Private Passenger Auto Insurance Financial Modeling

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Private Passenger Auto Insurance Financial Modeling

The pricing and assuming risk (risk-based pricing) model and reinsurance model are the main business models (used for budgeting and operations) among insurance companies (including auto insurance companies). Some companies that offer auto insurance services like State Farm and GEICO leverage risk-based pricing to determine the premium associated with their auto insurance products.

Risk-Based Pricing Model

  • Revenue models vary among property insurance (including auto insurance) companies. The fundamental task for any insurer is risk pricing and charging of premium for assumed risks.
  • Under the risk-based pricing model, an insurance company offering a policy with a conditional payout assesses the likelihood of a prospective customer triggering a conditional payment. This process helps the company to extend the assumed risk based on the duration of the associated policy. Under this model, insurance underwriting is very critical.
  • Without sound underwriting, an insurance company can charge some customers too high and others too low for assuming risk. This situation could "price out the least risky customers," causing rates to soar even further.
  • When an insurance company prices its risk effectively, it will bring in more revenue (premiums) than its spending on conditional payouts. Scholars have identified several positive effects associated with risk-based pricing models on automobile insurance companies.
  • For the automobile insurance industry, observed characteristics upon which pricing of risks revolve include location, driving record, miles driven, age, gender, type of vehicle, claims history, credit history, education, and employment. Auto insurance companies use the above characteristics to set prices after "estimating correlations" between past losses and rating variables using "multivariate statistical models."
  • Typically, an insurer's actual product is insurance claims. Whenever customers file claims, insurance companies must process them, check them to ensure they are accurate, and make payment. This adjusting process is mandatory to filter fraudulent claims, minimizing the insurance company's risk of loss (to increase the likelihood of profit).
  • The risk-based pricing model helps auto insurance companies to beat the market competition. It helps them search for and identify potential policyholders to charge at a lower rate yet make reasonable profits.
  • State Farm is one of the top auto insurance companies in America and has 17% of the nation's auto insurance market share. The company leverages the risk-based pricing model and classifies cars and drivers into various risk groups (such as the high-risk auto insurance group) based on observed characteristics and records like a history of accidents or speeding tickets. State Farm leverages risk levels to determine the price associated with its auto insurance products.
  • GEICO is also one of the largest auto insurance companies in America and controls 13.4% of the nation's auto insurance market share. GEICO leverages a risk-based pricing model and considers both "high and low-risk factors" when calculating and charging a premium for assumed risks.
  • GEICO mentions and analysis property insurance risks (which typically includes car insurance risks) in the profits and loss analysis for its parent company known as Berkshire Hathaway Inc (GEICO primarily offers "private passenger automobile insurance to individuals in all 50 states and the District of Columbia.")

Reinsurance Model

  • In June 2019, the NAIC Executive (EX) Committee and Plenary endorsed revisions to the Credit for Reinsurance Model Law (#785) and Credit for Reinsurance Model Regulation (#786). Insurance operators across the United States are required to adopt these new revisions before September 1, 2022, or face possible federal preemption by the Federal Insurance Office. The reinsurance model law must be adhered to precisely as adopted by the NAIC.
  • Reinsurance is a business model that insurance companies engage in to protect themselves from excessive losses due to high levels of their exposure. Reinsurance is a vital component of insurance companies' efforts to remain solvent and avoid "default due to payouts." Regulators mandate the reinsurance model for companies of stipulated sizes and types.
  • Reinsurance is known as insurance for the insurer or stop-loss insurance. Reinsurance is a practice through which insurers transfer a portion of their risk portfolio to third parties via a form of agreement to lower the likelihood of making payments for a hefty obligation from an insurance claim.
  • The party diversifying its insurance portfolio is called the ceding party. The party accepting part of the potential obligation for a share of insurance premium is the reinsurer.
  • Regulators have made it mandatory that an insurance company can only issue a policy with a "cap of 10% of its value unless it is reinsured." Thus, reinsurance helps insurance companies to become more aggressive in gaining market share. Reinsurance also allows insurance companies to transfer risks.
  • Reinsurance smoothens out the natural fluctuations associated with insurance companies, often leading to "significant deviations in profits and losses."
  • One way insurance companies make money is by diversifying or reinvesting premiums in other interest-generating assets. Like every private business, insurance companies strive to leverage diversification in marketing themselves to minimize administrative costs and increase profits.
  • INSHUR offers 100% digital commercial auto insurance. It has been offering commercial auto insurance services in New York for over twenty-four months and recently raised $7 million via Series A funding. Its insurance services for the commercial auto industry are smart, data-driven, and flexible.
  • INSHUR is one of the auto insurance companies leveraging the reinsurance model. Its recent funding round meant for diversification (to increase its chances of making profits) was led by the investments arm of a reinsurer known as Munich Re Ventures. INSHUR offers modern insurance services that target private passenger (hired) drivers, courier, and food delivery drivers.
  • According to Reinsurance News (a company dedicated to publishing news relevant to the reinsurance and risk transfer sectors), INSHUR will use its newly raised capital to expand into new territories and "target new insurance verticals." The company hopes to expand into the broader commercial sector. By February 2019, the company had underwritten up to $24 million in gross premiums within ten months of launching in the United States.

Research Strategy

The research brief has investigated examples of budgeting or operational models in the insurance industry (of the United States). We examined insurance industry publications, encyclopedia, academic resources, journals, and other resources for operational models linked to the P&L (profit and loss) statements of insurance companies, or at least a line item in their P&L statements. A limited number of resources discussed budgeting or operational models specific to the insurance industry. We researched a few examples from the private passenger auto insurance segment to confirm that the uncovered budgeting or operational models are relevant to the private passenger auto insurance segment. We included only US-based resources (like Investopedia) or publications regarding companies operating in the United States.

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