The first profit driver for an insurance company is its core business—the underwriting business. The underwriting performance of an insurer depends on the pricing of the insurance contracts, which allows them to pay claims and other operating expenses and still make an underwriting profit.
The pricing of insurance policies uses the laws of large numbers. An insurer tries to make an underwriting profit through a mechanism called risk pooling. Risk pooling involves writing contracts with uncorrelated risks in a portfolio, which improves the certainty of the amount of claims.
Although the complexity of the calculations increases with the type of business (life or P&C), the duration of the contracts (long-term or short-term), and availability of prior data on which to base the calculations, the underlying principle remains the same.
Analyzing the combined ratio
The combined ratio is a metric that is used to measure profitability of a P&C insurance business. A combined ratio can be broken down into two components:
- loss ratio: the proportion of claims paid to the premiums received
- expense ratio: the proportion of expenses paid out of the premiums
A combined ratio below 100% implies an underwriting profit, while a ratio above 100% means a loss in the underwriting business.
Performance of US P&C sector
In the above chart, we show the evolution of the combined ratio of P&C insurers in the US. As we can see, the US P&C sector made an underwriting profit in 2013, due to lower losses from natural catastrophes. These companies include AIG (AIG), ACE (ACE), Travelers (TRV), Allstate (ALL), and Chubb (CB) and are included in the SPDR S&P Insurance ETF (KIE). The loss ratio appears to be the main driver, as the expense ratio has remained fairly stable over the years.
An underwriting loss is not unusual for an insurance company. In a soft pricing environment, pricing of P&C products is low due to intense competition. This leads to reduced profitability from underwriting, resulting in insurers relying on returns from their invested assets to improve their profitability.
In the next article, we’ll look at an insurance company’s cost structure and how it impacts underwriting.