We all know that the insurance industry has a bright future and insurance companies are very profitable. So where does the net profit of the insurance company come from? It comes from within the remaining margin.
What is the residual margin? The residual margin is the present value of the policy's profits in future years. Calculation formula:
Residual Margin = Discounted Value of All Annual Premiums of the Policy – Discounted Value of All Annual Expenses and Claims Expenses of the Policy
According to the prudential principle of accounting, the residual margin will not be reflected in a lump sum on the first day of the policy, but will be released year by year, which is the core of the net profit of the insurance company**. The chart below shows the profit model of an insurance company.
If you only talk about theory, it may be more complicated, and you may not be interested. Let's take a look at some examples.
Let's say there is company A, and high-net-worth person B, and they enter into a loan agreement. B borrows 1 million yuan to company A, the interest rate is 3%, the term is 10 years, and the repayment method is to repay the interest of 30,000 yuan per year, and repay the interest and principal of the last year after maturity.
Company A received a loan of 1 million yuan to invest in a project with a yield of 5%, and received 50,000 yuan per year, and recovered the income and principal of the last year after maturity.
Therefore, from the perspective of cash flow, Company A is equivalent to an empty glove white wolf, with a net income of 20,000 yuan per year and a cumulative net profit of 200,000 yuan in 10 years. However, 200,000 yuan in 10 years is obviously different from the current 200,000 yuan. How much is 200,000 yuan in 10 years equivalent to now?
Using different discount rates, the calculation results are different, we use the discount rates of 4% and 5% respectively, see the table below.
As can be seen from the above table, if the discount rate is calculated at 4%, 200,000 yuan in 10 years is equivalent to 16220,000 yuan, calculated at 5%, equivalent to 15440,000 yuan.
Cash flow is discounted from the future to the present, which is called the discount rate. Cash flow is calculated from the present to the future and is called the expected return on investment. The two are inverse operations of each other.
If a third party wants to buy this asset, what is the right price to buy? If the person's expected return on investment is 5%, it will take 15440,000 yuan is the most reasonable purchase. Anything above this will not achieve the expected return on investment of 5%.
In fact, the company needs to keep a part of the working capital for its operations, so how much capital (called "reserves") does company A need to keep to repay the principal and interest of B?
We still use the discount method to calculate and discount future expenses to the present. Please note here that the reserve is not placed in a bank account, the reserve has investment income, and this rate of return is the discount rate. We use the discount rates of 4% and 5% to calculate as follows:
Discounted at a discount rate of 4%, the discounted value of future expenditures is 91890,000 yuan. Discounted at 5%, the discounted value of future expenditures is 84560,000 yuan. This sentence can be expressed in another way, in order to cope with the repayment of debt and interest in the next 10 years, Company A needs to prepare 91 at present in the case of 4% investment yield$890,000 in cash. In the case of a 5% return on investment, it is currently necessary to prepare 84$560,000 in cash. This sentence is very important, and in order to understand it, we work backwards on future cash flows with a 5% return on investment. As shown below:
As shown in the table above, Company A received $1 million in cash, but in fact only needed to prepare $84$560,000 payable for future interest and principal expenses, the difference of 15440,000 yuan is the discounted value of Company A's future profits.
You may want to ask, how can Company A ensure that the annual rate of return is 5%? What if it's not enough? In order to prevent default, Company A then drew reserves at a discount rate of 4%. As a result, the cash of 1 million yuan received by Company A can be expressed in the form of the following:
In the image above: A:8110,000 yuan, free funds, is the present value of future net profits.
b：7.330,000 yuan, risk reserve, when the expected investment rate of return is not reached, the risk reserve is used to repay the interest and principal.
c：84.560,000 yuan, a reasonable estimate of the debt, the discounted value of the interest and principal to be paid in the future, and only need to prepare so much cash at present.
In this case, Company A is the insurance company, and HNWI Person B is the policyholder, as shown in Part A of the above diagram, i.e., 8110,000 yuan is the residual margin, and the net profit of the insurance company mainly comes from this.
This case is a simplified situation, i.e., a lump sum payment of premiums. In insurance practice, premiums are often paid periodically, i.e. on an annual basis.