Background
The insurance industry is a sector of the financial services industry that deals with the transfer of risk. It involves individuals or businesses purchasing insurance policies from insurance companies to protect themselves against potential losses or risks in exchange for premium payments.
The insurance industry plays a crucial role in the economy by helping individuals and businesses manage and mitigate risks, promoting stability, and provides a mechanism for financial recovery in times of crisis or unforeseen events
The insurance industry encompasses different types of insurance, including amongst others:
Life Insurance: Provides coverage and financial protection in case of the policyholder's death or other specified events, such as critical illness or disability.
Property and Casualty Insurance: Covers losses related to property damage, liability claims, and other events. This includes home insurance, auto insurance, commercial property insurance, general liability insurance, and various specialized coverages.
Health Insurance: Provides coverage for medical expenses, including hospitalization, doctor visits, prescription drugs, and other healthcare services.
Reinsurance: Reinsurance companies provide coverage to primary insurance companies to help them manage and spread their risks. Reinsurers assume a portion of the risks underwritten by insurers in exchange for a portion of the premiums.
Key Players in the Insurance Industry
The insurance industry consists of a wide range of players each with their own business model specifics. These include:
Insurance Companies: These are the primary entities that underwrite insurance policies, assume risks, and provide coverage to policyholders.
Reinsurers: Reinsurance companies provide coverage to primary insurance companies to help them manage their risks and protect against catastrophic losses. They assume a portion of the risks underwritten by insurance companies in exchange for a portion of the premiums.
Insurance Brokers: Insurance brokers act as intermediaries between insurance companies and policyholders. They help individuals and businesses find suitable insurance coverage and negotiate terms on their behalf.
Insurance Agents: Insurance agents, which include Managing General Agents (MGAs), act as intermediaries between insurance companies and policyholders. They are licensed professionals who help individuals, businesses, or other entities find suitable insurance coverage to meet their needs. Agents represent one or more insurance companies and typically earn commissions or fees for their services.
Third-Party Administrators (TPAs): TPAs provide administrative services to insurance companies, such as claims processing, policy administration, and customer support.
Uses of Financial Modelling in the Insurance Industry
Financial modelling is useful in the insurance industry for several reasons including:
Financial Planning and Budgeting: Financial models enable insurance companies to plan and forecast their financial performance accurately. Financial Models project premium revenue, claims costs, and other expenses over a specific time period, helping insurers determine their profitability and make strategic decisions regarding resource allocation, expense management, and capital requirements. Financial modelling assists in budgeting, setting performance targets, and evaluating the financial impact of different scenarios and business strategies.
Merger and Acquisition Analysis: Financial modelling is crucial when evaluating potential mergers, acquisitions, or other strategic transactions in the insurance industry. Models help assess the financial impact of such transactions, estimate synergies, evaluate the valuation of target companies, and analyse the potential risks and returns associated with the transaction. Financial modelling supports decision-making by providing insights into the expected financial outcomes and integration considerations.
Capital Adequacy, and Solvency: Insurance companies are required to maintain sufficient capital to cover potential losses and comply with regulatory solvency requirements. Financial modelling helps insurers assess their capital adequacy by analysing the impact of different risk scenarios on their financial performance and position. By stress-testing the financial models, insurers can evaluate their ability to withstand adverse events, make informed decisions about capital allocation, and ensure compliance with regulatory standards.
Pricing and Underwriting: Financial modelling plays a crucial role in determining the appropriate premium rates for insurance policies. Models help insurers analyse historical claims data, evaluate risk factors, and estimate expected losses to develop pricing structures that are both competitive and aligned with the insurer's profitability objectives.
Risk Assessment and Management: Insurance involves the management of risk. Financial modelling helps insurance companies assess and quantify risks associated with their insurance policies and portfolios. By incorporating historical data, actuarial analysis, and risk modelling techniques, financial models can estimate the likelihood and severity of potential losses, helping insurers make informed decisions about pricing, underwriting, and risk mitigation strategies.
Key Considerations when Modelling Insurance Companies / Intermediaries
There are a number of factors and specifics that need to be taken into consideration when preparing a financial projection for an insurance company or intermediary. The following are the top aspects to consider:
Premium Revenue: Insurance companies generate revenue primarily through premium receipts. These premium receipts may be subject to a number of variations including:
Premium rates including variations over time and for new and renewal customers;
Premium volumes including renewal rates;
Cancellation and mid-term adjustment (MTA) volumes;
Policy administration fees including for mid-term adjustments and cancellations
Policy coverage period, referring to the period over which the risks are being covered.
Claims: Insurance companies existing to payout claims when events / losses covered by the policy arise. When modelling claims, the followings aspects should be taken into consideration:
Financial models should incorporate historical claims data, actuarial analysis, and risk assessments to estimate the expected loss ratio;
Expected recoveries from proportional (e.g. Quota Share) and non-proportional (e.g. Excess of Loss) reinsurance;
Expected claims payout patterns representing the period over which the incurred claims are settled.
Commissions: Insurance companies typically pay out commissions to intermediaries, such as to insurance agents or brokers as compensation for their services in selling insurance policies. In some cases, insurance companies may offer contingent commissions to agents or brokers based on certain performance criteria. When modelling commissions the following aspects should be considered:
Standard commission rates payable to intermediaries;
Any profit commissions due to insurance agents based on underlying profitability of the book of business and time period when profit commission payments are settled;
Any sliding scale adjustments to the standard commissions due to intermediaries based on overall actual loss ratio for the book of business;
Any other contingent commissions due to intermediaries when specific targets or milestones, such as sales volume or customer retention, are achieved.
Reinsurance: Insurance companies typically transfer a portion of their risks to reinsurance entities, to mitigate their exposure and enhance their risk management capabilities. In modelling reinsurance impacts a distinction should be made between proportional reinsurance (e.g. Quota Share) and non-proportional reinsurance (e.g. stop loss and excess of loss). In the case of proportional reinsurance, the reinsurer typically takes on a proportional portion of all premiums, claims and direct expenses (e.g. commissions), whilst non-proportional reinsurers would typically only absorb claim costs above a certain loss ratio, threshold or severity.
Investments: Insurance companies typically receive premium monies upfront and invest the premiums they collect from policyholders in financial instruments to generate income and grow their assets to be able to pay out future claims, expenses, dividends and/or increase the capital-baser of the company. When modelling investments the following aspects should be considered:
The different financial investment types and the company may invest excess funds in (e.g. bonds, equities, money market securities, private equity etc.);
The allocation of funds across these investment types, i,e. the overall investment composition;
The total expected return by investment type and split of that return into the cash portion (e.g. dividends or interest) and changes in market value;
The target portion of cash or liquid assets the company will aim to maintain to paid out immediate claims and expenses, with any difference being the funds that are invested.
Expenses: Insurance companies have various operating expenses apart from commissions, including underwriting expenses, administrative costs, and claims processing expenses. Financial models should capture these expenses and project them based on historical data, industry benchmarks, and anticipated business growth.
Solvency and Regulatory Compliance: Insurance companies need to maintain an appropriate level of capital to cover potential losses and meet regulatory requirements including solvency ratios, reserve adequacy, and capital adequacy. Financial models should incorporate risk assessment methodologies, stress testing, and regulatory guidelines to determine the required capital levels. This helps ensure the company's financial stability and ability to withstand adverse events. Some regulatory solvency calculations are quite detailed and complex to bring into financial models in their entirety, therefore they are typically modelled separately, including via specialised applications, or simplified calculations are used as an approximation.
Accounting Bases: Insurance companies are subject to a number of different accounting bases depending on the jurisdiction they operate and are incorporated in. They are intended to provide relevant and reliable information to stakeholders, including investors, policyholders, regulators, and other interested parties. Different accounting bases can impact the presentation, measurement, and disclosure of financial information which, in some cases, e.g. GAAP and IFRS can be significantly different. Financial projections should reflect the specifics of these accounting bases to be as close as possible to the expected future actuals of the entity for the specific scenario. The main accounting basis by jurisdiction include:
United States: Generally Accepted Accounting Principles (GAAP): Insurance companies in the US typically follow US GAAP for financial reporting. The Financial Accounting Standards Board (FASB) establishes and updates the accounting standards applicable to insurance companies, including the specific guidance outlined in the Accounting Standards Codification (ASC) Topic 944 - Financial Services - Insurance. In addition to GAAP, insurance companies in the US are required to prepare statutory financial statements based on SAP. SAP is defined by the National Association of Insurance Commissioners (NAIC) and focuses on regulatory compliance and solvency.
European Union: International Financial Reporting Standards (IFRS): As of January 1, 2023, insurance companies within the European Union are required to adopt IFRS 17 for the accounting of insurance contracts;
UK: Financial Reporting Standards (FRS): Insurance companies in the UK may follow the Financial Reporting Standards issued by the Financial Reporting Council (FRC). The specific standard for insurance companies is FRS 102;
Australia: Australian Accounting Standards (AAS): Insurance companies in Australia follow the accounting standards issued by the Australian Accounting Standards Board (AASB). The specific standard for insurance contracts is AASB 17 - Insurance Contracts;
Other International: IFRS, a globally recognized accounting framework, is typically used in many countries outside of the United States. Insurance companies in jurisdictions that follow IFRS adopt the standards issued by the International Accounting Standards Board (IASB), including IFRS 17 - Insurance Contracts, which provides specific guidance for insurance contracts accounting.
Available Resources
Projectify offers a strong selection of insurance industry financial modelling templates catering for different insurance industry players (including general insurance companies, insurance brokers and insurance agents) as well as different accounting bases (eg IFRS 17 and GAAP) and templates to analyse the financial outcomes for various counterparties involved in writing an insurance product or book of business.
These templates also serve as a valuable resource for anyone looking to understand the key working, economics or accounting treatments relevant to the insurance industry.
Projectify can also support with designing and building tailored insurance financial models to the customer's requirements. For further details, contact us via email (hello@useprojectify.com) or chat function on our website.
The following links contain the key financial modelling templates offered by Projectify relevant to the insurance industry: