How Adjusted Underwriting Profit Works

The insurance industry centers around trading undefined losses for a specified cost. It's built on uncertainty and the hope that the unfavorable events covered will not happen. If the circumstances don’t happen, the insurers profit from the underwritten business (the sale of new insurance policies, and if the events happen, they must draw from the revenues received. The profit of an insurance company is then a measure of the management’s accuracy in predicting the times and the likelihood of the specified incidences.

The term ‘underwriting' refers to the receipt of payments or fees in exchange for the company’s readiness to compensate for potential risk. Insurers are underwriters, and they come up with a price that would sufficiently compensate customers for the insurable risks. The company then makes money from the sale of insurance policies to new customers or the renewal of policies by existing clients.

So the adjusted underwriting profit, also called the underwriting gain, is the sum of the proceeds an insurance company nets by adding the capital gains from its investments and the premiums paid out, then subtracting its expenses and the claims it pays out on its policies.

Adjusted underwriting profit = (Returns on Premiums + Premium Payments) – (Expenses + Insurance Claims)

Insurance Claims and Expenses

In the insurance business, claims are the formal requests that customers make to insurance companies seeking payment after an event that the insurance policy covers. Insurance companies incur expenses from paying employee wages, utilities, advertising, and commissions paid to the sales force.

Before paying out the claims, the insurance company must first review their validity. If the claim is legitimate, the company pays the compensation to the insured customer or the requesting party. The requesting party is the individual or institution that seeks compensation on behalf of the insured.

An insurer’s income fluctuates with the occurrence of events for which it ensures its customers. Accidents and natural disasters like fires, road accidents, hurricanes, earthquakes, and other unforeseen incidences increase the number of claims made. If the claims and expenses exceed the revenues received, the insurance company runs into a loss.

Adjusted Underwriting Profit Real-Life Example

Suppose a company has 600 customers who pay $2000 insurance premiums every year. The insurer invests the money received in bonds and received 10% returns. The total premiums received are $1,200,000. The returns on premiums are 10% of %1,200,000, which is $120,000. The claims paid out are $700,000. And the expenses are $100,000. Insurance companies calculate their adjusted underwriting profit using the formula below:

Adjusted underwriting profit = Returns on Premiums + Premium Payments – Expenses – Insurance Claims

Using the given values, the adjusted underwriting profit would be as follows:

$1,200,000 + $120,000 - $700,000 - $100,000 = $520,000

But, the company could still make a profit even if the claims are 100% of the premiums, although it’s unlikely that claims would ever exceed the premiums. The company would still profit from the income received in the form of the returns on the investment premium. Let’s assume that the same company above pays out 100% of the total payments received:

$1,200,000(Total premiums) - $1,200,000(claims) - $100,000(Expenses) = -$100,000

But, the company still makes a profit from investing the premiums received:

$120,000 (Investment profit) - $100,000 (Expenses) = $20,000

The company would still have an adjusted underwriting profit of $20,000.

Adjusted Underwriting Profit vs. Operating Profit

It's easy to confuse adjusted underwriting profit and operating profit. The two terms are similar in definition, and the only difference is that they refer to profits reported in different types of companies. Operating profit is similar to adjusted underwriting profit, except that the latter is specific to insurance companies while operating profit applies to all kinds of industries.

A company calculates its operating profit by adding all the gains from its business activities in a given period after paying for its variable costs such as claims, payments, taxes, and interest. The definition excludes gains made from certain earnings like the company's investments.