiums they collect. This investment is not tied to interest but is managed and controlled by the insurance company. The money collected from premiums is referred to as the insurance "float."
Insurance companies often invest in private equity through associations like the Private Placement Investment Association. These investments are not typical savings deposits but are placed in private equity funds, which can yield significant returns.
Private Equity Investments
Private equity investments operate on a model where fund Managers receive a percentage of the returns. For example, if an insurance company invests $1 million and private investors contribute $99 million, they form a $100 million fund. The returns from these investments are substantial, contributing to the insurance company's profitability.
Conclusion
Understanding the financial operations of insurance companies provides insight into their business model. They collect premiums, manage operational costs, and invest in private equity to generate returns. This knowledge is crucial for comprehending the broader financial landscape and the role of insurance companies within it.
