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INS 21
Mar 25, 2023
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Insurer Financial Performance INSURER PROFITABILITY AND INCOME AND EXPENSE MANAGEMENT Sound management of an insurer includes careful attention to its financial performance. A n important aspect of an insurer's financial performance is its profitability and whether it generates enough profit to survive and grow. To survive long term, an insurer must generate more income than it spends; that is, an insurer's revenue must exceed its expenses. In a given month or year, an insurer's expenses might exceed its revenues, requiring the insurer to pay some of those expenses with accumulated funds. Such a pattern, however, will eventually deplete accumulated funds, and the insurer will fail. Like any other business, an insurer must manage its revenue and expenses to produce an overall income gain (revenue minus expenses) from its operations and to ensure profitability. Managing Insurer Income Insurers charge their insureds premiums for insurance coverage, part of which insurers invest to earn additional income. Consequently, insurers receive income from these two major sources: the sale of insurance and the invest- ment of funds. The sale of insurance generates underwriting income, which is the amount remaining (either a gain or a loss) after underwriting losses and expenses are subtracted from premiums. The investment of funds generates investment income, which is the amount remaining (either a gain or a loss) after invest- ment expenses are subtracted from the gross amount earned on investments during a period. While some insurers receive other income from the sale of specialized services or other incidental activities, most of the income an insurer receives is either underwriting income or investment income. During a particular calendar year, an insurer calculates its written premiums by totaling the premiums charged on all policies written with effective dates of January 1 through December 3 1 of that year. Written premiums are the total premiums on all policies put into effect, or "written," during a given period. For example, when a policy is written to become effective on July 1 for a premium of $600, that entire $600 is counted as written premiums on July 1, even though the insurer may not have collected it yet. If the policy is changed on September 12, resulting in a $75 refund, the insurer's written premiums 3.3
3.4 Property and Liability Insurance Principles are reduced by $75 on September 12. Although written premiums provide a source of cash for insurers, rules of accounting allow insurers to recognize only earned premiums on their income statement. Earned premiums arc the portion of the written premiums that apply to the part of the policy period that has already occurred. The remaining portion of written premiums applies to the policy period that has not yet occurred and is therefore called unearned premiums, representing insurance coverage yet to be provided. Earned and unearned premiums can be compared to a non-insurance business transaction; for example, how a magazine subscription might operate. When a subscriber pays a $24 annual subscription fee for a monthly magazine, the pub- lisher does not "earn" the entire $24 subscription amount until the magazine has been provided for twelve months. If the subscriber cancels the subscrip- tion after receiving only six monthly issues, the publisher might refund $12, or half of the subscription amount—the "unearned" portion. Likewise, when an insured pays a premium of $600 on July 1 for a one-year policy, the $600 premium is not fully "earned" until the end of the twelve-month coverage period. The entire $600, however, is considered written premiums for the cur- rent calendar year. As the exhibit shows, only half of the $600 annual premium paid on July 1 is earned as of the end of the calendar year because only six months, or half of the protection period, has passed. Therefore, at the end of the calendar year, the insurer calculates S300 of earned premiums and $.300 of unearned pre- miums for this policy. See the exhibit "Earned Premiums—One-Year Policy Issued on July 1 for $600." During the next calendar year, between January 1 and July 1, the unearned portion of the premium is earned as coverage is provided by the insurer. If this policy is not renewed on July 1 of the second year, the insurer records no written premiums for this policy in the second year (remember that the entire Earned Premiums—One-Year Policy Issued on July 1 for $600 1/1 7/1 12/31 7/1 12/31 Policy Issued Policy Expires Policy Term - $ 3 0 0 — i Premiums Earned M —$30C Premiums Earned [DA02103]
Insurer Financial Performance 3.5 $600 was considered to be written during the first year). The insurer records only the earned premiums of $300 from the previous year's written premium. See the exhibit "Examples of Written, Earned, and Unearned Premiums." Examples of Written, Earned, and Unearned Premiums Annual policy with $600 premium is effective July 1. At the end of Calendar Year 1: Written premiums = $600. Earned premiums = $300 (6 of the 12 months of coverage have elapsed). Unearned premiums = $300 (6 of the 12 months of coverage have not elapsed). At the end of Calendar Year 2 (assuming the policy is not renewed): Written premiums = $0. Earned premiums = $300 (the remaining 6 months of coverage have elapsed). Unearned premiums = $0 (there is no more coverage; all the premium is earned). If instead the annual policy were effective December 1 of that year, then the written premium would be the same, the full $600; but the earned premium would be $50 (1 of the 12 months has elapsed), and the unearned premium would be $550 (for the other 11 months). At the end of that calendar year, assuming the policy was not renewed, the earned premiums would be $550, and the written and unearned premiums would be $0. [DA07662] Underwriting Income Underwriting income is an insurer's gain or loss as determined by subtracting the insurer's paid losses and loss adjustment expenses (LAE) from its earned premiums (the revenue from the insurer's underwriting operations). The losses paid by an insurer's policies plus the expenses associated with controlling and adjusting those losses are the primary underwriting expenses. When calculating underwriting income for the year, or for any other period, an insurer must determine the portion of its written premiums that is earned premiums and the portion that is unearned premiums during the period, because if the policy were subsequently canceled by the insurer or the policy- holder, the unearned income would not be earned. Consequently, the use of written premiums could create a false impression of profitability. Loss adjustment expense(LAE) The expense that an insurer incurs to investigate, defend, and settle claims according to the terms specified in the insurance policy. investment Income Because an insurer collects premiums from its policyholders and pays claims for its policyholders, an insurer handles large amounts of money. Insurers invest available funds to generate additional income. Investment income can
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