How Insurance Companies Lose Money
Understanding the business is crucial to your success. Now that you know how insurance companies make money, let’s talk about how they lose money. The insurance business is fabulous; just make sure you know what you are getting into. Make sure you understand the risks.
Insurance companies can lose money in their investments or on the insurance contracts they have written. Losses from investments are losses that the company had with the float (its reserves). The losses from insurance contracts, commonly known as underwriting losses, come from insurance contracts on which the company had to pay claims. When the claims are more than the premiums received, there is an underwriting loss. The insurance company lost money because it mispriced the insurance by underestimating the risk. This is why knowing the risk is extremely important in order to not lose money in this business.
The most important function in the insurance company is underwriting. Underwriters select and price risk. They make sure that actuarially the policies written are expected to have a positive return. For example, in a life insurance policy, the underwriting unit is the one that figures out how long a 40-year-old male, nonsmoker, with a clean bill of health is expected to live. Then with this information they figure out how much to price the premium for the life insurance for this segment of the population in order to have a positive expected return.
If the underwriting unit is wrong, the loss ratio will be higher than expected, and the company will lose money. They will pay out more than they collect in premiums.
This sounds like a simple business, but it is not. The company estimates the probability of losses to a segment it wants to insure. Next, based on those estimates, it prices the premium needed to make a profit. Then, it sells the insurance policies. It collects the premiums and invests them while it waits for the policy to expire or the event to happen. Finally, if the event happens it pays out the claim, or if the event does not happen it pockets the premiums as profits.
Where is the ugly, you ask? Overall, insurance is a good business. However, the ugly comes when there are risks that are hard to calculate. The financial crisis of 2008, when AIG almost went under and the U.S. Government bailed it out, is an example of the ugly. AIG was selling credit insurance, credit default swaps (CDS), to insure mortgage-backed securities. However, it did not calculate the risks correctly, and when subprime mortgages started blowing up, AIG was in big trouble. AIG sold $450 billion of credit insurance without a clear understanding of how the risks behaved. When the subprime mortgages started to default, the underlying mortgage-backed bonds insured by AIG started failing and AIG was caught without enough liquidity to back the securities it had sold. It turned ugly very fast and was due to poor underwriting. AIG did not know the risks it took on and did not collect the necessary premiums to cover the risks. In fact, it didn’t manage its portfolio of risks correctly because it was overexposed to subprime mortgage risks without knowing their magnitude. It was a disaster that almost brought down the entire financial system. That’s the ugly.
Insurance companies sell “paper,” a promise to pay in the future in exchange for cash now. In the future who knows whether it will have to pay or not, but most likely it will pay out less than the cash it collected.