Economics of Insurance 101
Let's face it from a customer viewpoint, property and casualty insurance
coverage are costly relative to benefits received. Just 6.1 percent of
car owners filed a lawsuit, and 5.3 percent of homeowners filed a claim
in 2016. For the remaining policyholders, their insurance policy worth
is mainly intangible. This intangible value is often called "peace
of mind" in industry.
A means for an end
Insurance is typically an end-user. People buy insurance because they want.
It would help if you had motor vehicle insurance to run a vehicle. (At
least, data shows that 1 in 8 drivers in the U.S. is uninsured.)
To buy a house, the lender demands the home be insured before closing.
Landlords may require tenants to obtain insurance. Insurance isn't
a volunteered product. Instead, mandated. Since insurance is not a commodity
most people want to buy, the expense is substantial. From one angle, P&C
insurance premiums fit comparably priced products.
Wholesale profit margin is the equivalent to profit margins, agent fees,
and insurance procurement expenditures. A typical way of calculating the
relative cost of insurance is to look at the portion of the premium dedicated
to paying claims, referred to as damages, and related loss adjustment
expenses or LAE. LAEs are the costs of collecting, prosecuting, and settling
cases. Also, claims resulting in no award include loss-adjustment fees.
Both non-claim expenses are referred to as underwriting expenses and include
all other costs associated with operating an insurance policy. A loss
ratio is a standard industry measure of total losses, and LAE is paid
as a percentage versus premiums. According to NAIC, based on data from
the National Association of Insurance Commissioners (NAIC), here is a
summary of rates, losses, expenditures, and (operational) income from
the latest 2016 data.
Some business lines, such as homeowners and numerous commercial hazards,
are more vulnerable to disaster losses and experience broader profitability
fluctuations than other cables. Although losses can vary from year to
year and affect loss adjustment expenses, the remaining broad cost categories
are more predictable. General prices include running expenses such as
staffing, IT, office space, and appliances.
Sales expenses include advertisement and marketing, and fees of agents
and brokers, the primary source of underwriting expenses for most carriers.
Agents and brokers usually receive commissions to buy a new policy and
another package of policy-renewing commissions. Based on the details for
these four business lines, note that the loss ratio—the number of
premium dollars spent on paying claims—varies significantly from
product to product. For private passengers and commercial vehicles, loss
ratios indicate that about 70 cents are used for each premium dollar to
In contrast, only 40 cents was expended (leading to a loss of about 10
cents per dollar in 2016). While 61 percent of Americans think car insurance
is too costly, the recent challenges for auto insurance profitability
come. For homeowners and various commercial risks, loss ratios indicate
that about 50 cents of each premium dollar are used to pay damages. The
majority, however, is used to cover costs and provide a benefit. The portion
of premiums not used to cover losses allows carriers to reduce costs,
whether lowering loss adjustment expenses or underwriting expenses.
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