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.

Why Insurance Business is Different?

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.

Why is Financial Modelling for Insurance Companies so Complicated?

1. Financial modeling in insurance companies relies on a lot of assumptions. Firstly, it needs to be understood that there may be a big difference in the actual cash expenses and the recognized expenses of an insurance company. This is because of the way in which expenses are recognized. If a 20-year insurance policy is sold in a year, then the premium may be recognized as revenue in the same year.

   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.

2. Secondly, the losses that insurance companies face are often not linear. This is due to the fact that most insurance companies reinsure their policies as well. In simple terms, this means that for example, the first $10,000 of the claim are borne directly by insurance companies. However, once the threshold is reached, the reinsurance policy kicks in, and the company may not have to bear loss up to a certain amount.

   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.

How Data Flows Through The Financial Model?

1. The financial modeler must begin by projecting the premiums that the company is likely to earn. Direct written premiums to be earned by the company are the starting point for financial modeling

2. The next step is to figure out the percentage of premiums to be written off as expenses. Some expenses, like commissions and operating expenses, are easy to predict. On the other hand, expenses like claim pay-outs are sporadic and hence difficult to predict. If we subtract the premiums from expenses, we arrive at the net earned premiums.

3. The remainder of the income statement flows just like normal companies. Selling and administrative expenses are recognized. Taxes are recognized, and finally, the net profit number is reached.

4. The balance sheet of an insurance company flows from its income statement. The difference between paid out expenses and recognized expenses appears on the balance sheet of the company. Another peculiar item on balance is called the deferred acquisition costs. This amount refers to the commission that has been paid to the brokers. However, due to the matching principle, it cannot be recognized on the balance sheet at the same time. Therefore the amount of premiums earned and claims paid have a direct influence on the numbers on the balance sheet.

5. Lastly, just like banks, insurance companies do not have complete control over all the funds which are at their disposal. Regional laws dictate how that money has to be apportioned between investments. Also, insurance companies are required to maintain a high solvency ratio. This is required so that people trust the insurance system.