How do insurance companies profit?
In: 2
https://www.investopedia.com/ask/answers/052015/what-main-business-model-insurance-companies.asp
“Insurance companies base their business models around assuming and diversifying risk. The essential insurance model involves pooling risk from individual payers and redistributing it across a larger portfolio. Most insurance companies generate revenue in two ways: Charging premiums in exchange for insurance coverage, then reinvesting those premiums into other interest-generating assets. Like all private businesses, insurance companies try to market effectively and minimize administrative costs.”
More money is paid in to policies than is paid out, and they do everything they can to deny claims to policyholders if at all possible to keep as much money as they can. Also they use a significant chunk of their capital to invest and grow the value.
Statistics and laws.
There is probably no greater repository of statistical data than what is held by the insurance companies. So using those statistics, they figure out the likelihood of various events, how much it would cost to recover from those events, divide that by the number of policy holders they have, and set their rates and policies accordingly to ensure that they make a profit on whatever they insure. Additionally, most jurisdictions require people to hold an insurance policy on certain types of property (cars and homes, for example), so insurance companies are guaranteed customers.
To give a concrete example with made up numbers:
The data they have tells them that an auto accident will cost them, on average, about $25,000 to cover. They have 3 million auto insurance customers. Of those, 1% will be involved in a qualified accident. So they will have expenses of $750,000,000 every year to cover those accidents. So to break even on covering their insurance customers every year, they need to charge each of them *at least* $250/year. They decide that they would like to make a 50% profit margin, so they charge each customer $500/year and take $750 million in profits.
In reality it’s more complicated than that, and many jurisdictions specify by law how much profit they’re allowed to take. But that’s the basic rundown: Figure out how much it costs you to service your policies, and then charge enough to make sure you always make a profit.
The insurance company, based on historical data and probabilities, estimates how much money they’d have to pay out for any given event among their customer base and how frequently those events happen. They charge their customers a monthly rate to pay for those expected “losses”, plus extra for profit.
The customers get the peace of mind that, should the worst happen to them, they will get compensated by the insurance company.
The insurance company gets a very steady income, with hopefully small and infrequent payouts.
There are way more people paying for insurance who don’t end up needing it, than there are people who actually need it.
Simplified example: There are 100 people in a city. Each person has $100. Every year, 1 person on average has their house randomly burn down, causing them to lose all of their $100. The insurance company says “if you give me $2 this year, I will give you $100 if your house burns down this year.” Everyone in the city agrees to this deal, so each person pays the insurance company $2.
The insurance company collects $200 that year, but if only one person has their house burn down, the insurance company only gives $100 back, so they make $100. However, if there are two fires in a year, the insurance company doesn’t make any money. If there are three or more fires, the insurance company loses money.
Insurance companies basically look at the statistics of how often people get into accidents and how much money they need, then charge their customers enough that on average they make more money than they give out. But if there are more disasters than they predicted, they can go bankrupt because they run out of money to give back to people.
They use a lot of math to guess how much they will have to pay out to each customer, then they charge everybody more then that
two ways.
1. They bring in more in premiums than they pay out in claims and expenses.
2. This is common for most large insurers. They invest the money you pay in premiums and make money from investments. Most large insurers have a combined ratio “premiums/(claims + expenses)” of 1.01-1.03 That is for every $1 they get in premiums they spend $1.03 dollars on claims and expenses. This is why you often get a small discount if you pay everything up front. This gives them more time to make money on the money you sent them
EDIT: auto correct mangled the first one
They are gamblers.
Insurance doesn’t make sense with just one person. It’s a bad deal. For the insurance company to profit, you would KNOW that they are charging you more than it would take to pay for the disaster. In that case, you’re better off saving the money yourself.
Now divide that across 100 people. Let’s say the numbers indicate over a year, ONE of those 100 people is going to have a car accident that costs $4500 to deal with. If each individual person has to cover that risk for themselves, they have to put $375/month into savings to cover it. But if we divide that over 100 people, the insurance company breaks even if they charge all 100 people $3.75/month. In reality, they might charge more like $6/month. That means they make 6 * 100 * 12 = $7200, and the statistics indicate they only need to pay out $4500 of it to claims. That’s a profit of $2700.
Further, the accident happens *later*. The insurance company can invest the money they’ve taken. That’s more profit, and the people paying for policies aren’t entitled to that.
This goes poorly if there is bad luck, and, say, 5 people get in an accident. Then the insurance company has to pay out more than they expected. In reality, the factors mitigating this are:
* Insurance companies have thousands or millions of customers. The more people are in “the pool” the more accurate the statistics become.
* Usually if something goes way outside of expected statistics, it’s because of a disaster like a hurricane. Governments tend to give people aid in those scenarios and, because of that, many insurance policies limit their coverage when those events happen. (You can get more coverage, but you have to pay them more to deal with the higher risk.)
The only exception is excess deaths due to some mysterious cause over the past few years. For some reason, life insurance companies are seeing claims rise by 10% and sometimes even as high as 40% over the last 3 years. Nobody knows what could be accounting for all of these extra deaths, but their previous bar for “catastrophic financial loss” was around 5% above their expected rate. It’s a real big mystery and we’re working hard to do nothing about it, if it sinks their company then they made bad individual choices.
Answer: Usually, the things they cover have been studied. How often they happen. Who they happen to. How it happens. How much does it cost to “make up for” it when it happens (replace stolen item, burned-down house, wrecked car), etc.
People who are good in a maths called Statistics and who research such things set how probable (“probability”) that those things will happen, and price insurance to cover folks for those things. If they did their jobs right, out of all the people who have insurance, only a small percentage will ever have those things happen to them, and an even *smaller* percentage will have to be paid out for them.
What happens to the money paid by all the *other* people who *didn’t* suffer any losses or make any insurance claims? The company keeps the “extra” payments (“premiums”) as profit, after paying people in the company, and other insurance companies that cover *them*.
Insurance companies adjust their pricing/models to ensure that, generally, the premiums they collect are greater than the costs incurred by the policies (claims, operating costs etc).
So, to create a simple example, say you insure 1000 $20k cars, on average 10 out of 1000 will get totaled and it’ll cost $50k to administer those policies.
If you were to charge $400 for each of those 1000 cars to be insured, your revenue would be $400k, your claims payouts would be $200k (the 10 totaled cars) and you’d spend another $50k administering the policies, leaving $150k in profit.
Now, I said “generally” in the first paragraph because there are, of course, instances of black swan events that cannot be accounted for through modeling. This is where reinsurance comes in – insurance companies insuring other insurance companies. Since your question wasn’t about reinsurance, I won’t go into the details, but I did at least want to mention it given the context.
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