Almost universally consumers and businesses hate insurance. There are many reasons for this and the industry often does itself no favours in the PR department. However, at its core the main reason is that no one really understands how insurance is priced and therefore cannot make a value judgement on the product. Insurance buyers simply see convivial brokers who seem to live a good life and huge insurer balance sheets that can go into hundreds of billions of pounds. The impression that premiums flow into the insurance industry and not so much flows back to the customers. Insurance on the face of it does not look like an industry that offers much value to customers. Here at MRSL Enterprise we are seeking to change that. We want to discuss the value of different insurance options with our clients and that has to start with the clients understanding how insurance is priced.
To understand the value of insurance it is important to be clear on what insurance actually is. Insurance is there to cover losses that the buyer cannot sustain themselves. Homeowners insurance is there to pay to house your family and rebuild your house if it burns down. Although it is covered, homeowners’ insurance should not be about replacing a stolen television.
The value of insurance is that it pays for things that you can’t afford. The cost of insurance is that overall you pay more that it would cost you personally. The additional cost pays for the people and offices that make the insurance company run, same business expenses as any other company, and provide a return to the investors who take the risk of more losses than expected each year.
The actual split varies both by the type of insurance and by insurance company. However, as a general guideline – an insurance policy that costs £1,000 will have the following components.
Firstly, in the UK there is an insurance premium tax which is 12% for most types of insurance. Insurance premium tax is much like VAT. This means that the buyer will pay £1,120 for the insurance and £120 will go to the Government. The rough, generic breakdown is as follows:
|Premium with tax||£1,120|
|Tax to Government||£120||£1,000|
|Marketing and sales||£200||£800|
|Profit for shareholders||£50|
Pricing insurance has three components:
Estimating the costs of an insurance product is the one part of the business which is much like any other business. Most insurance businesses have an established network of insurance brokers. The brokers take the cost and risk of selling the produce for an agreed commission so that part of the cost is reasonably known. The insurer will also need to produce systems to analyse the risk, provide underwriters to accept the risk, provide staff to issue the policies and keep track of them and also provide claims staff to assess and pay claims. The insurance company will make an assessment of how much of this resource is needed and what it will cost.This process is much like any other business pricing a product.
The product that insurers sell is the ability to pay claims in the future. The amount that will be paid out in claims is one of the most important costs for an insurer to estiamte to price a product. This is one of the tasks for the actuaries.
You can view this task vety much like guessing the number of sweets in a jar. There ae a number of ways of going about it. None of these methods is perfect. The chances of getting the absolute right answer are almost zero.
The traditional approach to estimating claims costs is to look at the data of what actually happened before and assume that much the same will happen going forward. This approach has a few problems.
Rather than looking to the past, the current approach to estimating insurance claims is now a task for a futurist. The insurance company will estimate what might go wrong and how much that might cost. Computer simulations can then generate predicted losses. This approach also suffers from the unknown unknows - ie those risks that no one thought of. Insurance policies will generally try to exclude this type of risk by having a very clear and explicit covered risks clause.
Some insurance that is sold in high volume against a perceived market price, like motor insurance, is priced on a factor approach. Insurers will develop a suite of factors, sometime twenty five or more, that impact the risk. The insurance will start from a base market price which will be adjusted according to these risk factors. These risk factors are many and varied and their impact can be unpredictable. The price of motor insurance can be affected considerably by the postcode in which you live. This is not necessarily due to a particularly increased risk of theft or accident. Insurers monitor fraudulent applications for insurance. These are applications that include incorrect information with the aim of reducing the buyers insurance premium. For example a thirty two year old female nurse will be charged a much lower insurance premium than a nineteen year old male scaffolder. Insurers detect people who keep requesting insurance quotes with different information and this is logged against postcodes.
Insurance is a business. If insurers do not make a profit than there will not be insurance.
Insurers do not make particularly large profits. Over the previous ten years Apple's return on equity has ranged between 30.5% and 46.3% with a current value of 37.5%. The average return on equity for Allianz over the past five years is 11%.
Insurers tend to make between 10% and 15% return on equity.
In the example above the insurer makes £50 profit, but we need to know how much capital the insurer needs in order to assess the return on equity.
Generally commercial businesses requires capital to invest into premises, machinery and stock. Insurers require capital to absorb risks. Say an insurer prices a homeowners' insurance on the belief that ten houses will have a fire, but in fact twelve houses have a fire - the insurer needs extra money to pay the additional claims. This money is capital.
Commercial insurers have a minimum amount of capital that they need to hold. This minimum amount is set by the regulators to protect the buyers of insurance. The capital amount is set to ensure that an insurer can still pay its claims if losses are much worse than expected. Many choose to hold substantially more than the minimum standard to ensure that they can pay claims in particularly bad situation.
The amount of capital that is needed is set by detailed computer simulation to assess how bad losses can get in almost any situation. The result is that property and liability insurers tend to need to hold capital of between one fifth (20%) and one third (33%) of the premium that they are paid.
So if the insurer needs to hold 33% of the premium paid in the example above than this insurer would have £330 of capital. The £50 of profit would be a return on equity of 15%. This is likely to be the target return for the insurer.