What Does Underwriting Income Mean?
Underwriting income is profit generated by an insurer's underwriting activity over a period of time. Underwriting income is the difference between premiums collected on insurance policies by the insurer and expenses incurred and claims paid out. Huge claims and disproportionate expenses may result in an underwriting loss, rather than income, for the insurer. The level of underwriting income is an accurate measure of the efficiency of an insurer's underwriting activities.
Underwriting Income Explained
An insurer's underwriting income may fluctuate from quarter to quarter, with natural and other disasters such as earthquakes, hurricanes, and fires leading to huge underwriting losses. Hurricane Katrina, the largest natural catastrophe in US history, caused an underwriting loss of $2.8 billion for the US property/casualty insurance industry in the first nine months of 2005, compared with underwriting income of $3.4 billion in the corresponding period of 2004.
Underwriting Income vs. Investment Income
Underwriting income is calculated as the difference between an insurance company's earned premiums and its expenses, claims and any dividends paid out when settling policies. Here's a simple explanation of how it works. If an insurer collects $50 million in insurance premiums over a year, and spends $40 million in insurance claims and associated expenses, its underwriting income is $10 million. Investment income, meanwhile, comes from capital gains, dividends and other investment related to the purchase and sale of securities.
Contrary to underwriting income, an insurance company generates investment income from its capital gains, dividends and other investment activities related to the purchase and sale of securities. For example, assume an insurance company had a profit of $50 million last year and wants to invest a portion of its profits into futures contracts. The insurance company buys 10 S&P Index futures contracts, trading at $2,110.25 per unit. Therefore, the notional value is $5,275,625, or $2,110.25*250*10. If the insurance company closes out its position above $2,110.25 per unit, the return is considered investment income.
Underwriting Income and the Underwriting Cycle
The underwriting cycle is the periodic rise and fall of an insurance industry's underwriting income. The sources of this cycle aren't completely clear. However, since the swings in investment income are mild, fluctuations in underwriting income drive this cyclical rise and fall. The number of insurance company insolvencies is inversely proportional to the rise and fall of underwriting income. Large drops in underwriting income indicate that the underlying insurance policies are under-priced. Insurance companies with solidly performing underwriting income are generally stronger financially because they don't have to make up for poor performance by increasing their risks on the investment side of the business.