A:

Insurance companies base their business models around assuming and diversifying risk. The essential insurance model involves pooling risk from individual payers and redistributing it across a larger portfolio. Most insurance companies generate revenue in two ways: Charging premiums in exchange for insurance coverage, then reinvesting those premiums into other interest-generating assets. Like all private businesses, insurance companies try to market effectively and minimize administrative costs.

Pricing and Assuming Risk

Revenue model specifics vary among health insurance companies, property insurance companies and financial guarantors. The first task of any insurer, however, is to price risk and charge a premium for assuming it.

Suppose the insurance company is offering a policy with a $100,000 conditional payout. It needs to assess how likely a prospective buyer is to trigger the conditional payment and extend that risk based on the length of the policy. (For related reading, see: How an Insurance Company Determines Your Premiums.)

This is where insurance underwriting is critical. Without good underwriting, the insurance company would charge some customers too much and others too little for assuming risk. This could price out the least risky customers, eventually causing rates to increase even further. If a company prices its risk effectively, it should bring in more revenue in premiums than it spends on conditional payouts.

In a sense, an insurer's real product is insurance claims. When a customer files a claim, the company must process it, check it for accuracy and submit payment. This adjusting process is necessary to filter out fraudulent claims and minimize risk of loss to the company.

Interest Earnings and Revenue

Suppose the insurance company receives $1 million in premiums for its policies. It could hold onto the money in cash or place it into a savings account, but that is not very efficient: At the very least, those savings are going to be exposed to inflation risk. Instead, the company can find safe, short-term assets to invest its funds. This generates additional interest revenue for the company while it waits for possible payouts. Common instruments of this type include Treasury bonds, high-grade corporate bonds and interest-bearing cash equivalents.

Reinsurance

Some companies engage in reinsurance to reduce risk. Reinsurance is basically insurance that insurance companies buy to protect themselves from excess losses due to high exposure. Reinsurance is an integral component of insurance companies' efforts to keep themselves solvent and to avoid default due to payouts, and regulators mandate it for companies of a certain size and type.

For example, an insurance company may write too much hurricane insurance, based on models that show low chances of a hurricane inflicting a geographic area. If the inconceivable did happen with a hurricane hitting that region, considerable losses for the insurance company could ensue. Without reinsurance taking some of the risk off the table, insurance companies could go out of business whenever a natural disaster hit.

Regulators mandate that an insurance company must only issue a policy with a cap of 10% of its value, unless it is reinsured. Thus, reinsurance allows insurance companies to be more aggressive in winning market share, as they can transfer risks. Additionally, reinsurance smooths out the natural fluctuations of insurance companies, which can see significant deviations in profits and losses.

For many insurance companies, it is like arbitrage. They charge a higher rate for insurance to individual consumers, and then they get cheaper rates reinsuring these policies on a bulk scale.

Evaluating Insurers

By smoothing out the fluctuations of the business, reinsurance makes the entire insurance sector more appropriate for investors.

Insurance sector companies, as any other non-financial service, are evaluated based on their profitability, expected growth, payout and risk. But there are also issues specific to the sector. Since insurance companies do not make investments in fixed assets, little depreciation and very small capital expenditures are recorded. Also, calculating the insurer's working capital is a challenging exercise since there are no typical working capital accounts. Analysts do not use metrics involving firm and enterprise values; instead, they focus on equity metrics, such as price-to-earnings (P/E) and price-to-book (P/B) ratios. Analysts perform ratio analysis by calculating insurance-specific ratios to evaluate the companies.

The P/E ratio tends to be higher for insurance companies that exhibit high expected growth, high payout and low risk. Similarly, P/B is higher for insurance companies with high expected earnings growth, low risk profile, high payout and high return on equity. Holding everything constant, return on equity has the largest effect on the P/B ratio.

When comparing P/E and P/B ratios across the insurance sector, analysts have to deal with additional complicating factors. Insurance companies make estimated provisions for their future claims expenses. If the insurer is too conservative or too aggressive in estimating such provisions, the P/E and P/B ratios may be too high or too low.

The degree of diversification also hampers comparability across the insurance sector. It is common for insurers to be involved in one or more distinct insurance businesses, such as life, casualty and property insurance. Depending on the degree of diversification, insurance companies face different risks and returns, making their P/E and P/B ratios different across the sector.

(For related reading, see: How to Value an Insurance Company.)

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