Legal & Insurance

How Do Insurance Companies Make Money?

insurance agreement signing

Every Insurance company makes money by betting on risk – the risk that you won’t die before your time and make the insurer payout, or the risk your house or business premises won’t burn down or your vehicle won’t be condemned.

The concept for the revenue-generating for an Insurance company is a business arrangement with an individual, company or an organization where the insurer (Insurance Company) promises to pay a specific amount of money or replace the asset for a particular asset loss by the insured, normally by damage, illness, or in the case of life insurance, death.

In return, the insurance company is getting paid regularly (usually monthly) by its customer, for an insurance policy that covers life, home, auto, travel, business, and other insurable assets.

Another main way of generating revenue is reinvesting the premiums which were charged from insurance customers into other interest-generating assets. Same as all private businesses, insurance companies also try to market effectively and minimize their administrative costs.

 

How Insurance Companies Make Money

earnings

As an insurance company is a for-profit initiative, it has to create an internal business model that generates more income than it pays out to customers, while factoring in the costs of running their business. To do so, insurance companies build their business model in two ways- underwriting and investment income.

Underwriting

Underwriting is a process in which an individual or institution takes on financial risk for a fee. The risk mostly involves loans, insurance, or investments. The word termed “Underwriter” was originated from the practice of having each risk-taker write their name under the total amount of risk they were willing to accept for a specified premium amount.

For insurance companies, underwriting revenues generating from the cash received on insurance policy premiums, minus money paid out on claims and for administration cost of the business.

For example,

let’s say XYZ Insurance Corporation earned $10 million from the premiums paid out by customers for their policies in a year’s time.

Let’s also say that XYZ Insurance Corp. paid $8 million in claims in the same year. That means on the underwriting side, XYZ Insurance earned a profit of $2 million ($10 million minus $8 million = $2 million)

 

The whole life insurance underwriting process is very systematic to ensure a potential customer actually qualifies for an insurance policy. The applicant is examined well and key points such as health, age, income, gender, and even Financial & credit history also are measured, with the goal of landing at a premium amount level where the insurance company gains maximum advantage from a risk point of view.

It’s important, as the insurance company underwriting business model ensures that insurers stand a good chance of making an additional income by not having to pay out on the policies they sell. Insurance companies work hard on crunching the data and algorithms that indicate the risk of having to pay out on a specific policy.

If the collected data tells them that the risk is too high, an insurer may don’t offer the policy or will charge the customer more for offering insurance cover. If the risk is low as per the data, the insurance company will offer the policy, knowing that its risk of ever paying out on that policy is comfortably low.

 

Investment Income

Insurance companies also make a bundle of money through investment in their premium income. When an insurance customer pays their monthly premium, the insurance company takes the money and invests in the financial markets, to increase their inflow.

Since insurance companies don’t have to invest their money to build a product, like a vehicle manufacturer or a Mobile phone company, there’s more money to put into an insurer’s investment group and more profits to be made by insurance companies.

That’s a great money-making plan for insurance companies. The insurance company gets the cash upfront from customers, in the form of policy payments. They may or may not have to pay off a claim on that policy, and they can put the money to work for them right away earning investment income on Wall Street.

Insurance companies have an out too if their investments go bad – they just raise the price of their premiums and pass their losses to customers, in the form of higher policy premiums.

 

Other Ways Insurance Companies Come Out Ahead Financially

While underwriting and investment income are far and away from the largest sources of revenues for insurance companies, they have other avenues to profit, as well.

Cash Value Cancellations

When consumers who have whole life insurance plans discover they have thousands of dollars via “cash values” (generated through investment and dividends from insurance company investments), they want the money, even if it means closing the account down.

Insurance companies are highly motivated to assist with their full knowledge when a customer takes cash value money and closes the account, all liability ends for the insurer. The insurance company keeps all the premiums already paid, pays the customer with interest earned on their investments, and keep the remaining cash. In that case, cash value payouts are honestly a financial bonanza for insurance companies.

 

Coverage Lapses

All too often, consumers fail to keep current on their insurance policies, which triggers a profitable scenario for the insurer. Under the insurance policy agreement or deed, a policy lapse means the actual policy expires without any claims being paid out. In that condition, insurance companies cash in again, as all previous premiums that are paid by the customer are kept by the insurance company, with no likelihood of a claim being paid.

 

The Takeaway on How Insurance Companies Make Money

There is no doubt, insurance companies have prepared the system in their favor, and keep cashing in as a result. Industry data reflects that for every 100 insurance customers paying their premiums every year. But only three of those consumers make a claim. Meanwhile, insurance companies get all those premium payments and re-invest the cash to increase their profits.

It’s been a recipe for financial success for hundreds of years, and will be the same going forward – and there’s not much the average insurance customer can do about it, except keep paying their premiums and looking for the best.

 

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