The Financial Literacy Cell
Insurance Companies Decoded
Did you wonder how much financial loss an automobile company would have incurred if unfortunately fire breaks out at its factory? But thanks to the insurance company who stood up for them and paid all the losses. We see many such instances on regular basis. It is important to understand what exactly is insurance and an insurance company and how do they work.
In simple words, Insurance is the financial protection which an insurance company gives to its policyholders against the losses caused due to unavoidable and undesirable circumstances. The year 2020 saw many new things and the cancellation of the Wimbledon tournament is one of them. Wimbledon had to face huge losses due to SARS 2003 outbreak but it was wise to get pandemic insurance afterward costing around $1.9 million premium per year. This insurance helped the organizers to get a claim of around $142 million as they decided to cancel the tournament in 2020 due to the coronavirus pandemic. It is believed that Titanic, the unsinkable ship got itself insured for a premium of £7,500 just 2 weeks before it sank and got a total claim of around £1 Million within 30 days of the tragedy. This gives rise to the question that why an insurance company is ready to give us money when we incur losses. The answer is simple- it charges a premium for this from us. Premium is the cost of acquiring a policy which is paid either monthly, quarterly, half-yearly, or yearly.
It is important to understand how an insurance company works and makes profits. An insurance company has mainly 5 departments- Underwriting department, Marketing department, Investing Department, Claim Department, and Legal Department. The job of the underwriting department is to formulate policies covering risk and to set premiums accordingly. Generally, the higher the risk, the higher is the premium charged. For instance- a health insurance policy covering a diabetic person would always be costlier (high premium) as compared to a non-diabetic person due to more risk of ill-health. The marketing department is concerned with bringing more and more policyholders and ensuring a good retention ratio (a ratio indicating the number of policyholders who renewed their policies). While the underwriting and marketing department works to ensure maximum underwriting profit, i.e. bringing more and more good-risk customers (those policyholders whose probability of filing a claim is negligible), the investing department works on the concept of float. Float is the time period between the insurance premium received and the claim being given. With the excess money received in the form of a premium, the investing department generally invests in safe securities to earn investment income. Thus, the company makes a profit by receiving returns from the investments made.
Unlike banks who have to pay interest to the depositors for keeping their money, insurance companies are in fact receiving returns without paying anything for holding the money. This float concept helps the insurance companies make a lot of profit and thus expand their business. Life Insurance Corporation of India (LIC), one of the biggest insurance company of India started with a capital of ₹5 crores in the year 1956, however, it began the financial year 2019-20 with an investible capital of ₹348,692 crores. It collected a total premium of ₹3,33,185 crores in the FY 2018-19 and paid total claims of just ₹1,63,104 crores. With this investible capital of ₹348,692 crores in the beginning of FY 2019-20, it made investments in various government long-term securities and various financial securities like equity, bonds, etc. in the stock market. It had a total investment of over ₹34,000 crores in the year 2019-20 in the stock market and earned a profit of over ₹14,000 crores. Currently, it is the largest stock market investor in India. Whatever LIC has achieved today is due to proper risk management and judicial use of float.
The job of the claim department is to assess the various cases it has received for the claims and to provide claims in accordance with the policy framed by underwriting departments. The claim department looks to earn claim profits, i.e., it tries to reject as many claims as possible that it finds to be fraud or nonrecoverable. Though the marketing and underwriting department do not intervene in the claim procedure, however, at times it may have to interrupt as the rejection of claims would have a direct negative impact on the retention ratio. Here, the legal department acts as a mediator between these departments. Besides, the legal department also handles the legal cases filed against the insurance company in the court.
Moreover, to prevent itself from huge losses due to a sudden increase in potential risk, an insurance company reinsures itself. Reinsurance refers to a process in which insurance companies insure themselves with some other insurance company by paying them some part of the premium received, thus, becoming risk-free. In 1992, seven insurance companies became insolvent due to damage of $15.5 billion in Florida from Hurricane Andrew. Have they been judiciously reinsured, they might have to bear fewer losses.
Additionally, to prevent moral hazard, i.e. to prevent the casual approach of the policyholders towards their activities, insurance policies always contain deductibles. Deductibles are the money to be paid out-of-pocket by the insured to kick start the claim procedure. Deductibles help ensure skin-in-the-game, i.e. give insured a sense that any loss to the insurer would result in some loss to insured as well. For instance, a boy has his mobile phone insured and any damage to the phone would be covered by the insurance company. If there are no deductibles, the boy would adopt a casual approach towards handling his phone. However, the policy states that deductibles are ₹3,000, i.e. any loss over and above 3,000 would be borne by the insurance company. Thus, he would handle the phone with utmost care as he would also be a part of the loss incurred. Therefore, having deductibles ensure the prevention of moral hazard as well as the financial stability of the company.
In this way, an insurance company works by taking advantage of the fearful mindset of the people and assuming the risk of its policyholders. For assuming the risks, it receives money in the form of premiums, and with this premium makes further money through investments, and this process keeps going on and on.
By Pulkit Aghi