Insurance companies make money by betting on risk: the risk that you don’t die early and make the insurer pay, or the risk that your house doesn’t burn down or your truck isn’t destroyed in an accident.
The concept that drives the revenue model of insurance companies is a business agreement with a person, company or organization in which the insurer agrees to pay a specific amount of money for the loss of a specific asset by the insurance company. of the insured, generally for damages, illness or in the case of life insurance, death.
Reading: How do insurance companies afford to pay out
In exchange, the insurance company receives regular (usually monthly) payments from its client, 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 any loss suffered by the insured across a variety of asset spectrums, in exchange for smaller, regular payments made by the insured to the company of insurance.
The promise is based on an insurance contract, signed by both the insurance company and the insured client.
That sounds pretty easy, right? but when you look at how insurance companies make money, i.e. get more revenue than they pay out, things get more complicated.
Let’s set the record straight and examine how insurance companies make money, and how and why their risk-based revenues have proven so profitable over the years.
how insurance companies make money
Because an insurance company is a for-profit company, it has to create an internal business model that collects more money than it pays out to clients, taking into account the costs of running its business.
To do so, insurance companies build their business model on twin pillars: underwriting and investment income.
subscription
For insurance companies, technical revenues come from cash collected for insurance policy premiums, less money paid for claims and for operating the business.
For example, let’s say ABC Insurance Corporation earned $5 million from the premiums paid by customers for its policies in one year.
Let’s also say that abc insurance corp. it paid out $4 million in claims in the same year. That means on the underwriting side, ABC Insurance made a profit of $1 million ($5 million minus $4 million = $1 million).
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make no mistake, insurance company underwriters 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 that a potential customer actually qualifies for an insurance policy. The applicant is thoroughly vetted, and key metrics such as health, age, annual income, gender, and even credit history are measured, with the goal of arriving at a level of premium cost where the insurance company gains the greatest advantage from the point of view of insurance. of risk.
That’s important, as the insurance company’s underwriting business model ensures that insurers have a good opportunity to earn extra income by not having to pay for the policies they sell. Insurance companies work very hard to analyze the data and algorithms that indicate the risk of having to pay for a specific policy.
If the data tells them the risk is too high, the insurer either won’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 policy to a client, knowing that their risk of paying for that policy is comfortably low.
what differentiates insurance companies from traditional companies. An automaker, for example, has to invest heavily in product development, paying money up front to build a car or truck that consumers want. they only recover their investment when they sell the car.
That’s not the case with an insurance company that relies on the subscription model. they put no money up front and only have to pay if a legitimate claim is made.
investment income
Insurance companies also make a lot of money through investment income.
When an insurance customer pays their monthly premium, the insurance company takes the money and invests in the financial markets to increase their income.
Because insurance companies don’t have to invest money to build a product, like a car manufacturer or a cell phone company, there is more money to put into an insurer’s investment portfolio and more profit for the companies insurance.
That’s an excellent money-making proposition for insurance companies. An insurer collects money up front from clients, in the form of policy payments. they may or may not have to pay a claim on that policy, and they can put the money to work for them right away, earning investment income on wall street.
Insurance companies also have a way out if their investments go wrong: they simply raise their premiums and pass the losses on to clients, in the form of higher policy costs.
It’s no wonder Warren Buffet, the sage of Omaha, invested so heavily in the insurance industry, buying Geico and opening his own insurance company, Berkshire Hathaway Resurance Group.
See also: Health Insurance: Understanding What It Covers – familydoctor.org
buffet knows a sure thing when it sees it.
other ways insurance companies get ahead financially
While underwriting and investment income are by far the largest sources of income for insurance companies, they also have other avenues to profit.
cash value write-offs
When consumers who have whole life insurance plans discover they have thousands of dollars in “cash values” (generated through investments and dividends from insurance company investments), they want the money, even if it means closing the account.
Insurance companies are happy to oblige, in the 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 client with the interest earned on their investments and keeps the remaining cash.
In that sense, cash value payments are actually a financial windfall for insurance companies.
expiry of coverage
Too often, consumers don’t keep up with their insurance policies, setting off a profitable scenario for the insurance company.
According to the insurance policy contract, the expiration of the policy means that the policy itself expires without any claim being paid. In this situation, the insurance companies charge again, since all the previous premiums paid by the client remain with the insurer, without the possibility of a claim being paid.
That’s another cash windfall for insurers, allowing the consumer to bear all the risk of keeping an active policy and walk away with the money if the customer goes over the coverage schedule or doesn’t keep up with payments. of the cousin.
The bottom line on how insurance companies make money
Insurance companies have undoubtedly rigged the system to their advantage and continue to charge as a result.
Industry data shows that for every 100 insurance customers who pay their premiums each year, only three of those consumers file a claim. Meanwhile, the insurance companies take all those premium payments and invest the cash, increasing their profits.
With the field tilted significantly in their favor, insurance companies have a clear path to profit and they take that path to the bank every day.
It’s been a recipe for financial success for hundreds of years and will continue to be the same well into the future, and there’s not much the average insurance customer can do about it except keep paying their premiums and hope for the best.
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