Insurance Industry Analysis Term Paper

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Introduction

The industry on which this paper will focus is the insurance industry, which has the NAICS code of 524133. The insurance industry is divided among a number of subsections. These subsections function roughly the same way. An insurance company identifies the risks associated with something, and then offers up insurance against the negative event. The customer pays the insurance company based on what the insurance company expects to pay out, plus whatever markup the insurance company pays. The basic premise is that if the insurance company prices risk properly, it will be profitable, but if it misprices risk, it will not be profitable.

Critical Problem

The insurance industry's critical problem is pricing risk. There are a few interesting elements, though. One is that the insurance business is heavily regulated, and that can create specific situations that challenge the firms in the industry. An example would be the uncertainty that surrounds the fate of the ACA. The ACA was passed, and insurance companies knew the operating conditions, but then then new administration has called into question if the ACA will continue to survive. This regulatory uncertainty is an issue that challenges insurance companies, because they rely on math to determine their profitability, and when there are variables where there should be certainty, such as with respect ot the legal environment, this can be incredibly challenging for insurance companies.

Importance of Solving the Problem

The insurance industry relies on mathematical equations in order to offer a product that risk averse people value. These mathematically challenged individuals fail to realize the insurance companies are a casino that always wins – they offer the sense of security at a price that allows them to know they will always come out ahead. For companies that want to minimize downside risk, insurance has a lot of value, so they pay. The reality is that the downside risk of things like fire, or natural disasters, is catastrophic in nature. Thus, businesses will typically be willing to pay to protect themselves against any type of risk that is catastrophic in nature, and it is this specific vulnerability that insurance companies exploit in order to earn their profits.

Changing regulations at any level of government creates a challenge for insurance companies. They run their business based on historical data that tells them the odds of certain events. Changes in regulations can change the likelihood of the events that they are defending against, the cost to insure against those events and other variables. No doubt there is fairly intense competition among the major insurance companies, but overall those companies are not hurting for business. The real threat comes from changes in legislation that might change the math upon which insurance companies rely to establish their pricing. When pricing is misaligned with risk, insurance companies cannot profit.

Central Theme

The central theme of this paper is to examine profitability in the insurance sector, relative to the different drivers of profitability that exist. Elements like market structure, conduct and profitability will be discussed.

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Importance of Resolving the Problem

Uncertainty is basically the enemy of the insurance industry, which creates an imperative to resolve the problem. The reality is that insurance companies look at massive data sets in order to set their rates. To do so requires that past performance needs to be at least a somewhat reliable indicator of future performance. In the case of many insurance businesses, this is not the case. The math relies on being able to apply numbers consistently, and that will simply not happen when there is poor data. Thus, whenever the rules change in the insurance industry, there are problems for the companies that exist in this industry. When rules change dramatically, they can result in changes to the pricing which in turn will create substantial problems for the insurance business with respect of being profitable. So there are some fairly strong reasons why it is challenging to run an insurance company.

To overcome this challenge requires some activity on the lobbying level. The reality is that the insurance business is quite mature, and the biggest gains will come through lobbying that changes the math. Everything else – mastering pricing, lowering costs, and that sort of thing, are really just incremental gains. Changing the math is what really matters.

Macroeconomic Issues

Macroeconomic issues don't matter all that much. The insurance industry, for most customers, is viewed as non-discretionary. There are certain insurance companies that do seem to be more discretionary in nature, and those would be more affected by changes in the macroeconomic environment. The macroeconomic environment is important in terms of understanding how the business will in general, though. If there is a recession, for example, that will result in fewer companies that exist, which means that fewer companies need insurance. All told, that's not good for insurance companies. So while there isn't a whole lot of non-discretionary component to insurance spending, a health economy still has its benefits.

Market Structure Conduct and Performance

The link between market structure, conduct and performance is fairly straightforward. In a monopoly, firms will generally seek to abuse monopoly to increase profits. In an oligopoly, firms will compete against each other. If there is no collusion, tacit or otherwise, firms will lose money in an oligopoly because of the strength of their competitive responses to each other. In a state of monopolistic competition, firms will typically seek to differentiate themselves from their competitors as a means of establishing a point at which they can profit. Firms in a state of perfect competition will price in line with competitors, will be unable to differentiate and thus will be unable to earn profit.

The insurance business is in a state of monopolistic competition, but has strong tendencies towards perfect competition. First, the product is basically undifferentiated. Backed by the same math, the reality is that insurance companies offer roughly the same products at roughly….....

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