How do insurance companies profit?
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They charge more for policies than they pay out in claims.
Insurance companies have teams of number crunchers called actuaries who determine what they need to charge for insurance policies based on various factors. For example, with car insurance they look at the driver’s age, gender, address, marital status, vehicle use, past driving record, along with type of car, cost of car, cost to repair the car, etc. to determine cost for auto coverage.
in the past, similar questions typically ask about life insurance… the answer there is that most life insurance sold is term life insurance, which covers for a specific period of time. So one might buy a 30-year policy when they buy a house with a 30-year mortgage, doing so at age 30 so it covers them from ages 30 to 60. Since most people don’t die during that time frame, the policies can be affordable since only like 5 or 10% of people die and the policy pays out.
Two ways
Underwriting. You insure 100 people’s car. You expect there to be 10 crashes a year. You charge them each 11% the cost of a crash, so you have money to pay for 11 crashes. After paying off the crashes, you have money left over
Float. You charge people insurance at the begging of a 6 month period. Crashes happen over the 6 month period, so you have 3 months worth of money that your customers have paid and have not been used to pay for the crashes. You earn money from investing that float.
It’s a numbers game.
You match your insurance rate so that the sum you collect from the people is enough to cover the % people who will file a claim.
You want a ton of people so that there is less variance, and if these people are likely to file a claim you’ll bump up their rate (iE young drivers are more likely to cause a car accident so their rate tends to be higher)
And most importantly, insurance doesn’t sit on the money. Insurance invests it, it uses the capital raised to invest what it got and uses the returns to pay claims and salaries.
They have good statistics, and based on those statistics, they try to guess how much it will cost to insure all the cars that they have policies for.
Vyer simplified, if they insure a thousand identical cars, and ten of them are totalled in a traffic accident every year, then all the insurance policies will have to cost the thousand owners TOTALLY about the same as it would cost to purchase ten new cars. And some extras, because this is a money making game.
The problem is just that they are NEVER that simple in their calculations.
If you insure against theft and vandalism, it all suddenly matter a lot where you live. It will be cheaper far off from the major cities, and more expensive in…problematic suburbs.
If you insure against damage on other vehicles in traffic…it will depend a lot on your annual mileage.
Want to insure against a drivetrain issue with the car? Will depend on vehicle age and annual mileage. And costs of some types of repairs on the car.
Own something VERY uncommon that, if it happens to need body work will require MONTHS of waiting time…then they are going to have to provide you with a rental for months too…and that will be taken into account.
Is it a historical car? Maybe the policy will require that you also own a daily commuter car, OR it will cost extra.
They also take into account age of the owner. Sometimes the owners sex (because young guys tend to have a more reckless driving style, statistically speaking) comes into play. And they DEFINITELY want to know of you have had a drivers license, uninterrupted, for at least five years.
If you add all of these factors, you end up with a gambling game where the insurance company predicts that “Volvos are damn expensive to repair, but most drivers are very careful with them because they attract a certain clientele” and “we are getting more and more and more vandalism costs in that area, we have to increase the policy costs there, real soon.”
And so on.
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.
Actuaries study risk. They monitor vast quantities of statistical data to produce “actuary tables” which describe the likelihood of any number of events befalling a person over the course of their lives.
From these tables, insurance companies calculate the likelihood of a payout for certain events might actually occur, then sets policy rates such that, over specified periods of time, the company will collect more money in policy fees than it pays out to claims.
To add to the other fine answers, you can think of it as like how casinos and bookies make money. The slot machines will pay some money out, but they make sure its always less then the amount that comes in
The same way as any other bookmaker – by calculating the odds, and setting the stake to payout ratio in their favour.
Why “bookmaker” and “bet”? Because almost all insurance is, simplistically, basically just a bet between you and the company. You effectively bet a small stake (i.e your premium) every so often that something will happen – your house will collapse, say – and the insurance company bets a much bigger amount that it won’t. In the unlikely event that your house does indeed collapse within the period, you “win” your figurative bet, and get a big payout. If it doesn’t, the company keeps your stake. The thing is – the company has LOTS of information about how likely such things are, and they’ve lots of clients making similar bets all the time, so (provided they’re careful about what bets they take) basically it’s just about crunching numbers to ensure that, on average, the stakes collected from the people who “lose” will more than cover the payouts to the ones who “win”.
Insurance is unusual in the gambling world, in that few people play for fun, and most players hope to lose their bets…
You’re making a bet with the insurance company that something will go wrong and they’ll have to pay you or that nothing will go wrong and the company will collect and keep the money from you for the duration of the agreement.
As a business that wants to remain solvent they want to know exactly what they’re betting on and that you aren’t concealing anything hinky. They will also abide only by the contract conditions of the bet so as to avoid paying out for anything that does go wrong and isn’t specifically covered by the contract.
Document everything. Get all communication in writing and know the terms of the bet.
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