We have looked, in the last two instalments of this series, at the basics of calculating insurance premiums. There is, of course, a host of additional complexity to be included in a premium calculation such as:
- Brokerage Fees
- Capital Costs
- Profit Margins
- Recovery Costs
- Internal Costs (e.g. Operating Costs)
- Cost of Claims
- Cash Flow/Liquidity
Some of these items are relatively simple to calculate and others are much more complex. A lot will depend on the arrangements that the insurer has to make to deliver each item on the list. Some, like brokerage fees, may not exist at all if the insurer only deals with insured parties direct.
However, once we have calculated our premiums we need to look at the reserves we must carry in order to be reasonably certain that we can meet our obligations to pay out claims under the policies.
It should be fairly obvious that an insurer cannot carry reserves equal to the total maximum pay out under all policies that it has underwritten. Apart from the fact that it would tie up enormous sums of capital needlessly, as it is unlikely that all policies held are going to claim in the same period, it would make insurance an unprofitable venture. If you had to hold £100,000 in reserves for every £100 in premiums you collect… you would need more wealth than Apple (the highest valued company in the world today) in order to insure a large number of policyholders.
Thus most insurers will carry enough in reserves so that they are likely to meet all claims made; this leaves an outside (but distinct) possibility of bankruptcy in the event of a major event triggering a huge volume of claims. This is a risk that has to be borne by the industry as a whole. If providing insurance was to become so expensive as to be unprofitable; there would be no insurance at all.
A common calculation for insurers for reserves is to assume that they will have two years with a 99% shortfall in claims:
shf (S) = <S¦S>Q(99%)>
This assumes that there will be bad years and that the insurer will be able to ride out such a period. It does not, however, assume that this scenario will continue indefinitely. Each insurer will use their own judgement and any regulatory requirements to determine their own minimum level of reserves. The idea is to optimally balance the needs of the insured with the business needs of the insurer.
In the UK there are certain regulatory protections for certain classes of insurance; if the insurer does become bankrupt. Insured parties should understand any such protection before taking out a policy. Ideally, their insurer will explain any protections as part of the insurance sales process.
Responsible insurers monitor conditions in order to re-evaluate their minimum reserves if external factors suggest that this would be sensible. For example, in the event of an Ebola pandemic it can be safely assumed that the business environment of a nation would become depressed. This could lead to bankruptcies, increased criminal behaviour, etc.
They also monitor the emergence of new technologies and markets to test for unforeseen impacts on insured parties. For example; black box technology for monitoring vehicles can be used to decrease the risks to the insurer and lead to fairer premiums for drivers. Conversely, the risks of nano-technology are less well-understood and may increase the risks to the insurer and lead to higher premiums overall. Reserves as well as premiums will be affected in these instances.