How do Insurance Companies make money?

3.03.2020
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Introduction

Everyone knows that change is the only constant in this unpredictable world that we live in. But human beings have evolved themselves by getting familiar with the surroundings. As a result, they either try to repel the change that inhibits their basic functions or adapt themselves to it. In an environment that is run by the mighty nature, we are still at its mercy. To avoid any unprecedented circumstances, (be it an earthquake, accident, terminal illness, etc.) that can affect our livelihood, insurance was invented.

What is Insurance?

Insurance is a shared bond between the insurer and the person/thing that has been insured. It is an ancient form of shared co-operation which includes everyone putting 1 Dollar in the pot after an interval of time and the person who suffered any loss gets the larger amount from the pot.

Modern insurance companies are a sophisticated version of this invention. Let us understand with the help of an example. Assume that there are 100 people living in a city and the possibility of them, meeting with an accident (per year) is 3%. Now an insurance company asks everyone to contribute 1 dollar every month in the form of Premium. At the end of the year, the insurance company has 1200 dollars in its pocket. Of which, 500 dollars were spent to run the insurance company itself, 300 dollars were given to the people as part of the claims. The rest 400 dollars would be the profit of that insurance company. In this way, people can continue with their daily lives without being worried about any unprecedented eventuality by contributing a small share of money each month. The insurance companies take advantage of this situation by playing their chances that all those people who bought the insurance will NOT claim it.

How do Insurance Companies make money?

Profit simply means the revenue earned minus the costs incurred. From the above-quoted example, it might look quite a simple process. But it gets complicated in a real-life situation where hundreds of different factors come into the picture and big companies making 0.5% profit on every dollar they earned as Premium is considered a profitable business.

There has been a debate among the industry researchers about how insurance companies make money and by what proportion an element dominates. We will be discussing some of the possible ways that an insurance company makes itself a profitable business.

  • Underwriting:
    This is a term used when an insurance company keeps the premium rates higher than the possible claim amount that can be made in a given time. Taking help from the above-stated example, 400 dollars that the insurance company earned as a profit from the transaction will be called as Underwriting. The process of Underwriting is quite complex, because insurance companies who compete with each other, have to keep the premium rates as low as possible in order to get the customer.
    Now, many experts find this to be superficial and say that Underwriting is by no means how insurance companies can make a profit. Insurance companies end up spending 1 dollar on each dollar earned as an integrate after paying for the general expenditure. They seem to think that it is the return on investment that insurance companies get is what actually makes them a profitable business. Let’s discuss that.
  • Return on Investment:
    This is where it gets complicated. The money that any insurance company gets after selling its policies is gathered into a pool and made available for investment. Think of it as the loan industry where banks use the money deposited by the people and giving it to those who need a loan on higher interest. Slightly different, insurance companies have to pay claims on when and if basis. However, the percentage of paying for claims turn out to be way lesser than expected (3% as discussed in the above example).
    Now imagine the insurance company that gets 100 dollars each month from a hundred people and invests that money upfront on the interest of 9%. In the 2nd month, the company has raised 9 dollars with the money earned from those people. If the interest compounded on a yearly basis means much more profit for the company. In this scenario, even if the company spends 1200 dollars that it had earned by those hundred people, it gets the interest earned on that money. Now imagine the pool to be of hundreds of billions of dollars and the interest earned on that. No wonder, Warren Buffet, who could see the potential in this industry was among the first ones to invest heavily in the insurance sector.

While Underwriting and Investment Returns are largely how the insurance companies make money, they make some good profit via various other means. Cash Value Cancellations, that contain those group of people who encash their policies to get the interest earned on them while forgetting about the premium they have paid in the past. Coverage Lapses, pertains to those people who don’t renew their insurance policies, that in effect means the premium paid for the first year is income for the insurance company.

Although insurance companies run on profit, they are also prone to nature’s might. In the past, hundreds of insurance companies have gone bankrupt for their inability to pay the claims made by the public. But this has largely happened in case of a natural or a man-made disaster.

How can insurance companies make money through underwriting?

Underwriting is a term used when an insurance company keeps the premium rates higher than the possible claim amount that can be made in a given time. The process of Underwriting is quite complex, because insurance companies who compete with each other, have to keep the premium rates as low as possible in order to get the customer.

What is return on investment?

The money that any insurance company gets after selling its policies is gathered into a pool and made available for investment. Think of it as the loan industry where banks use the money deposited by the people and giving it to those who need a loan on higher interest. Slightly different, insurance companies have to pay claims on when and if basis. However, the percentage of paying for claims turn out to be way lesser than expected.

What are the ways for an insurance company to make money other than underwriting and return on investment?

Other ways insurance companies make money are: 1. Cash Value Cancellations, that contain those group of people who encash their policies to get the interest earned on them while forgetting about the premium they have paid in the past. 2. Coverage Lapses, pertains to those people who don’t renew their insurance policies, that in effect means the premium paid for the first year is income for the insurance company.

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