Eli5: How does insurance work ? How is it a good deal for both the customer and the company ?
In: Economics
One rarely discussed factor in insurance companies is that it’s also an investment business.
If your insurance company takes $100 in premiums in a year, you design it so that you will pay out about $85 on average per year. It costs you about $20 to run the company, salaries, sourcing replacement goods, dealing with subcontractors and so on. That’s $105 in total. But because you pay the $85 out at different times, you can also invest the $100, and it returns $110 over the year. So you make $5 for doing absolutely nothing. A lot of competitive insurance markets end up working this way, where the actual profits come from investment returns.
One other interesting thing is reinsurance. This is basically insurance for insurance companies – they buy a policy from a special reinsurance company that says that they will pay the first $5m of any claim, but anything over that is paid by the reinsurer. This means that they’re protected from the really huge losses that do arise from time to time.
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