How Do Insurance Companies Make Money?
Ever wondered how the insurance companies make money while they still pay huge sums of money to their customers? This question crosses many people’s minds. As of 2017, there were 20 insurance companies in the Forbes 500. Moreover, Berkshire Hathaway was second on the list with a staggering $223, 604 million that year.
There are a lot more evidence that shows that these companies make millions in revenue. In this article, we will talk about the economical side of the insurance companies. We will cover the operations of these companies and try to understand how they make their millions.
Why do people get insurance? The answer is rather simple. There is a lot of uncertainty in life. Moreover, you might not be financially apt throughout your life. You would incur major losses if your car got stolen or your house caught fire. There are chances that you or a loved one could fall terminally ill. In these cases, you need insurance to help you avert these financial losses. Insurance helps to keep your financial status intact amidst crisis.
Moreover, in most countries, it is necessary to get medical and auto insurance. Hence, getting an insurance is important.
Let’s go over the basics so that we can learn more about insurance companies.
What is insurance?
In simple terms, insurance is a protection from financial loss. The concept of insurance is found in earlier times as well. It is the human instinct to minimize risk in their activities. Hence, the presence of insurance in ancient times should not be surprising. Chinese and Babylonian traders used insurance in third or second millennia BC.
The modern dictionary explains the term ‘insurance’ in this way:
An arrangement by which a company or the state i.e. the insurer undertakes to provide a guarantee of compensation for specified loss, damage, illness, or death of the insured in return for payment of a specified premiumDefinition of insurance
In modern times, sailors and merchants who sailed through treacherous waters to sell their goods across the world used insurance. Back in those days, there were chances of losing your cargo and ship due to attack from pirates or rough waters. Hence, the concept of insurance was adopted to minimize the risk.
They either distributed the cargo in numerous ships or signed contracts that worked in a similar manner as modern insurance.
Similarly, the premium that is paid these days is the fraction of the sum or value of the good that is insured. This premium is distributed in fractions and paid monthly or quarterly. This is similar to the practice of sailors in the 15th century onwards.
The Business Model of Insurance Companies
The payout by insurance companies is an expense on their account. For any business to be profitable, it is crucial to have more profit than expense. Insurance is all about risk management. Hence, their business involves risk.
Insurance companies have different policies and types of insurance that they market. The insurance premium depends on the type of policy. It can vary for different customers. The premium is calculated by involving various factors. There are a set of algorithms that are used for this purpose.
Business models of all insurance companies calculate the payout before approving an insurance request of a customer. The probability that the insurer will have to give the payout is calculated. In most cases, insurance companies approve the request. However, the insurer might decline the request if there is too much risk involved. If the request is approved, the risk is spread out along the premium payment plan.
The amount of premium payments accumulated over a year is usually greater than the amount of money that the insurance companies have to give in payouts that year. Companies invest the profit from premium payments in safe, profitable short-term assets. Insurance companies generate revenue from these practices.
Expenses such as marketing costs, commissions, salaries etc. are paid from revenues. Insurance companies check for the authenticity when a customer makes a claim for the payout. Steps such as these are take to minimize the risk of fraud involved.
How Do They Generate Revenue?
Insurance companies make money by investing the premiums they receive. Moreover, they make money from underwriting income. Difference of premium collected and the money paid when a claim is made is known as underwriting income.
Investment is a crucial part of the revenue model of insurance companies. They invest the premium in different markets and use the accrued interest to pay for expenses. Moreover, this also helps them to generate revenue. Most of these companies have a strong investment portfolio and they may either invest in low risk, fixed income opportunities or high risk, high return securities.
Why Do Insurance Companies Have Different Premium For Different Customers?
Customers who are seen as high risk by the insurers have higher premium than customers who are seen as less risk. For example, a sick person is seen as high risk. Hence, the sick person will pay more premium than someone who is healthy.
How Do Insurance Companies Set Premiums?
These companies keep record of the claim ratio every year. They calculate it by dividing the total amount of premium earned from the total expenses incurred. Hence, this helps to set the premium for coming years.
After predicting the expenses for the following year, insurance companies set a margin for profit and decide the premium. After the end of the fiscal year, companies compare predicted figures with the actual statistics. The insurers adjust premium to maximize profits.
Companies need to evaluate the premium after involving various factors.
- Auto insurance: They take in account the age and make of the car. Moreover, insurers consider the crime rate of the city as well.
- Health insurance: Insurance companies take customer’s medical information into consideration. This also includes family history.
- Life insurance: The companies consider the average lifespan of people living in a specific region.