How do insurers make money?
We are all familiar with the basics of insurance. But do you know how this sector works, how it is regulated and where its profits come from?
Insurance is nothing more than a financial tool to cover certain risks. They have been doing so for thousands of years. The Code of Hammurabi, a compendium of laws from ancient Babylonia, already regulated loans, which made it possible for lenders and shipowners to share the risks and profits of maritime trade.
We are all more or less familiar with the basics of insurance. A policy is nothing more than a contract between the insured and the insurance company by means of which, in exchange for a premium (insurance price), the insurance company undertakes to compensate for damage caused or to pay a capital sum, rent or other benefit in the event of a loss covered by the contract.
All the details of the insurance coverage and other conditions are set out in the policy, which establishes the rights and obligations of both parties. The policyholder, who is the person or company that contracts the insurance and pays the premium; the insured, who is the one exposed to the risk covered by the insurance, and the beneficiary, who is the one entitled to receive the consideration agreed in the policy, may coincide or be different persons or entities.
All these concepts are probably familiar to us. But, do we know how the insurance sector works? We review how it is regulated and where its benefits come from.
The regulatory framework
There are different types of insurance companies depending on their legal constitution: public limited companies, mutuals, cooperatives and mutual benefit societies. Moreover, each of them can operate in one or multiple fields (automobile, household, civil liability…), but they always require the authorisation of the regulatory body.
To ensure the proper functioning of the sector, both the characteristics and the operation of these entities are regulated, establishing limits on their activity and imposing minimum solvency requirements or certain training for their employees.
On 1 January 2016, Solvency II, the European directive by which all European insurers estimate their financial soundness in the same way, came into force. This directive makes it mandatory to calculate the amount of resources an insurer must have to cope with possible negative scenarios related to business (more claims than expected or higher claims), investments (e.g. a fall in the stock market) or other types of events. The insurer must have sufficient own funds to cover this potential gap.
Solvency II is based on three pillars. The first determines the minimum own funds required of each insurer, depending on the risks assumed. The second pillar proposes the qualitative assessment of risks, which are identified, measured, monitored and managed according to the risk appetite of each company, and establishes internal control of these risks through corporate governance in order to improve the efficiency and profitability of the institutions. The third pillar seeks greater transparency for insurance companies thanks to the regular reports that they must submit.
This European directive is complemented by the Law on the regulation, supervision and solvency of insurance and reinsurance companies, which regulates the sector in Spain.
A primary source of income
According to data from the International Monetary Fund, the volume of premiums written in the world reached 24 trillion euros in 2016, 85% of which belonged to life insurance.
In the case of life insurance, the main marketing channel is the banking sector, with a market share of just over 70%, while insurance agents and brokers have a market share of just over 20%.
In contrast, other insurance products are mainly marketed through insurance agents and brokers, who have a market share of about 60%, followed by direct sales (19%) and the banking channel (13%).
A primary way in which insurance companies make money is by carefully assessing the risk of each of these policies so that the premium income exceeds the claims they have to pay out.
The true nature of the business
However, insurers are primarily managers of the resources that their customers entrust to them through premiums, as they use part of that income to invest. In fact, it is estimated that 12% of the world’s assets are in the hands of insurance companies.
However, since the great financial crisis, legislation has set strict prudential limits on investment. Until 2007, the insurance sector experienced an idyllic period of tranquillity. But the great financial crisis, which took the US insurance giant AIG by storm, brought to the surface the close relationship between insurers and banks, both in terms of their shareholdings and in their fixed-income and equity issues.
According to Unespa, which brings together nearly 200 insurance companies in Spain, they invest mainly in public debt and, to a lesser extent, in private funds and shares: for every euro invested in the latter, six are devoted to public debt. Moreover, the association points out that, in times of economic boom, “insurers have come to have an investment capacity equivalent to 2 % of GDP”.
Reinsurance, a booming business
A third source of income is reinsurance. These are agreements whereby one insurer, called a cedant, transfers all or part of its risks to another insurer, called a reinsurer, in exchange for a part of the premium. This allows the cedant to protect itself from large potential losses in situations of overexposure.
Climate change and the COVID-19 pandemic are driving this area of business, the volume of which is expected to exceed 500 billion euros by 2025.
Big changes on the horizon
There are many signs that the insurance industry is preparing for a time of momentous change. Ecosystems are expected to form in which providers from different industries will interact to create value from shared data. As a result, it will be less about selling products and services in isolation and more about experiences created by a multitude of players.
67% of insurance industry leaders believe that current business models will be unrecognisable in the next five years and that these ecosystems will be the main agent of change, according to Accenture Research. In addition, 58% of insurance companies report that they are already actively seeking ecosystems in which to integrate and three out of four expect that at least half of their profits will come from these ecosystems in the next five years.
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