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Planes, Trains or Automobiles- What is YouCover Covering?

From launching satellite stations to vets’ treatments for family pets, there are thousands of types of risks out there needing insurance cover. You’re hungry for the premium income, so why not write as many types of policies as you can? At this point we should heed the advice of US investment guru Warren Buffet, who over the last 40 years has made billions of dollars for his shareholders in the insurance market. In 2001 he stated his basic principles insurance companies should follow in order to be successful, the first of which was:

“They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that…carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.”

In other words, stick with what you (and your underwriters) know. Underwriters are those knowledgeable sorts who actually write the policies and set the premium level to be paid by customers. Even if you chose to do business in a fairly standard category such as motor vehicles, there are many sub-categories to choose from (women drivers, older/younger drivers etc.), each with their own unique risk profile.

Broadly speaking, you need to position yourself at some point on a sliding risk scale. At one end you have high volume, lower risk business (e.g. motor vehicle and home contents) where competition is fierce. At the other is the more esoteric world of aviation, marine and commercial property cover- far more sedate, but then one overnight disaster could end up costing you millions.

Selling the Product- the Direct Approach, or Going for Broke?

These days, there are two main methods of selling YouCover insurance to the customer, both of which entail different forms of direct selling costs:

1. Through independent Brokers: brokerages are businesses that sell insurance, but don’t write any themselves. The upside of this is that they do a lot of the legwork in areas such as marketing, contacting customers and taking their details. The downside is that they don’t do this for free; commission needs to be paid on every policy sold.
2. Increasingly popular these days is selling Direct: YouCover maintains all the staff and systems required to handle and sell to customers itself. There’s no commission to pay, but costs will obviously be much higher and require careful management. In addition, YouCover’s marketing budget will rocket upwards in an effort to get the phones ringing.

These direct selling costs need to be paid out up-front to get the customers rolling in. However, the premium income received should more than cover all this, leaving you sitting on a very nice pile of cash (often referred to as the float). Now comes the nasty part…

Claims- Coughing Up for Catastrophes

YouCover’s claims number will be one of the first called when the bad things in life happen. Car accidents, theft, fire and floods- YouCover needs to pay out for whatever it’s covering. Hopefully the underwriters set the premium levels high enough to cover all these payouts. However, insurance companies can often suffer bad years through no real fault of their own, for example covering home contents in a year of much higher than average flooding.

Of course, it’s not just as simple as writing out cheques and putting them in the post. Claims handling expenses will be incurred at several stages, from salaries for the basic handlers who take claimant’s calls and file the details, through to loss adjusters and legal advisory teams for the more complex (and costly) cases.

Anyway, it’s the end of YouCover’s first year of trading and guess what, you’ve got money left over after paying out for claims and expenses. Time to pop the champagne corks? Not quite yet…

Showing Reserve

The more complex cases mentioned above tend not to get settled overnight- especially when lawyers get involved. Think about a car accident where the insured ends up in a wheelchair- it may take several years’ worth of medical reports and legal challenges before a final payout settlement is reached. Indeed, with some classes of insurance it may be the case that an event triggering a claim has occurred but is not yet known about. For example, a chemical plant could have been leaking harmful pollutants underground for many years before the damage is discovered.

All these potential future claims need reserving for before a final underwriting profit or loss can be assessed. Reserve levels required are assessed not by yourself (the temptation to under-reserve and declare a larger profit may be too much!), but by your team of actuaries. Actuaries, professionals highly trained in their particular brand of dark science, come up with what they feel is a reliable figure for the total cost of all the policies written.

Well, wouldn’t you know it? Those pesky actuaries have now blown our underwriting profit out the water- it turns out the total long-term cost of claims, reserving and expenses is now higher than our premium income. In other words, we have an underwriting loss.

Floating in Cash- Investment Income

Though it would be nice if we could avoid it, an underwriting loss is not necessarily a disaster. Because premiums are received before claims are paid, YouCover will always be running a sizeable cash float. This float is not merely kept in a bog-standard bank account until needed, but handed over to our investment managers. Hopefully, these highly paid individuals can focus their expertise into making more than enough money to bring YouCover back into the black. Indeed, underwriting losses are sometimes referred to as simply the cost of float, emphasising the role of underwriting in bringing money into the business for investment.

If writing thousands of policies on which you expect to lose money overall causes you to cower under your desk, you should note that this business model has proven very successful in recent years. For example, US property and casualty insurance companies had underwriting losses totalling $142.3 billion in the five years ending 2003, but overall profit for the same period was $68.4 billion after float investment income was added in.

Though big money can be made from general insurance, it’s certainly not a business for the faint-hearted. Just one freak storm could wipe out years of carefully accumulated profits if YouCover is not careful enough about the policies it writes. Perhaps you would be best to heed Mr. Buffet’s wise words; admit you know nowhere near enough, and stick to the day job.