- How Insurance Companies Make Money
- How Insurance Companies Lose Money
- Success Drivers of the Insurance Business
This chapter is from the book
This chapter is from the book
This chapter is from the book
Success Drivers of the Insurance Business
The key for an insurance company to be successful boils down to doing four things right:
- Risk Selection: Identifying the risk it is willing to take, which means being good at underwriting and pricing.
- Risk Management: Managing risk, reinsuring unwanted risk, and managing claims effectively.
- Risk Acquisition: Subscribing insurance, using sales channels, and effective marketing to attract clients and sell insurance policies.
- Investment Operations: Earning good returns on the reserves (or float).
Reviewing the value chain, Figure 1.2, as you compare the traditional insurance company value chain to TOMIC’s simplified value chain, you see that their functions and their success factors are the same. The investment operations of TOMIC are very simple. TOMIC keeps the required reserves in money market funds or in cash.
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Figure 1.2. Comparison between value chains of a traditional insurance company and TOMIC.
TOMIC’s value chain has three primary functions:
- Trade Selection: Encompasses underwriting and pricing. Selects the market and strategies to trade.
- Risk Management: Encompasses money management, trade sizing, hedging (reinsurance), trade adjustment (claims), and trade decisions.
- Trade Execution: Is the equivalent of client acquisition in the traditional insurance company. In this case TOMIC goes to the option exchanges to sell its options (insurance policies).
These success drivers need to be managed in any insurance company that wants profits. At The One Man Insurance Company you need to constantly watch and manage these drivers to avoid ugly results:
- Trade selection. This function encompasses selecting markets, pricing the risk, and selecting a strategy and a timeframe. Allstate and State Farm select geographic regions where they sell homeowners insurance. It is the same process in The One Man Insurance Company (TOMIC), but instead of homes in different geographies, TOMIC selects which underlying indexes or equities markets it will write options on. TOMIC could write options on the SPX, RUT, NDX, DIA, AAPL, IBM, PG, JNJ, or GOOG, to name a few. Pricing of the insurance is very important. In an insurance company like Allstate the underwriting department defines the expected losses for a specific group of insured. For example, for automobile insurance they would use variables to predict expected losses from a segment of drivers. They know to expect fewer crashes from married women age 32, driving a minivan, than for single males age 18, driving a two-seat convertible. At TOMIC the pricing is very similar. The difference is that you are the underwriter and will need to know the volatility and price of the underlying equity or index you are going to insure (write options against). Once you know the market and the risk you want to take, you select a strategy. Your strategy selection could be a vertical spread, calendar spread, condor, and so on. Finally, you should decide on a timeframe for the trade—a week, 20 days, 30 days, and so on. Homes are usually insured on an annual basis.
- Risk management. This function could be more accurately called active risk management. This function continuously monitors the risk portfolio and divests any risk that is not wanted. At Allstate if the loss ratio on married women driving minivans starts increasing year after year, they have to determine what has changed. Maybe it is that the women have more children who cause distractions when the women are driving. Given that they are constantly monitoring their insurance portfolio, Allstate adjusts (raises) the price of the insurance for this market, or they might not insure married women with kids driving minivans. The same should happen at TOMIC. For example, if TOMIC insures defense contractors and new legislation from Congress cuts defense spending by half, TOMIC might stop writing options on defense contractors or it might reinsure its position by buying puts. TOMIC has to constantly be aware of changes in volatilities and prices of the underlying market. Risk management at TOMIC involves position sizing, money management, trade adjustments, portfolio insurance, and portfolio diversification.
- Trade Execution. This function is equivalent to the sales of insurance policies by the traditional insurance sales force. Instead of having agents like Allstate, at TOMIC we have the option exchanges. TOMIC goes to an option exchange, using a broker, to buy or sell options. There is no need for a sales force to sell insurance, only a computer connected to an exchange. The efficiency and effectiveness in which TOMIC can execute a trade will have a direct impact on profitability. There are different ways to execute a complex trade, and there are many factors that impact the execution. The factors could be the size of the market, size of the trade, the time of day, the exchanges the market is traded on, and the market makers. This function is a crucial link to having a successful TOMIC or not, and you must know how to execute your trades well.
All the key success factors of an insurance business need to be in place at TOMIC in order to have an ongoing successful business. TOMIC operating profitably and successfully is, in theory, achievable. Figure 1.3 shows what TOMIC looks like when you include all of its functions: primary and support.
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Figure 1.3. TOMIC value chain.
Every business has some kind of “infrastructure” before it begins to operate. For example, a fast-food franchise needs real estate, stoves, refrigerators, and telephones. At TOMIC, you need hardware (computers, Internet connections, and telephones), software (trading software and a plan), and working capital in order to operate. For TOMIC to execute its functions (trade selection, risk management, and trade execution), it needs to have a set of supporting functions in place. The supporting functions allow you to operate TOMIC successfully. These functions are divided into trading plan, trading infrastructures, and learning processes. Table 1.2 shows an outline of the supporting functions and their important processes.
Table 1.2. TOMIC Supporting Functions
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Trading Plan |
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a. Trade goals |
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b. Markets to trade |
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c. Strategy selection parameters |
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d. Risk management checklist |
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e. Entry/exit plans |
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f. Checklists |
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Trading Infrastructure |
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a. Broker |
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b. Execution software |
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c. Analysis software |
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d. Portfolio margin |
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f. Information sources |
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g. Risk capital |
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Learning Processes |
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a. Trading journal |
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b. Trading group |
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c. Trading coach |
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d. Continuing education plan |
The trading plan is the operational plan of a traditional insurance company. The trading plan specifies trade goals, the markets to trade, the strategies, the risk management parameters, and the entries and exits. The trading plan is the operational guideline for the manager of TOMIC. It describes the parameters in which TOMIC should operate.
The trading infrastructure is the collection of brokers, execution software, analysis software, information resources, portfolio margin, and risk capital.
The learning processes are a set of habits TOMIC needs in order to continuously improve its business. This function contains a trading journal, a trading group, a trading coach, and a continuing education plan.
In this chapter, we provided you with an overview of the insurance business, and we showed you how TOMIC is just like a traditional insurance company. In the subsequent chapters of Part I, we discuss in detail each of the primary functions and support functions of TOMIC’s value chain.