there are many issues that we need to care about this matter:
First, what does an insurance company sell?
- Most of what is called "Life Insurance" are just tax-efficient savings products. You put money in more-or-less at will; the insurance company manages it for you (for a fee); you can take your money back whenever you want or at a given date.
It is "insurance" in the sense that the company will guarantee the amount you can take back (for example in the form of a yearly increase on x%) and that the money will be available at the dates set in the contract.
- Property and casualty insurance (P&C), but also Health insurance, promise to reimburse you for a damage you have suffered.
For example, your car windows get broken, you go to the garage, have the windows replaced, you pay: that is the "damage". You file a claim with the insurance company sending copy of the invoice, and they give you the money back. (They might pay the garage directly too -- actual process will vary.) Or the damage is the value of repairs for your house that burnt down.
It is the same for Health, in a way: the insurance company pays the bills for you.
The amount paid out by the insurance company might also include a deductible -- or they pay only a percentage of the total cost, etc. Lots of variations exist, but the principle is the same.
- Another part of Life Insurance works like P&C (which I why I discuss it only now): imagine you die tomorrow -- in a way, that would be a "damage" for your spouse and kids. So you can take an insurance contract that would pay out a set amount (say, USD 500 000) to cover the risk of death, or disability (or long illness), etc.
Second, How does the business work (financially)?
I'll focus on the last two types of insurance. For the first type, we are basically talking about money management, which I will consider not "real" insurance.
You see from the above that the insurance company receives the money (the premiums) before it knows how much it will have to pay to whom.
Let's assume we talk about a company that writes contracts with yearly guarantees -- that is, the client pays premiums for coverage against any accident occurring over the next 12 months exactly. To simplify matters, I'll assume the premium is paid on 1-Jan -- but you can keep the same principles pro rata temporis for a fraction of a year.
We face two issues:
- How soon will a claim on the contract be filled?
- When will the payment be made? In case of several payments, how much and for how long?
This is where we introduce the Claims Ratio concept -- the ratio between claimsactually paid over the total premiums due (*), at a given time.
Insurance companies has historical data on the evolution of the Claims Ratio over time.
For example, of all contracts written in 1996, for total premiums received of €120 (vast majority in 1996 plus a few clients who only paid in 1997 after the company chased them):
- €40 actually paid out in 1996 (33%)
- €20 actually paid out in 1997 (50% cumulative)
- €10 actually paid out in 1998 (58% cumulative)
- €5 actually paid out in 1999 (63% cumulative)
- €1 actually paid out in 2000 and 2001 -- nothing since (64% cumulative)
Thanks to a variety of statistical tools -- of which a simple average! -- insurance companies can figure out the best estimate for the sequence of pay-outs for the current year. It can also estimate the "ultimate" claims ratio for the current year. This is often called the
Loss ratio.
Add the overhead / claims management costs (eg, the salary of the claims adjuster + heating of the company headquarters) and the total pay-out will typically be around 98% -- resulting in a margin of 2% for the company.
That's also the main technique to determine the price of a product / the premium to be paid by a client. Actuaries estimate the probable losses, then add estimated management costs and distribution costs (commissions to brokers and agents), and a bit of margin. Statistical models help tailor the premium to the specific risk (probability of having a damage, amount of the damage) of the client, of course.
On 31-Dec, the insurance company sets aside enough money to cover for all anticipated losses (sometimes with a prudence margin, ie, setting aside more than the best estimate) into an accounting reserve. This amounts to the expected ultimate loss ratio multiplied by the total premiums due (eventually with a margin of prudence).
Then, year after year, the insurance companies compares the actual pay-out with the original expectation -- adjusting the accounting reserve up or down as needed. If the actual losses are below expectations (usually, below historical average), this creates profits. If not, it creates losses.
As noted above, a margin of 2% to 5% would be typical.
Another important aspect is that the insurance company will not let the money it collected as premium sleep in a 0%-interest bank account. As noted above, some of the money will stay "in the coffers" less than one year, but a fraction will stay 5+ years.
So the insurance company invests this money in the financial markets -- mainly in governance and corporate bonds. A whole expertise of Asset-Liability Management ensures that we appropriately "match" the timing of the in-flows and out-flows of money.
How the investment income is shared between the client and the insurance company will depend on the product itself and on local regulations. Most of the time, the investment income is taken into account for pricing the product -- that is, there is a slight discount vs. the "pure premium" so the client gets some benefits. But it really can vary a lot.
Finally, how does it work operationally?
Insurance companies can be much more complex than it may seem. I won't go into the details, but i'll try to give you a flavor of the variety of things to do:
- Marketing and product development -- we have to understand what our clients want and design the product including "features" and guarantees (eg, include dental or not in a health plan? Restrictions on prior illnesses? what kind of questionnaire do we ask the client to fill in?), the pricing, the regulatory constraints, etc. And IT, of course, for the systems to support this product.
- Distribution -- How do we bring our products to client? Agents, brokers, direct sales channels all exist, plus the development of Internet sales and smartphone apps
- Customer services and claims -- the "paper processes" including the customer changing address or phone number, the call center for the client who has a question, the people to review the files and pay the claims, etc.
- Finance -- Not only the usual financial planning and management (eg, to pay the bills), but also all the financial analysis to invest the money and generate a return, the computation of the reserves and accounting, etc.
- Risk, Compliance and Regulations -- This includes investigation of fraudulent claims and anti-money-laundering, on top of all the accounting controls and risk management to ensure the company does not take on too much risk.
- Usual support functions, IT, HR, etc.