We pay monthly premiums so that if our property is damaged or stolen, then we can claim for a cash injection to replace these items. In the case of life insurance, we pay our instalments to ensure that our loved ones will be left with enough money in the unfortunate event of our passing. While we all have a good idea of how insurance works and why it is needed, the question is, how do insurance companies make money?
Picture a scenario where you have only paid one premium on your house insurance policy and then suddenly, your geyser bursts and floods your home and you need to claim for £1000 worth of damages. How would your insurance company make a profit from what looks like a considerable loss?
If you delve into the structure and objectives of an insurance company, this question is easy to answer and you might find the details quite interesting. If you weren’t already in the loop, you could be surprised to find that stable insurance providers make millions if not billions in profit annually!
Before we find out exactly how the money is made, it’s important to know that not every insurer makes a profit using the same method/s. There are three types of insurance companies and each of these companies generates their profits differently.
There Are Three Types of Insurance Companies
While the insurance industry is very complex, it can generally be divided into three basic types of insurance businesses:
- Commercial insurance companies. These are usually corporations where investors pool together to start the company and then make profits from the premiums gathered. It’s not uncommon for a commercial insurance carrier to charge higher premiums than insurers who fall into a different category.
- Mutual insurance companies. This type of insurance company is jointly owned by its customers. The main objective of a mutual insurance company is to provide insurance coverage for its members (policy holders), and the members are given the right to select the management thereof. This type of insurance company is expected to return unused premiums to its policy holders/members in the form of dividends.
- Underwriting insurance companies. These insurance businesses provide additional or high-risk cover, usually through intermediary companies. Underwriters usually work directly with smaller insurance brokers by supplementing cover that the broker might not be able to provide. For example: If your business needs to take out £10 million in liability insurance, your broker may only be able to cover £5 million of that liability. He will then supplement his own coverage with additional coverage from a larger Underwriting Insurance company, which then underwrites the additional risk.
How Do These Insurance Companies Make A Profit?
Each of the insurance industries listed above can make a profit in one of two ways (or they can implement both strategies). These methods and strategies include:
- Underwriting your risk and then charging an applicable premium for the risk that they are willing to deal with.
- Investing premiums into the correct stock markets with the intention of generating a profit from this investment.
The first method requires that the insurance company charges more in premiums than it will ever have to pay out in claims. This means that individual premiums are increased to cover the collective risk or more policy holders are acquired to cover the total risk and more. However, because the insurance markets are extremely competitive, the insurance carriers cannot charge unreasonable premiums. This is reassuring to the consumer who, of course, does not want to fall victim to extortionists.
All the premiums are then pooled together and collectively they outweigh any risk that the insurer might be faced with.
Underwriting can be a very difficult concept to grasp, in fact, there is a whole science devoted to the topic and it is commonly referred to as “actuarial science”. Actuarial science uses statistics, math and probability to determine the possibility of risk occurring.
The second method that insurance companies often make use of to generate a profit is by investing their funds into different stock markets and accounts. Money that comes into the company in the form of premiums but isn’t being paid out in claims is referred to as the “float” money. The insurers invest this float money into numerous different opportunities such as the stock market, mutual funds, bonds, securities and alternative forms of investment options.
In essence, we can conclude that insurance entities generate a profit by selling insurance for more than the risk it needs to cover. It can also be considered as the process whereby the insurer temporarily borrows money from its policy holders with the intention of using it for their own investments. This money is borrowed with no interest attached to the transaction, making it an ideal way to acquire money.
What is interesting to consider is that even an insurance company needs to have insurance in place. This is because insurers can make bad investments which could incur a loss. If the company has enough liquidity and asset value to cover the investment losses whilst still covering customer claims, it will continue to operate as usual. If, however, the bad investment leads to bankruptcy with no other options of recuperating losses, then the insurer may need to seek assistance from a backer. A backer could be a bank or a large-scale multi-billion corporation that purchases a percentage of ownership stakes in the entity. It is also possible that another, larger insurance company buys the smaller company and takes on all of its liabilities (customers and customer policies).
No matter which way you look at it, there is huge money to be made in the insurance industry. For an insurance company to be a success, however, it needs to be strategic in its dealings and the directors need to have extensive knowledge on where the money is coming from as well as how, when and what it will be invested in.