Economics of the Insurance
The insurance industry is an essential business within an economy that is amongst the oldest sectors in the world. It has been around for nearly four millennia. Since that time, the main aim of an insurance policy is to protect the properties, health, and lives of people. The insurance industry has become a cardinal sector for the economies of countries in the world.
The insurance industry’s critical function is that it helps businesses operate economically. This function transfers risks from businesses to third-party insurance companies. The operation of insurance companies is vital as risky situations occur, no matter how careful an individual or a business is. When such an incident occurs, it usually negatively affects business.
The role of an insurance policy is to protect businesses from such harm. As such, insurance is a proactive step taken by a business to cushion the effect of risks, which fosters a positive mindset and increases confidence at all levels within an organization.
The function of the insurance industry is more evident in developed economies than in developing economies. Businesses have greater confidence for insurance companies in such countries. Therefore, most companies in such countries purchase one form of an insurance policy or another to protect their businesses against numerous unforeseen events.
Also, these insurance policies are critical for protecting the staff of such businesses. A few examples of these insurance policies include vehicle insurance, healthcare insurance, life insurance, and property insurance.
The everyday transactions that occur within the insurance industry positively impact the economy. The exchange of resources by payment of premium or payout of policy impacts the GDP of countries. Additionally, insurance companies provide direct and indirect employment to thousands of people, which is an excellent thing for economies.
Economic Functions of Insurance Institution
The insurance industry plays an essential role in the economies of the world. The main economic functions of the insurance industry are explained below.
- Security against risk
The provision of security against risk is the primary function of an insurance company in an economy. It offers economic support to businesses in cases of disasters. The type of insurance policy a company purchases determine the degree of coverage it gets. For instance, in the event of an explosion that destroys a large part of a business’s factory, an appropriate insurance policy can provide security against such a risk.
- Provide resources
Primarily, all insurance policies purchased by businesses involve payment of periodic premiums, which keeps the contract valid. The collection of premiums from various companies can be used for investments in various markets such as stock and securities markets.
- Encourage saving
In addition to protection, insurance encourages businesses and individuals to save more money. Appropriate insurance policies have provisions that accommodate investment. Therefore, the premiums paid by businesses and individuals are split into two to cover insurance policies and investment packages. The return from the investment is given to clients directly or used to finance the payment of premiums.
- Spread risk
Since numerous companies pay premiums into a pool, the insurance policies help to spread risk between the insurance companies and businesses accordingly. In the event of a disaster involving an insured company, the pool of resources provides the insurance company the ability to payout the business based on agreed terms.
- Provide healthcare
It is well known that only healthy workers can be productive in business. Therefore, health insurance is an important policy that provides medical cover for the staff of a business. In some cases, health insurance further extends to the family members of staff. This function is essential as it ensures productivity.
The best way to understand the importance of the insurance industry on the economy is to look at specific economic indicators. Several indicators help to make sense of the financial standing of the insurance industry. This article is going to discuss two, which are expense ratio and loss ratio.
This indicator helps the insurance sector to quantify profitability. The calculation for determining the expense ratio is carried out by dividing certain expenses by the collected premium. These expenses include underwriting, premiums service, acquiring, advertising, commissions, and employees’ remuneration. This ratio highlights the profitability of an insurance company before considering payouts and investments standing. The expense and the loss ratios are used together to determine the combined ratio of an insurance company.
The expense ratio can be determined using two methods, which are statutory accounting and generally accepted accounting principles. The statutory accounting method, when used, gives more traditional ratios by using net premiums written. The generally accepted accounting principles make use of premium collect over a given time.
The loss ratio is another essential tool that is used to provide economic context to insurance companies. It is the ratio of total losses to income. It is also the direct antithesis of the financial indicator called the gross profit ratio. Therefore, when an insurance company wants to calculate its loss ratio, it adds up all losses and divides the expenses by the entire premium collected.
The loss ratio of insurance policies that cover property and accident is usually 50%, which may range ±10%. These insurance companies collect a significant amount of premium that exceeds the amount of payout made to policy owners.
On the other hand, those insurance companies that have higher loss ratios tend to be financially unstable. Such companies may be collecting insufficient premiums that cannot completely cover expenses and generate an acceptable amount of profit.
Permissible loss ratio or target loss ratio refers to the necessary loss ratio that satisfies the profit margin of an insurance company.
This type of ratio is calculated by subtracting the expense ratio from 1. These expenses include commissions, administrative costs, advertising costs, contingencies, and other expenses. In some instances, payouts are included in the loss ratio calculation. So, to calculate the rate change, the incurred loss ratio is divided by the target loss ratio.
In the past, the loss ratio for healthcare insurance policies was between 60% to about 100% and above. In recent years, the ratio is now between 80% to 85%.