How do insurance companies profit?
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The total premiums paid will be higher than the amounts they need to pay out over a period of time. While any given policy may payout before its paid in enough to cover the cost, on average there will be more policies paying in than paying out.
Mathematically, though this is extremely simplified to the point of being incorrect, you can think of this as follows.
If I know there is a 1% chance per month (or 1 in 100 months) that something will happen that will make me pay $1000, I know I need to put away *about** $10 per month to cover it. As such, I could offer to insure somebody against that happening for $10/month and *probably* not lose money. Now, I might get unlucky, and I have to pay out the very first month, losing $990, but I also might get lucky and it doesn’t happen for 200 months, making a profit of $1000.
If you make that same deal to enough people and keep it going for a very long time, it will all come out to about a wash and I’ll neither make nor lose money. I can even better average it out if I work in multiple types of risk. I could, say, issue both car insurance and home insurance polices as there is lower risk that both types will need to pay out due to the same action.
I can also charge a slight premium, say $1/month for a total of $11/month, for taking on the risk that I’ll lose money in the short term due to bad luck, which turns into profit for me. The other party wins because they are reducing their risk of having to pay out $1000 in exchange for that $1/month extra charge.
The entire system of insurance revolves around actuaries whose entire job is to calculate risk and how much needs to be charged to breakeven on the risk itself. Then various accountants and business people will figure out how much it costs to maintain what is needed for writing the policies, figuring out which policies need to be paid how much (claim adjusters), lawyers to enforce contracts, and all the other overhead of the business and add that to the policy cost. Then they will add on how much they want to take as profit beyond that.
* Its more complicated than this as a 1% chance per month event can mean a few things, so the actual price needs to be different than 1/100 the policy limit. These numbers just make it easy to understand.
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