How does an insurance company calculate profits?

8.01.2020
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Introduction

Every business works with the intent of making a profit. The success of every business depends on its ability to constantly earn profits. Profit, in business usage, is the excess of total revenue over total cost during a certain period of time. Profit is equal to a company’s revenues minus expenses. For insurance companies, annually profit margins represent yearly profitability averages. These margins measure how well a particular business company does, over a period of time. From the perspective of insurance companies, profit margins are an important part of tracking the internal performance of the company. Let’s understand a little about the ways of insurance companies to calculate profits.

The following methods are used by insurance corporations to calculate profits:

  • As discussed, profit, in the most basic sense, is the company’s revenue costs. Therefore basic formula to calculate profits for the insurance companies is :

    Profit = Premiums + Return on Premiums – Claims – Expense

    Even if the payout for claims is 100% of the premiums collected(which is never the case), the insurance companies can still earn profit by investing the premiums. This becomes clearer by the following example:
    Suppose there are 500 customers, who pay an average premium of $2,000 annually. The insurer invests the money in stocks or bonds and gets a 16% return (after investment costs).

    Total Premiums = $1Million
    Claims = $1Million (100% of premiums)
    Expense = $100k (10% of premiums)
    —————-
    Underwriting Profit (premiums – claims – expense) = – $100k
    Investment Profit = $160k (16% of premiums)
    Total Profit = $60k or 6% of premiums

  • Profit margins are perhaps the most widely and simply used financial ratios to calculate the profit of a company. The profit margins of a company are measured at three levels. The most basic is – gross profit – and the most comprehensive is – net profit. Between these two operating profit lies. All three have respective profit margins which are calculated by dividing the profit figure by revenue and multiplying by 100. Annualized profit margins for an insurance company can change from year to year; based on the number of claims it receives, policy price changes, and changes in the cost of the services. Now take a closer view of these profit margins one by one:-

    1. Gross profit margin:-

      Gross profit margin is a ratio that shows the performance of a company’s sales and production. This ratio is made by accounting for the cost of goods sold (COGS —which include all costs generated to produce or provide any product or service) and the total revenue. The gross profit margin is usually expressed as a percentage of sales and is called the gross margin ratio. If a company’s business has a gross profit margin of 24%, it means that 24% of the company’s total revenue became profit. A higher gross profit margin indicates a higher work efficiency of a company. The gross profit margin is calculated by deducting the cost of goods sold (COGS) from total revenue and dividing that number by total revenue.

      The formula for calculating the gross profit margin ratio is:
      Gross Margin Ratio = (Total Revenue – COGS) ÷ Total Revenue

    2. Operating Profit Margin:-

      The operating profit margin indicates how much profit a company makes after paying for variable costs of production such as payments, wages or claims, etc. It is also expressed as a percentage of sales and then determines the efficiency of a company by comparing the costs and expenses associated with business operations. Operating Profit Margin is a performance ratio that is used to determine the profit percentage of the company produced from its operations, before subtracting taxes and interest charges. This margin is also known as EBIT (Earnings Before Interest and Tax) Margin. The operating profit margin ratio is calculated by dividing the operating profit by total revenue and expressing it as a percentage.

      The formula for this margin ratio is:
      Operating profit margin = Operating profit* ÷ Gross revenue
      *(Operating profit = Sales – Operating expenses – COGS)

    3. Net Profit Margin:-

      Net Profit Margin (also known as “Net Profit Margin Ratio”) is a financial ratio used to calculate the degree of profit of the company produced from its total revenue. It measures the amount of net profit that a company obtains per dollar of revenue gained. The net profit margin is equal to net profit divided by total revenue. It is expressed as a percentage. The difference between the operating profit and the net profit is that the former is based solely on its operating expenses by excluding the cost of interest payments and taxes.
      The formula for Net Profit Margin is:
      Net Profit margin = Net Profit* ÷ Total revenue
      *(Net Profit = Sales – COGS – Operating expenses – Taxes)

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