How does an insurance company’s non-life business work?
Non-life business essentially comprises property and liability insurance, such as motor vehicle and home contents insurance. The profitability of this business consists of two components: the technical result and the Company’s gains or losses on its investments. We have used the tour map to illustrate how this works.
The customer pays an annual premium (B1), which in the example below amounts to 100. If a claim occurs, the insurance company uses part of the Premium earned to cover costs of 40 (B2) that have already been incurred. Because the claim has then still not been finally settled, however, a further 30 of the premium earned is used to set aside claims reserves of 200 (B3) for future insurance benefits and is channelled into investments that will yield a return (B4 / C4). The reserves recognised by a typical all-lines insurer of course vary in amount, depending on the sector. However, the total reserves set aside are – as is the case at Baloise, for example – roughly twice the amount of annual premium income, i.e. in this example 200 (B3). Out of the remaining 30 of the premium earned, 25 (C2) is used to cover insurance operating expenses such as claims handling costs and staff expenses. The residual 5 constitutes the technical result, i.e. the gross profit on the premium received (C2 / D2).
The better the insurance company’s cost containment and the risks in its client portfolio, the higher this amount – i.e. the technical result – turns out to be. Technical profitability is measured in terms of the so-called combined ratio, which is one of the key performance indicators used in insurance. This is a relative figure that denotes the ratio between an insurer’s costs and its premium income. If its combined ratio is less than 100 per cent, an insurance company has generated a technical profit. The combined ratio in the example below is 95 per cent (D1 /D2), which means that the technical result is positive.
How do insurance companies ensure that they have sufficient capital available in years when high levels of claims occur?
In years when high levels of claims occur as a result of natural disasters, an insurer’s claims ratio may be well above 100 per cent, which means that its claim payments and administrative expenses exceed its premium income. In order to ensure that enough capital is still available to pay insurance benefits in such years, equity is required so that non-life business can be transacted.
The amount of capital needed here depends on risk-related and business-specific factors and on regulatory requirements. In this case, this amounts to 80 (C3). Gains or losses on investments (C4) are calculated as the investment yield (C4) on the equity provided by shareholders (C3) and on the technical reserves. The gains on investments and the technical result must be used to cover all taxes, the cost of capital and the minimum rate of return required by shareholders (D3 / D4). In the next section of the tour, our guide Dietmar will explain the details of how reserves are calculated.