Insurance

How Insurance Firms Make Profits In Nigeria

Insurance is described by many authors as a necessary evil, and this is not far from the truth. Paying monthly, quarterly or semi-annual premiums can feel really unpleasant. No one enjoys spending money on an impalpable item like insurance. All over the world, people need a great deal of convincing to buy an insurance package. This is rather surprising, judging from the numerous benefits of insurance.

In Nigeria, the situation is more grave as many Nigerians have remained skeptical investing in the sector. When you hear the word ‘insurance’, what are the first thoughts that come to your mind? let me guess; “I’ve got too much financial obligations already, is this really necessary?” “This is too complicated, I better stick to my usual savings package” “Do these guys really pay claims?” “It’s too expensive, I cannot afford it”.

Yeah, no doubt, many understand how important buying insurance is, but only a few are conversant with the practical details of how the sector really works. And insurance agents and companies aren’t doing enough to educate the masses on the inner-workings of the sector.

In spite of the numerous challenges, the insurance industry has remained the back bone of a country’s risk management system.

This article aims to educate and inform the general public on what insurance really is, and how insurance companies make money in Nigeria.

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What is insurance and why do we need it?

Insurance is an arrangement whereby a company or a state undertakes to provide a guarantee of compensation for a specified loss, damage, injury or death in return for payment of a specified premium. In Nigeria and most Countries of the world, Insurance Companies operate in the financial services sector.

Broadly speaking, Insurance business involves an insurance company guaranteeing the replacement or repair or shorty of an asset or service that may have been damaged, impaired or defaulted under terms and conditions in exchange for a premium.

An insurance company will arrange for compensation in the event of damage to or loss of (property), or injury to or the death of (someone), in exchange for a regular fee you must have paid upfront to the company or State.

For instance, if the property is a car, an insurance company insures the vehicle against it being stolen or damaged by accident by replacing it or repairing it at no additional cost to you in exchange for the premium you must have paid in advance.

How insurance business works

In the example earlier in this thread, if the value of the insured amount is N10 million, you will normally pay a premium of N500k (5%) to the insurance company. If the car is stolen or damaged, the insurance company is obliged to pay a maximum amount of N10 million for the repair or replacement of the vehicle, depending on the type of claim.

However,

Your premium typically spans one year in duration. If you do not have any claims during the year, the insurance company will not refund any part of the premium to you.

Above is a basic overview of the business model of insurance. From an investor’s point of view, however, there is a little more to it than above. The insurance business concept as you must grasped above is a risky undertaking. For insurance companies to stay afloat and make good profit, they must undergo a proper risk assessment to ensure that the risks they are taking are not too much to run them out of business.

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So how do insurance companies make profits?

Most Insurance Companies make money in basically two ways;

  1. Net Premium Income
  2. Income from Investments.

What’s Net Premium Income?

Net premium income is the insurance company’s income from the gross premium it receives after deducting claims against it in a particular year. This is also referred to as ‘Underwriting profits’.

With reference to the earlier example above, the insurance company receives a premium of 5 percent (500k) in exchange for N10 million insurance. So assuming it agrees to insure 5000 cars worth N10 million each, it basically took a N50 billion risk in exchange for a N2.5 billion premium. They also know that all insured vehicles are unlikely to make claims throughout the year.This is also factored in their assessment of the risks.

So if they pay N1 billion claims during the year, then they are left with 1.5 billion underwriting profits.
Thus, the higher the claims during the financial year, the lower the underwriting profits and vice versa.

How insurance companies make money through Investments

Insurance companies also make money through investment proceeds. Remember that they receive a lot of money from premiums during the year in exchange for a commitment to pay claims. These premiums are also interest-free, unlike bank deposits where banks pay some form of interest on the amount deposited.

They often invest the premiums in several assets including bonds, shares, treasury bills, private equity, real estate, etc. instead of having the premiums to lay idle. The revenue derived from these investments is an addition to the net premium income ( underwriting profits).

Insurance companies around the world are often larger than banks and own billions of dollars in savings next to pension funds. For example, Warren Buffet is able to finance many of his investments from premiums earned from GEICO (an insurance company that owns several billion dollars). Premiums are strictly cash backed and interest-free, making them one of the most liquid armory needed to invest.

What about the overhead (operational) costs?

Insurance companies also carry out other huge operations. They hire and pay employees. Thus, after deducting operational costs and taxes from Underwriting Profits and Investment Income and you get a positive number, profits are actually made.

Is it possible to have an Underwriting Loss?

Underwriting losses are very common in markets where there is a lot of competition. In this situation, insurance companies offer consumers many levels of incentives to make their premium fall below what they would usually have paid. For example, the company may demand for 2.5 percent premium instead of 5 percent.

The goal here is similar to the turnover model. They believe that if they collect a lot of premium to claims at a cheap percentage, even if the claims are more than gross premium and lead to a loss, they would be adequately compensated through investment income. This is because the larger the premium (cash) the greater the investment you can make and the greater the investment income you earn that covers for the underwing loss. To them, as long as you make better than the previous year, profit at the end of the year doesn’t really matter if you make losses from underwriting.

The Nigerian Insurance Market

The Insurance Market is made up of insurance buyers and sellers along with the intermediaries (agents and brokers) who take the two together. Often, there are regulators, legislative bodies or associations, consultants and professional advisors that are also part of the market.

Buyers

A buyer is anyone with legitimate insurable interest, that is a person with legally recognized relationship with property or pecuniary interest. The relationship may occur by ownership, part-ownership, responsibility for goods, liability to pay damages or some benefits.

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The insurance buyers in Nigeria are further segmented into 14 sub groups as follows:

  1. Governments (federal, state, local) and their agencies
  2. Parastatals
  3. Multinationals
  4. Conglomerates
  5. Manufacturing industrial concerns
  6. Small and medium scale industries
  7. Banking industry
  8. Health institutions
  9. Tourist and hospitality industries, hotels
  10. Transport industry
  11. Other corporate bodies
  12. Educational institutions
  13. Oil and energy industry
  14. Individuals and families
  15. Governments (federal, state, local) and their agencies
  16. Parastatals
  17. Multinationals
  18. Conglomerates
  19. Manufacturing industrial concerns
  20. Small and medium scale industries
  21. Banking industry
  22. Health institutions
  23. Tourist and hospitality industries, hotels
  24. Transport industry
  25. Other corporate bodies
  26. Educational institutions
  27. Oil and energy industry

For marketing purposes, the buyers can be further segmented to match the insurer’s or insurance agent’s approach.

The Sellers

Insurance sellers or retailers are the insurance companies and the reinsurance firms. There are currently approximately 57 insurance companies listed and 2 reinsurance companies licensed.

Pursuant to the 1990 Companies and Allied Matters Act, most insurance companies are incorporated. Of the 57 insurance companies, about 14 underwrite life insurance. The reinsurers provide the insurance firms with technical security and capacity and do not sell insurance directly to consumers.

Insurance Agents or Intermediaries

Insurance brokers and insurance agents are mainly the intermediaries. There are 460 insurance brokers registered and approximately 15,000 insurance agents. The Nigerian insurance market has been described as the market for brokers because brokers currently control over 90% of premium income, leaving less than 10% for insurance agents and even the direct marketing channel for insurers.

Insurance agents, however, dominate the market for individual life insurance. The banking industry has become a formidable channel to distribute insurance services not necessarily as intermediaries, but through the bancassurance model, by facilitating a form of direct marketing by insurers.

Participation by banks has also thus made mass merchandizing of those insurance products feasible. To reinforce some of their financial packages, banks offer insurance coverage as additional benefits. For example, an investor is offered three to four times the amount of capital invested in the event of death, payment of benefits in the event of injury, payment of school fees for children, and insurance cover for goods purchased on credit.

In order to meet these obligations, part of the interest due to investors is used to purchase insurance from insurance companies on their behalf. This is, however different from universal banking, which infers direct involvement in insurance broking and underwriting.

To sum it all up

The best Insurance companies are measured on how much profits they make from underwriting and investments. They must have a very good risk management system and balance the need for increased net premium growth due to competition with the need to mitigate risk.

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