Investing in the auto insurance market is a good financial decision. But just like any other business, you need to be strategic in order to make profits. For instance, some auto insurers have crashed due to market volatility, while others have shown the tenacity to endure harsh economic climates. It is thus wise to evaluate various options before entrusting your money to a given company. But how do you evaluate your options?
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People are constantly looking for auto insurance companies with affordable premium rates. But they don’t know what goes on behind the scenes in the auto insurance industry. For instance, why do prices vary from one company to another?
While there are many forces behind the varying auto insurance rates in companies, there is one specific point to note, especially if you are looking to invest in the industry. This is claim experiences. Most times, your premiums might suddenly increase because the rates that you’re paying are not enough to cover the company’s claims adequately. This is a red flag as it signifies poor financial planning in the company.
That said, let’s proceed to discuss how auto insurance works and how the providers generate profits from it. This will give us an answer as to whether you should invest in the auto insurance market or not.
How Do Auto Insurance Companies Work?
Insurance companies operate by pooling risks from individual payers and distributing them across a large number of people to minimize the cost impact of high-risk individuals.
Let’s assume that one policyholder runs into a car accident that requires a payout of $50,000 from your insurance firm. Keep in mind that the customer has been a client for five years and has only paid a monthly premium of $100. So, would this situation be a loss to the insurance firm or not? Insurers manage such risks by distributing financial burdens to the rest of the group members who don’t require payouts at that particular time.
Note that insurance companies invest in their policyholders’ funds to earn interest in return. This also enables them to raise large sums of money immediately after a policyholder files for a claim. As an insurance firm owner, you should have a long-term financial strategy that ensures you have enough cash at hand to run the company throughout the year.
Finally, most insurance firms have a liability cap policy. A liability cap refers to an agreement limiting the amount an insurance company can pay in total benefits. For instance, a driver paying a $50 monthly premium might be entitled to a $10,000 liability cap. This means that the insurer can only pay up to $10,000 for the damages attained in a road accident. The insurer increases the liability cap if the driver increases the premium payment.
How Do Auto Insurance Firms Make Money?
As much as insurance firms aim to help cover losses, they are in the business for the profits. Therefore, they must create a business model to help them collect more money than what they need to cover risks and running costs. These companies make money in two ways: underwriting and investment.
Underwriting
Underwriting involves charging customers a fee, also known as a premium, to guarantee financial risk coverage. Many insurers derive a significant amount of money through this strategy. To achieve success, an insurer would use statistics and mathematical models in evaluating financial risks that may arise. They then create specific insurance plans and set premiums after completing the financial risk assessment.
Actuaries involved in calculating auto insurance risks consider specific factors such as those stated above to determine how much premium a driver should be subjected to. The customer may then agree or disagree with the contract. They may also choose the type of coverage that they can afford.
Depending on the customer’s plan, the insurer covers the agreed amount and the policyholder is left to pay for extra liabilities. The amount of liability that remains as the customer’s responsibility is known as the deductible amount. It means that they have to pay a certain amount of money before the insurer pays for their vehicle damages.
Investment Income
Auto insurance firms collect huge sums of money through premiums, as stated above. However, they don’t need to pay any money until drivers claim it in the event of a car accident. So what do they do with all that cash at hand?
The firm sets aside funds to cover for any claims that may arise in the course of the year or term and invest the rest. Investment income is relatively smaller compared to the underwriting income. The companies invest conservatively in ventures such as bonds and the blue-chip stock markets. Let’s review these terms for an easy understanding.
Bonds
Auto insurers invest in various types of bonds to raise money. The bonds come with specific highlights and drawbacks. Here are the main types of bonds to expect in the market:
- Municipal bonds: These bond types come from municipalities, states, or local government entities. They’re meant to finance public projects. For instance, your town might ask you to provide a particular money investment in return for interest plus the invested money over an agreed period. Let’s say you invest in a 10-year bond worth $10,000 to earn an interest of 3 percent. In this case, the town would pay the 3 percent interest on your $10,000 every six months, then refund your invested $10,000 after ten years.
- Corporate bonds: These bonds offer a higher interest compared to other variants. However, companies providing corporate bonds have high chances of defaulting compared to government entities.
- Treasury bonds – Also known as T-bonds, these variants are issued by the U.S. government. They pose no default risks, which is why they don’t offer similar or higher interest rates to corporate bonds.
Blue Chip Stocks
Insurance companies invest in shares from well-known companies such as Johnson and Johnson, Coca-Cola, and Apple, among others. These shares are known as blue-chip stocks. Over the years, these stocks have proved to be a success for many insurance companies, making them one of the most popular stocks in the market.
They’re known to give high returns and endure tough financial climates. As a result, they have become a go-to investment for companies looking to generate more income.
How Do You Calculate Profit in the Auto Insurance Market?
To answer this question, you should understand both general and specific metrics used to analyze insurance markets. The general metrics include return on equity (ROE) and net margin. ROE involves evaluating a business’s money-making power by comparing market profitability, financial leverage (debt), and market management. This process helps you determine the general strengths of that particular business.
You should also understand the following insurance-specific profitability metrics to gauge how much you’re going to make from your investment:
- Loss ratio: You calculate a loss ratio by dividing a company’s incurred losses by its total collected premiums. After the calculation, a lower ratio translates to more profits and vice versa.
- Expense ratio: It’s the percentage of invested premiums used to run an insurance company. The ratio equals the company’s total operating expenses divided by the fund’s net asset average value.
- Combined ratio: It’s used to measure the profitability and financial strengths of a financial company. It’s calculated by combining the loss ratio and the expense ratio. For instance, a company with $100 million worth of premiums and $90 million in losses plus expenses has a combined ratio of 90%. Note that a combining ratio below 100% indicates an underwriting profit. Thus, the more the companies generate profits, the more dividends you earn as an investor.
How Much Can You Make From Investing in the Auto Insurance Market?
There is no precise answer to this question since the stocks market is highly unpredictable. Your wealth is mainly built from:
- An increase in share price: Your share price increases over the long term when the business expands and makes increased profits. For instance, if you invest in a $10 stock and the company grows by 20% in 10 years, you’ll get about $620 per share.
- Dividends: When a company pays you in the form of dividends, you receive cash in your savings, brokerage, or checking account. Dividends are paid per share. If, for example, you own 30 shares in a company and the company pays $3 in annual cash, you will receive $90 per year.
So, Should You Invest in the Auto Insurance Market?
You might want to invest in the insurance market for two main reasons:
- Insurance firms are known to deliver consistent and long-term profits, which you can earn as dividends.
- Unlike other sectors, insurance business models are more resilient to economic downturns, meaning investing in the auto insurance market is a safe choice.
But before you rush into an investment, you should know the special circumstances that the auto insurance firm operates under. This helps you evaluate whether the economic environment is conducive to its profitability.
