How does insurance companies make money? (2021)
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Do insurance companies make or lose money?

This article is written for those who want to enter the world of insurance or those who would like to have more clarity about how insurance companies make money.

Although there are variations between insurance products and insurance companies, the basic principles they use to make money are the same. 

Insurer surcharges

To provide insurance, insurers charge a surcharge, that is, the price of the insurance. You can pay surcharges in several ways, depending on the type of insurance and your preference. For example, car insurance used to be paid every six months. 

Today, many companies also allow monthly or annual payments. These surcharges constitute the money that insurers receive from their clients.

Insurer expenses

An insurer must pay under the terms of the insurance when a certain event occurs to an insured. In the case of people with insured houses, the company can pay in case of fire.

How does insurance companies make money? (2021)

In general, the maximum amount the company will pay is set out in its policy. These payments represent the expenses of the insurers.

Shared risk and big numbers

If a customer pays a $ 500 surcharge for their auto insurance, but does not have an accident, the insurer keeps the $ 500. 

Likewise, if a customer pays a $ 500 fee to insure their car and has an accident that causes $ 50,000 of damage, the insurer will pay $ 50,000 regardless of the customer paying much less.

This concept is called risk sharing. In the example above, if the insurer has 100 clients who pay $ 500 per year of surcharge, but those clients have no claims for every client who has $ 50,000 in claims, the insurer would not make or lose money.

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Every customer over 100 for one represents a profit, or every dollar charged over $ 500 represents a profit.

How does insurance companies make money?

Of course, the real world is not so orderly. However, statistics emerge on a large number of insured clients. With increasing numbers, these statistics are getting more and more accurate.

Bookings

Since claims are not filed on a regular basis, there are times when the insurer will have more money in reserve than it needs to pay claims. 

In our example above, if one in 5 people files an average claim of $ 5,000 per year, it would mean that in one year there could be five claims of $ 100 each (and other years when they will be higher). 

In this year, the insurer will have received US $ 5,500 in surcharges and will have only paid US $ 500 in claims. The additional $ 500 charged in the required amount is still a profit. 

However, the company has acquired US $ 4,500 that according to statistics they will later need to pay claims. Then the company will keep that money as a “reserve.” This money is not a profit.

Investment of reserves

The reserves of an insurer are not kept in a savings account. Instead, the insurer invests them. If the insurer has a positive return on this investment, that money would be a profit. 

So if the company makes a 10 percent return on the $ 4,500 before needing that money, it would make $ 450 in “extra” profit just by saving its reserves.

The combination of charging profitable surcharges plus the money they make from investing reserves is how insurers make money.

Selection and rejection of coverage

For the model to work, an insurer must have a way to statistically measure the risk involved in any insurance product. 

If it cannot measure this risk, an insurer cannot sell a certain product to a certain segment of the population or area. 

Also, if the company can project the risk, but cannot find a way to offer the product that covers such risk profitably, the insurer will not be able to offer the product.

For example, many companies have stopped writing home insurance policies in hurricane-prone areas, such as Florida’s coastal areas. 

In this case, the insurers determined that there are no profitable ways to offer such policies because the surcharges should be so high that few people would buy the insurance, and the risk-sharing model among many people would not work.

That’s it from us on how does insurance companies make money, let us know what you think think using the comments box below.

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