Creating a Revenue Model
February 12, 2025
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Financial strategy is at the heart of the business of any insurance company. This is because insurance companies need to deploy their funds in a manner which allows them to gain maximum returns. However, the nature of claims being faced by insurance companies is uncertain.
As a result, every insurance company is supposed to have some amount of its capital held in assets which can be easily liquidated. Managing the entire financial flow is quite a complicated task. However, financial models help in this regard.
Financial modeling is the art of predicting the revenues and expenses of the company over the next few years. In the case of normal companies, expenses can be easily predicted. There is some cause-effect relationship between the actions taken by the company and the expenses which accrue as a result.
The insurance business is quite different. Insurance companies take in upfront money in the form of premiums paid. These companies then have to compensate the buyers of insurance policies when the policyholder gets sick, loses his car, or even dies.
As a result, the inflow of premiums to the company is more or less stable, given the inelastic demand for insurance. However, the outflow from the company’s coffers could vary wildly between two years. This variation will mostly be the result of external circumstances such as weather or natural calamities which insurance companies have very little control over.
Predicting the outflow of funds from insurance companies becomes a challenging task. This is where financial modeling comes into action. Insurance companies try to find out the various situations they could find themselves in and how their cash flow would be affected as a result.
However, insurance companies usually appropriate a portion of their premiums to meet expenses later on. Hence, in year one, a huge expense may be recognized but not incurred at all. Similarly, in the forthcoming years, the cash pay-outs related to the expense may happen. It is for this reason that reconciling the income statement and cash flow statement is extremely complicated for insurance companies. A financial modeler needs to be truly well-versed with the intricacies of accounting in order to design a model.
Once the limit of the insurance policy is exhausted, the company may again have to bear the financial loss. Needless to say, building this logic in the financial model is complicated. This is the reason that the financial modeler needs to have an exceptional level of skill.
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