How does insurance work & what does it do with customers' premiums?
Insurance is essentially a way of sharing risk among lots of people. Insurance companies need a large pool of customers in order to be able to offer their products, which can divided into the following three areas – risk, savings and service. We mainly insure risks in the non-life business and we provide services that supplement this requirement. We also cover risks and offer services in the life segment. However, the focus here is on savings.
An insurance company’s balance sheet is a good starting point to obtain a better understanding of its business and how it adds value. The four key value drivers of insurance work in tandem here:
- Assets (A2 – B2)
- Non-life technical reserves (A3)
- Life technical reserves (B3)
- Equity (C3)
We use the premiums paid by our customers to buy assets (A2 – B2) such as equities, fixed-income securities and real estate. We use the regular income from these investments to provide our customers with the safety and security that we have promised them with respect to their risks and savings.
We offset the value of these promises on the equity and liabilities side of the balance sheet by setting aside technical reserves for our life and non-life business (A3 – B3). We always have to keep sufficient equity (C3) available to ensure that we can honour the promises made to our customers at any time. The minimum amount of equity that we need is determined partly by our own calculations and partly by the requirements set by the regulatory authorities of the countries in which we operate. This equity is provided to us by investors (shareholders). Because this equity is risk capital which – in the worst-case scenario – could be lost, our investors demand in return a level of compensation commensurate with the risk involved. This compensation is provided in the form of profits which are returned to investors in the form of dividends or a higher share price. Consequently, this circular flow of funds between risk sellers (customers) and risk buyers (shareholders) only works if an insurance company can earn profits. It does so if it invests its assets as profitably as possible and if the insurance claims that occur do not exceed the amounts set aside by the insurer in its technical reserves. Shareholders will continue to provide the insurance company with equity if the ratio between the profit that it generates and the capital that it employs (return on equity) is adequate.