Insurance Companies in Nigeria and around the world operate in the financial services sector. The business of insurance involves the insurance company guaranteeing replacement or repairs or shorty for an asset or service that may have been damaged or impaired or defaulted under terms and conditions in exchange for a premium. For example, an insurance company insures your vehicle against it being stolen or damaged by accident by replacing it or repairing it at no additional cost to you in exchange for the premium you must have paid upfront.
In the example above, if the value of the sum insured is N5million you typically will pay a premium of N250k to the insurance company. If the car gets stolen or gets damaged the insurance company is obligated to pay a maximum sum of N5million towards repair or replacement of the vehicle depending on the claim type. Your premium typically has a duration of one year. If during the year you do not have any claims, the insurance company does not return any part of the premium to you.
Above is a basic overview of the insurance business model. However, from an investors point of view there is a little more to it than above. The insurance business as you must have drawn from above is a risky one and so Insurance companies that are profitable are also associated with proper risk assessment to ensure the risk they are taking on is not too much to drive them into losses. So lets look at how they make money?
Insurance Companies make money in two major ways. Net Premium Income and Income from Investments.
Net Premium Income – Net premium income is the income the insurance company makes after it deducts claims against it in a particular year from the gross premium it receives. This is called Underwriting Profits. Using the vehicle example above, the insurance company receives a premium of 5% (N250k) in exchange for insurance of N5million. So assuming it agrees to insure 5000 cars worth N5million each it basically has taken a risk of N25billion in exchange for a premium of N1.25billion. They also know that it is unlikely that all vehicles insured will make claims during the year. This is part of their risk assessment. So if during the year, they pay claims of N500million then their underwriting profits is N750million. So the higher the claims during a financial year the lower the underwriting profits and vice n versa.
Income From Investments – Insurance companies also make money through investing. Remember they receive a lot of money from premiums during the year in exchange for a commitment to pay claims. These premiums are also interest free unlike bank deposits where banks pay some form of interest for the amount deposited with them. Rather than allow the premiums lay idle, they also invest the premiums in several assets such as bonds, shares, treasury bills, private equity, real estate etc. The income derivable from these investments is an addition to the underwriting profits. Around the world Insurance companies are often bigger than banks and next to Pension funds own billions of dollars in investments. Warren Buffet for example, is able to finance a lot of its investments from premiums received from GEICO (a multibillion dollar insurance company it owns). Premiums are purely cash backed and free of interest making them one of the most liquid armory required for investing.
What about Profits? If you noticed, I have not talked about other expenses. Insurance companies do run a huge operation and employ staffs. Therefore, profits are actually made after you deduct operating cost and taxes from Underwriting Profits and Investment Income you have a positive number.
Is it Possible to have an underwriting Loss – Underwriting losses are very common in economies where competition is rife. In this instance, Insurance companies offer several layers of discounts to customers making their premium fall below what they typically would have received. For example, instead of 5% they can ask for 2.5%. The aim here is similar to a turnover model. They believe if they collect a lot of premium at a cheap percentage to claims, even if the claims is more than gross premium and leads them to an underwriting loss they adequately make up for it through income from investments. This is because the larger the premium (cash) the more investment you can make and the more investment income you get which covers for the underwriting loss. To them, as long as you make better than the year before profits at the end of the year it really doesn’t matter whether you make underwriting losses.
What I look out for as an Investor – As an investor, I try as much as possible to take my self away from what the markets think and stick to the basics. Insurance companies must make improved underwriting profits, increase investment income and post increased profitability. This is how they are judged. They must have a very good risk management system and balance the need for increased gross premium growth due to competition with the need to mitigate risk. You can forgo one for the other. But that is my take, others might think differently.