Insurer’s Business Model

Profit = Earned Premium + Investment Income - Incurred Loss - Underwriting Expenses.

Insurers make money in two ways. Through underwriting, the process through which insurers select what risks to insure and decide how much premium to charge for accepting those risks and by investing the premiums they have collected from insureds.

The most difficult aspect of the insurance business is the underwriting of policies. Based on a wide assortment of data, insurers predict the likelihood that a claim will be made against their policies and price products accordingly. To this end, the industry uses actuarial science to quantify the risk they are willing to assume. Data is analyzed fairly accurately to project the rate of future claims based on a given risk. Actuarial science uses statistics and probability to analyze the risks associated with the range of perils covered, and these scientific principles are used to determine the insurers overall exposure. At the end of a given policy, the amount of premium collected minus the amount paid out in claims is the insurer's underwriting profit.

An insurer's underwriting performance is measured in their combined ratio. The loss ratio (incurred losses and loss-adjustment expenses divided by net earned premium) is added to the expense ratio (underwriting expenses divided by net premium written) to determine the company's combined ratio. The combined ratio is a reflection of the company's overall underwriting profitability. A combined ratio of less than 100 percent indicates profitability, while anything over 100 indicates a loss.

Insurance companies also earn investment profits on “float”. “Float” or available reserve is the amount of money, at-hand at any given moment, that an insurer has collected in insurance premium but has not been paid out in claims. Insurers start investing insurance premium as soon as it is collected and keeps earning interest on it until claims are paid out.

In the United States, the underwriting loss of property and casualty insurance companies was $142.3 billion in the five years ending 2003. But overall profit for the same period was $68.4 billion, at the result of float. Some insurance industry insiders, most notably Hank Greenberg, do not believe that it is forever possible to sustain a profit from float without an underwriting profit as well, but this opinion is not universally held. Naturally, the “float” method is difficult to carry out in an economically depressed period. Bear markets do cause insurers to shift away from investments and to toughen up their underwriting standards. So a poor economy generally means high insurance premiums. In general, this tendency to swing between profitable and unprofitable time periods alternating over time cycles is commonly known as the "underwriting" or "insurance" cycle.

Insurers currently make the most money from their auto insurance line of business. Generally better statistics are available on auto losses and underwriting on this line of business has benefited greatly from advances in computing. Additionally, property losses in the US, due to natural catastrophes, have perpetuated this trend.

Finally, claims and loss handling is the materialized utility of insurance. Claims handling management in insurance companies is to balance the triangle elements of customer satisfaction, administrative handling expenses, and claims overpayment leakages. Within this triangle, insurance fraud is a major business risk to manage and overcome.