HOW DO INSURANCE COMPANIES MAKE MONEY?
Insurance companies make money by betting on risk – the risk that you won’t die before your time and make the insurer pay out, or the risk your house won’t burn down or your SUV won’t be totaled in a crash.
Insurance companies make money by promising to pay a certain amount of money if an insured loses a certain amount of money because of damage, illness, or death. This is called a “claim,” and it’s what drives the insurance model.
In return, the insurance company is paid regular (usually monthly) payments from its customer, for an insurance policy that covers life, home, auto, travel, business, and valuables, among other assets.
Basically, the insurance contract is a promise by the insurance company to pay out for any losses to the insured across a variety of asset spectrums, in exchange for regular, smaller payments made by the insured to the insurance company.
The promise is cemented in an insurance contract, signed by both the insurance company and the insured customer.
That sounds easy enough, right? But when you get down to how insurance companies make money, i.e. earn more revenues than they pay out, things get more complicated.
Let’s clear the air and examine how insurance companies make money, and how and why their risk-based revenue has proven so profitable over the years.
As an insurance company is a for-profit enterprise, it has to create an internal business model that collects more cash than it pays out to customers, while factoring in the costs of running their business.
With these two things in mind, insurance companies build their business model on two things: underwriting and investment income.
For insurance companies, underwriting revenues come from the cash collected on insurance policy premiums, minus money paid out on claims and for operating the business.
For instance, let’s say ABC Insurance Corporation earned $5 million from the premiums paid out by customers for their policies in a year’s time.
The same year, ABC Insurance paid out $4 million in claims. That means ABC Insurance made a profit of $1 million on the side of the business that deals with insurance claims.
Insurers go to great lengths to make sure the financial math works in their favor.
The entire life insurance underwriting process is very thorough to ensure a potential customer actually qualifies for an insurance policy. The applicant is vetted thoroughly and key metrics like health, age, annual income, gender, and even credit history are measured, with the goal of landing at a premium cost level where the insurance company gains maximum advantage from a risk point of view.
That’s important, as the insurance company underwriting business model ensures that insurers stand a good chance of making additional income by not having to pay out on the policies they sell. Insurance companies spend a lot of time analyzing the data and algorithms that show how likely it is that they will have to pay out on a certain policy, and they do it very well.
If the data tells them the risk is too high, an insurer either doesn’t offer the policy or will charge the customer more for offering insurance protection. If the risk is low, the insurance company will happily offer a customer a policy, knowing that its risk of ever paying out on that policy is comfortably low.
That sets insurance companies far apart from traditional businesses. An auto manufacturer, for example, has to invest heavily in product development, paying money up front to build a car or truck that consumers want. They only recoup their investment when they sell the car.
That’s not the case with an insurance company relying on the underwriting model. They put no money up front, and only have to pay if a legitimate claim is made.
There are a lot of ways that insurance companies make a lot of money, too.
When an insurance customer pays their monthly premium, the insurance company takes the money and invests in the financial markets, to increase their revenues.
Insurance companies don’t have to put money down to make a product, like an automaker or a cell phone company. This means that insurance companies have more money to invest and make more money.
That’s a great money-making proposition for insurance companies. An insurer gets the money up front from customers, in the form of policy payments. That policy may or may not have to be paid off, and they can start making money on Wall Street right away.
Insurance companies, too, have a way out if their investments go bad. They raise the prices of their premiums and pass the costs on to their customers in the form of higher policy costs, which they then pay for.
It’s no wonder that Warren Buffet, the Sage of Omaha, invested so heavily in the insurance sector, buying Geico and opening its own insurance firm, Berkshire Hathaway Reinsurance Group.
Insurers have a lot of ways to make money, even though underwriting and investment income are their main sources of income.
Cash Value Cancellations
When consumers who have whole life insurance plans discover they have thousands of dollars via “cash values” (generated through investment and dividends from insurance company investments), they want the money, even if it means closing the account down.
Insurance companies are only too happy to oblige, with full knowledge that when a customer takes cash value money and closes the account, all liability ends for the insurer. The insurance company keeps all the premiums already paid, pays the customer with interest earned on their investments, and keep the remaining cash.
All too often, people don’t pay their insurance premiums on time, which leads to a good deal for the insurance company.
Under the insurance policy contract, a policy lapse means the actual policy expires without any claims being paid out. In that situation, insurance companies cash in again, as all previous premiums that are paid by the customer are kept by the insurer, with no possibility of a claim being paid.
That’s another cash bonanza for insurers, who allow the consumer to take on all the risk of keeping a policy active, and walk away with the money if the customer either outlives the coverage timetable or doesn’t keep up with premium payments.
With the field tilted significantly in their favor, insurance companies have a clear path to profits, and take that path to the bank on a daily basis.
It’s been a recipe for financial success for hundreds of years, and will be the same going forward – and there’s not much the average insurance customer can do about it, except keep paying their premiums and hope for the best.