How Insurance Companies Make Money

The world of business is one of specialization, where someone is looking to purchase something that they cannot obtain by themselves, or something that it would be more efficient to obtain from elsewhere. This happens all the time in the world of commerce and is what drives it.

So companies emerge that specialize in certain things, providing certain goods and services, which the market demands. Banks for instance provide people and other businesses with the means to raise capital through loans, and they specialize in this.

Insurance companies offer protection of capital and income streams, which is a service which if left unprovided, people’s lives would be much more uncertain and less stable. This is because there is a certain amount of risk in pretty much everything, and some of these risks can have a significant financial impact upon people’s lives if and when they do occur.

Insurable risk is indeed one that people do care about, insofar as they are willing to devote a portion of their current assets on an ongoing basis to obtain financial protection against insured outcomes.

So they enter into contracts with firms who specialize in taking on this risk for them, companies that have more significant financial resources such that these risks won’t cause financial burdens of the magnitude that it would cause the party looking to buy the insurance if they didn’t have it.

In order to make sense out of this arrangement though, the client does need to ultimately pay for the risk that is being covered, but if they can do so on a sort of installment plan, where the fee paid is enough to cover the probability of the risk happening over time, plus a little added in to provide a margin of profit to the insurance company, then both parties may benefit.

It’s About Protecting The Right Things

Now the client can now keep their risks down to an acceptable level, and they are the ones that ultimately decide how much risk they want to take on, and then can just assign the additional risk that they don’t want to take on to an insurance company, provided of course they have the resources to pay for this service.

If they don’t, well the risk just isn’t going to be managed, or perhaps they will have no choice but to bear it themselves. If someone can’t afford health insurance for instance and it is required, then this means that they will be limited in their treatment options should they require substantial health care, limited to what they can afford to pay out of their own pocket.

If they instead purchase insurance and make installment payments towards paying for these future contingencies, then they may have the benefit of these future services, whether that be repairing or replacing their car, paying off liabilities to others, getting an expensive medical procedure, seeing their family more comfortable after their death, and so on.

So that’s actually the best way to understand insurance, it is a contract to be provided with a service or other benefit at a future time, and one pays for this privilege through premiums, much like someone would make payments on a mortgage to one day own it. With insurance, you can make these payments so that if one day your house is taken away from you through loss, you can get it back.

Insurance wouldn’t be needed if people could easily manage these risks themselves. For instance people don’t buy insurance on their dishes so that if they end up breaking they can get them replaced, because dishes only cost a few dollars and the impact upon one’s lives would be very minimal.

If their home is broken into though and someone steals a lot of their possessions, and ones of real value, this is something they may want to protect, because this can end up becoming a financial burden that they may not want or may not be able to bear, so in this case the risk would be excessive and may be worth protecting.

Insurance Companies Profit By Managing Risk By Way of Volume

Let’s say you want to protect your home from loss from fire. Now the chances of this happening generally is pretty low, but if it does happen and you try to bear this risk yourself, you won’t be able to handle it. Other people have the same idea, and let’s say there’s a million people who insure their homes against this with an insurance company.

The insurance company knows what risk they are taking here on balance, meaning that out of these million policies there’s going to be a certain amount of claims, a certain amount of houses that burn down, let’s just say that it’s 1% per year for the purposes of illustration, and the average claim is $100,000

So this means that on average, among these million homes that are protected, there will be 1000 fires a year on average, and the total average payout per year will be $100 million. So this means that they need to charge people $100 a year to cover these claims, although they are going to have to charge more of course to make up for administrative costs, to build their reserves, as well as to make a profit. Let’s just say the price is $150 a year to account for all this.

If they were only insuring one home, the same situation that the individual homeowner would be in, well there’s a 1 in 100 chance of this happening to any given home, and therefore it’s likely that if this happens, they may not be able to pay the claim because they have not collected enough money to do it.

They are going to have to cross their fingers for 67 years in fact to even raise the money to pay for the claim, and the full 100 to cover all their costs and leave enough for the small profit they require to make sense out of the deal for them.

They aren’t just insuring 1 home though, they are insuring a million, and therefore the 1000 fires per year can be reliably paid for out of the premiums they collect. So they collect the $150 million a year in premiums, pay out $100 million on average, and this leaves plenty to not only handle the normal expected amount of claims as they occur, but to also provide a buffer should more homes burn down in a given year than is probable.

Providing the insurance company assesses their risk properly, and they spend a lot of time and effort and skill in doing so, since it is so crucial to know this for them to even stay in business, then the sheer amount of policies they hold can provide a very comfortable cushion for them by making their risk more reliable and quantifiable than if they were only insuring a few parties.

If the risk of a certain event is seen as too high for them to want to take on, they can still serve their policyholders by selling them as much insurance as they want to buy, but sell off some of these risks to other insurance companies, called reinsurers. This is particularly done to offset the risks to an insurance company should a catastrophe occur, where claims may be much higher than the normal probability distribution would provide for.

Insurance Companies Also Invest

If you ask Warren Buffet how he made his fortune he will tell you that investing excess insurance premiums, called the “float,” has played a very big role in his success. When people pay premiums to an insurance company, some of it is held in reserve to pay out future claims, and this money just doesn’t sit in the bank somewhere, it’s put to work.

Buffet of course is famous for the quality of his investment decisions over the years, but it’s float that has provided the backbone for these investments. His parent company Berkshire Hathaway is actually an insurance company, the world’s largest in fact by a good margin, although it owns a lot of other things now, as a result of Buffett’s sound investments over time.

So these funds can be used for a variety of other investments, and insurance companies do want to charge more than they pay out, and this money tends to accumulate over time as expanding reserves. These reserves can expand even further when deployed in the right investments.

This sort of investment actually serves to not only bolster the accounts of insurance companies, it also helps keep premiums down. The margin of profit with insurance is actually quite small compared to other industries.

So instead of just making money off of the premiums you pay, they make money from this plus the profit from investing the unused portion of your premiums, and this does serve to make purchasing insurance more cost effective generally than it would be otherwise.

Of course this investing does represent a greater risk to the insurance companies than just holding the funds in cash would be, but insurance companies specialize in managing risk, so they do know what they are doing and don’t leverage themselves without due regard, unlike some banks do actually, and in some aspects at least insurance companies are more risk averse than some banks are.

Like banks, insurance companies are highly regulated and while some of them do fail, they are very stable generally. People don’t want to worry that if something happens their insurance company won’t be able to cover it, so like with the banking industry, stability is extremely important to maintain, which is why both sectors are well regulated.

Some people think all insurance companies make money hand over fist and they may even see themselves as paying too much for insurance, but it’s actually a highly competitive industry with many companies fighting for your business, and the profit per $100 of premiums is actually among the smallest you’ll ever see in any business relationship.

Given that insurance provides a necessary service to individuals, businesses, and society as a whole, we are much better off with it than without it, although this doesn’t mean that we don’t need to carefully decide our particular insurance options and needs.