Insurance Q&A: “How do insurance companies make money?”
You know, dough, clams, bacon, cheddar, moolah…ever wonder how insurance companies are able to advertise nonstop and hire the top athletes in the world as spokespeople?
You might be really surprised by the answer.
But first a little background.
An Insurance Policy Is a Contract
- An insurance policy is basically a promise
- Between you and the insurance company
- To pay for any covered losses you incur
- In exchange for an upfront premium
An insurance policy is a contract, or a promise, between the insured (you) and the insurer (insurance company).
The insurance company collects a premium from you for the issued policy and agrees to pay for any covered losses you suffer.
It sounds like a pretty simple business model for earning money, but can be quite complicated and expensive to operate.
Ultimately, insurance companies are like any other business in the world. They have to make a profit to stay in business.
There are two basic ways this can be accomplished. They can earn underwriting income, investment income, or both.
Underwriting Income: Premiums Collected vs. Claims Paid
- This is the basic way of looking at the business
- An insurance company basically strives
- To collect more in total premium dollars
- Then they pay out in total insurance claims,
- Also have to consider operating costs
Underwriting income is derived from the difference between how much money is collected for all policies sold versus how much money is paid out in insurance claims for those policies in any given time period.
For example, Insurer “A” may collect $1,000,000 in premium for polices issued or renewed in a given year.
If they pay less than $1,000,000 in claims, they have made a profit. If they pay more than $1,000,000 is paid in claims, they suffer a loss.
Fortunately, insurers have a unique way to earn massive amounts of additional profit.
Unlike many other types of businesses, insurance companies collect huge sums of cash throughout the year and may not have to pay on claims on those policies for many years or ever.
This differs from a traditional business that buys and sells goods, where they must pay upfront for inventory and then need to recoup their costs via a sale.
Investment Income: When They Put Your Dollars to Work
- This is perhaps the real moneymaker for insurance companies
- Similar to financial institutions that hold onto your money like banks
- Insurance companies will invest the premium dollars they hold
- In the hopes of turning an even bigger profit on Wall Street
This unique situation allows insurance companies to invest that money while it’s not being used. Huge profits can be reaped, or lost, as a result.
This is exactly why Warren Buffet formed the Berkshire Hathaway Insurance Company…so he could generate capital to invest in the stock market.
In fact, insurance companies can knowingly charge too little for insurance policies and plan for an underwriting loss if they believe they can make a profit from investing the money they receive before having to pay claims.
In the early 2000s, when the stock market was booming, this was a common practice.
On the flip side, insurance rates may be raised to make up for stock market losses.
Additionally, some insurance companies may enter a new line of insurance or a new state and intentionally charge less than their competitors, causing an underwriting loss, simply to make a name for themselves.
Then the following year, raise their rates and hope to hang onto some of the business they wrote, typically because customers don’t take the time to argue, comparison shop, or even take notice.
Now you should have a better idea as to why insurance is such big business. Aside from turning a profit on the policy itself, insurers can deploy massive amounts of capital into the stock market and elsewhere for exponential returns.
This is the beauty of the insurance model – taking cash upfront before having to pay a claim in the future (or never) means insurers can put your money to work for them immediately.
And they’re smart enough to know exactly how to invest that money for the best returns. But if things don’t pan out, they can just charge you more for insurance coverage in the future.