So, with articles on basic insurance and Risk Management, it’s time we dig deep and learn how insurance company actually works, how they manage risks and most importantly, how insurance companies make money! And that too, when LIC is posting profits of more than Rs 25,000 Crores!
So, if I have to get straight to the point, the combination of charging profitable premiums, plus making money on invested reserves, is how an insurance company makes money. And to talk about LIC, it has invested huge in OIL companies, Banks and other like equities.
So, as in the previous articles, when the smart guy in the burnt house example charged everyone Rs 110 and one house did burn, he still made a profit of Rs. 1000/-. And this is what all of us think how profits are made by insurance. Well, it is one of the ways to make money, but not the only one. And yes they do invest in equities (Hold shares in different companies) which give handsome returns. And in India, where the concept of insurance is generally linked with savings cum insurance, where you do get your money back along with some predefined rate of interest if the insured is still alive, to put it blatantly, the concept of earning money through premiums does become obsolete and the idea of earning money gains traction.
So, technically speaking, insurance companies make money in two ways: Underwriting and Investments.
Investments, we have a bit of an idea how it works. Now, what is this underwriting? Underwriting is the process of evaluating the risk to be insured. This is done by the insurer (I am sure we all are sure about Insurer and the Insured here!) when determining how likely it is that the loss will occur, how much the loss could be and then using this information to determine how much you should pay to insure against the risk.
Just remember the smart guy in the basics of Insurance article, where he decided to charge Rs 110/ to insure the houses against fire. What he did was what we call as underwriting!
Let's simplify it a bit more. Imagine a life insurance company is going to issue RS.100,000 policies to 1000 people for a one year period. They collect a pot of premiums from those 1000 people. During that one year, some number of the 1000 insureds will die and collect the Rs. 100,000. The rest won't. Underwriting is choosing whom to sell the policies too and figuring out how much premium to charge.
There are different approaches to this. You could take all comers and charge them all the same amount. Of course, going into it you have to have a prediction of how many people are going to die so that you'll have enough to cover and still make a profit. Say you think 10 people will die. So you'll have to collect 10 x 100,000 = 1,000,000 to cover plus a little more for profit, administrative expense and a safety margin. Let's say you decide you need 1,250,000. You charge each of your 1000 insureds Rs.1250.
Of course you could also charge the 25 year old healthy male non-smoker less than the 75 year old obese overweight heart patient who smokes like a chimney because the first guy is far less likely to die during the year. After centuries, the life insurance industry is very sophisticated about predicting how many and when people will die. But the whole idea is that you collect enough from the large pool of insureds to pay the benefits of the small number that die during the year. That's the underwriting side of it!
Easy enough!
Now, for the other way, that is, through investment. Go back to our example. Say you collect Rs 1,250,000 in premiums on January 1 for that one year insurance policy. During that year you invest the Rs.1,250,000 and make a return -- for ease of calculation sake, say 10%. 10% of Rs 1,250,000 is Rs.125,000 -- Profit!
So, simply speaking, as insurance company's reserves are not held in a savings account. Rather, the insurance company invests those reserves. If the insurance company makes a positive return on those investments, then that money would be a profit. So, if the company makes a 10 percent return as described earlier, they will make a clean profit of Rs. 125,000, after accounting for the payments they have to make , which actually does incorporates all the expenses they have.
Now, to understand the investment process a bit more, I would say, clearly, we would have to understand the time value of money. In the simplest of terms, it means that a 100 rupees right now will be worth less tomorrow than what it is today. Let’s understand it in a better way. You were able to buy one kg of tomatoes for Rs. 30. Today they are at Rs. 60 a kg! So, the value of that Rs. 30 has decreased by a half!! That’s what we mean by Time Value of money. Or to say it in a different way, the present Rs. 30 is worth half of its value in the future, say after one years!
Or, to understand the business of Insurance better, we can say that if I borrow Rs. 30 from you today and then returning the same Rs 30 to you after one year, you are actually losing money! By the tomato analogy, you actually got half of what you should have got! So, the value of money of same amount of money today is more than what it will be after an year! And if you follow what I have been trying to say, a Rs 30 in future, here, is actually as good as Rs. 15 today!! Eureka!
Now, to understand it better, let’s get back to our books. So, if you remember something called Compound interest, the equations for which looks something like:
The equation simply means that if you invest Rs. 80 at the rate of 25% per year, after plugging in the values , the value after one year would be:
FV= 80* (1.10)^1=100
So, 80 rupees right now becomes 100 after one year.Now, just juggle the equations a bit, we will have:
What this equation does is simply exchange the places for Present value and Future value. So, if in future, if we have 100 Rs, here, it’s present value would be Rs. 80 only!!
So, when insurance companies charges you premiums based on that Rs 80 and gives you back the pledged amount after , say, 10 years, they have effectively made money with this investment without moving a muscle! That’s the beauty of time value of money! And the power of compounding, which Einstein said was the eighth wonder of the world! Insurance companies, in effect, know they will be paying a lot less ten years or even two years down the line than what they charged premiums for and this is where the major parts of the profits are made.
I am sure you would have a good idea by now how Insurance companies make money. In the next article, I will talk a bit more about risk management and then follow it up with articles on different types of Insurance. Keep reading!
So, if I have to get straight to the point, the combination of charging profitable premiums, plus making money on invested reserves, is how an insurance company makes money. And to talk about LIC, it has invested huge in OIL companies, Banks and other like equities.
So, as in the previous articles, when the smart guy in the burnt house example charged everyone Rs 110 and one house did burn, he still made a profit of Rs. 1000/-. And this is what all of us think how profits are made by insurance. Well, it is one of the ways to make money, but not the only one. And yes they do invest in equities (Hold shares in different companies) which give handsome returns. And in India, where the concept of insurance is generally linked with savings cum insurance, where you do get your money back along with some predefined rate of interest if the insured is still alive, to put it blatantly, the concept of earning money through premiums does become obsolete and the idea of earning money gains traction.
So, technically speaking, insurance companies make money in two ways: Underwriting and Investments.
Investments, we have a bit of an idea how it works. Now, what is this underwriting? Underwriting is the process of evaluating the risk to be insured. This is done by the insurer (I am sure we all are sure about Insurer and the Insured here!) when determining how likely it is that the loss will occur, how much the loss could be and then using this information to determine how much you should pay to insure against the risk.
Just remember the smart guy in the basics of Insurance article, where he decided to charge Rs 110/ to insure the houses against fire. What he did was what we call as underwriting!
Let's simplify it a bit more. Imagine a life insurance company is going to issue RS.100,000 policies to 1000 people for a one year period. They collect a pot of premiums from those 1000 people. During that one year, some number of the 1000 insureds will die and collect the Rs. 100,000. The rest won't. Underwriting is choosing whom to sell the policies too and figuring out how much premium to charge.
There are different approaches to this. You could take all comers and charge them all the same amount. Of course, going into it you have to have a prediction of how many people are going to die so that you'll have enough to cover and still make a profit. Say you think 10 people will die. So you'll have to collect 10 x 100,000 = 1,000,000 to cover plus a little more for profit, administrative expense and a safety margin. Let's say you decide you need 1,250,000. You charge each of your 1000 insureds Rs.1250.
Of course you could also charge the 25 year old healthy male non-smoker less than the 75 year old obese overweight heart patient who smokes like a chimney because the first guy is far less likely to die during the year. After centuries, the life insurance industry is very sophisticated about predicting how many and when people will die. But the whole idea is that you collect enough from the large pool of insureds to pay the benefits of the small number that die during the year. That's the underwriting side of it!
Easy enough!
Now, for the other way, that is, through investment. Go back to our example. Say you collect Rs 1,250,000 in premiums on January 1 for that one year insurance policy. During that year you invest the Rs.1,250,000 and make a return -- for ease of calculation sake, say 10%. 10% of Rs 1,250,000 is Rs.125,000 -- Profit!
So, simply speaking, as insurance company's reserves are not held in a savings account. Rather, the insurance company invests those reserves. If the insurance company makes a positive return on those investments, then that money would be a profit. So, if the company makes a 10 percent return as described earlier, they will make a clean profit of Rs. 125,000, after accounting for the payments they have to make , which actually does incorporates all the expenses they have.
Now, to understand the investment process a bit more, I would say, clearly, we would have to understand the time value of money. In the simplest of terms, it means that a 100 rupees right now will be worth less tomorrow than what it is today. Let’s understand it in a better way. You were able to buy one kg of tomatoes for Rs. 30. Today they are at Rs. 60 a kg! So, the value of that Rs. 30 has decreased by a half!! That’s what we mean by Time Value of money. Or to say it in a different way, the present Rs. 30 is worth half of its value in the future, say after one years!
Or, to understand the business of Insurance better, we can say that if I borrow Rs. 30 from you today and then returning the same Rs 30 to you after one year, you are actually losing money! By the tomato analogy, you actually got half of what you should have got! So, the value of money of same amount of money today is more than what it will be after an year! And if you follow what I have been trying to say, a Rs 30 in future, here, is actually as good as Rs. 15 today!! Eureka!
Now, to understand it better, let’s get back to our books. So, if you remember something called Compound interest, the equations for which looks something like:
FV= 80* (1.10)^1=100
So, 80 rupees right now becomes 100 after one year.Now, just juggle the equations a bit, we will have:
What this equation does is simply exchange the places for Present value and Future value. So, if in future, if we have 100 Rs, here, it’s present value would be Rs. 80 only!!
So, when insurance companies charges you premiums based on that Rs 80 and gives you back the pledged amount after , say, 10 years, they have effectively made money with this investment without moving a muscle! That’s the beauty of time value of money! And the power of compounding, which Einstein said was the eighth wonder of the world! Insurance companies, in effect, know they will be paying a lot less ten years or even two years down the line than what they charged premiums for and this is where the major parts of the profits are made.
I am sure you would have a good idea by now how Insurance companies make money. In the next article, I will talk a bit more about risk management and then follow it up with articles on different types of Insurance. Keep reading!
Awesome man! thanks
ReplyDeleteThanks! More articles coming up and do let me know if you want to read something specific!
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