How Do Insurance Companies Make Money?

The insurance company revenue model revolves around a claimant receiving compensation in the event of an accident, illness, death, or damage to an asset resulting from theft or a natural disaster. In return for continual insurance cover, the company charges a regular fee – otherwise known as a premium. In essence, insurance companies make money by carefully considering the risk of each policy. They bet that the holder will continue to pay for insurance coverage and never be required to make a claim.

Revenue Source	Description	Advantages	Drawbacks
Premiums	Insurance companies collect premiums from policyholders in exchange for coverage. Premiums are typically paid on a regular basis (e.g., monthly or annually).	– Steady and predictable income stream. – Provides funds to cover claims and operating expenses.	– Competitive market may limit premium growth. – Regulatory requirements can affect pricing.
Investment Income	Insurance companies invest the premiums they collect in various financial instruments, such as bonds, stocks, and real estate. They earn income through interest, dividends, and capital gains on these investments.	– Additional income source beyond premiums. – Investment returns can boost profitability.	– Market volatility can lead to investment losses. – Risk management required to maintain a profitable portfolio.
Underwriting Income	This is the difference between the premiums collected and the claims paid out. Insurance companies aim to underwrite policies in a way that results in a positive underwriting profit.	– Provides potential for profit even before investment income. – Effective risk assessment and pricing are rewarded.	– Losses from underwriting can offset investment income. – Requires effective risk management and pricing models.
Reinsurance	Insurance companies transfer a portion of their risk to reinsurance companies in exchange for payment (reinsurance premiums). This reduces the financial impact of large or catastrophic claims.	– Mitigates risk exposure for insurers. – Helps maintain financial stability in the face of major claims.	– Adds cost to the insurance process. – Complexity in managing reinsurance contracts and relationships.
Fees and Commissions	Insurance companies may charge fees for policy administration, policy setup, and other services. They may also earn commissions for selling policies through agents and brokers.	– Additional revenue streams beyond underwriting and investments. – Encourages distribution through agents and brokers.	– Competitive pressure on fees and commissions. – Regulatory compliance for fee structures.
Ancillary Services	Some insurance companies offer additional services, such as risk assessment, consulting, and loss prevention. They charge fees for these services, generating additional income.	– Diversifies revenue sources. – Enhances customer value and loyalty. – Expertise in risk management can be monetized.	– Requires expertise and resources to offer ancillary services. – Market demand may vary.

Table of Contents

Insurance company revenue generation

Most insurance companies make money via underwriting, investment income, and reinsurance.

Underwriting

Underwriting revenue can simply be defined as the money that is left over after the company subtracts the cash paid out in insurance claims from the cash collected via premiums.

Consider the example of a fictitious car insurance company that earned $15 million from insurance premiums in one financial year while paying out $9 million in claims over the same period. This means the company earned a profit of $6 million on its underwriting revenue.

Insurance companies devote a lot of resources to ensuring they make a profit from underwriting revenue. Applicants are vetted on a range of criteria including gender, age, medical history, claim history, and credit history. Whatever the criteria evaluated, remember that the company assesses each applicant according to the risk of them making a future claim.

If the risk level determined by an algorithm is too high, the company may raise the price of the premium or avoid doing business with the applicant altogether.

Investment income

If we return the previous example of the car insurance company with $6 million in underwriting profit, one could make the argument that the cash would be underutilized sitting in the company’s bank account.

To maximize returns, insurance companies invest their profits in the financial markets. They tend to have more money to invest than companies in other industries since none has to be spent creating or manufacturing physical products. Common investments include corporate bonds, treasury bonds, and interest-bearing cash equivalents.

Reinsurance

Some companies also sell reinsurance to other insurers. These insurers purchase reinsurance to protect themselves from excessive losses in situations where they are overly exposed to an event that could lead to insolvency.

For example, a company may run into financial difficulty if a severe hurricane causes widespread damage to infrastructure and a subsequent increase in claims over a short period of time. Indeed, reinsurance is a lucrative industry, with climate change and COVID-19 related drivers expected to grow the global reinsurance market to around $556 billion by 2025.

Key takeaways:

Insurance companies make money by analyzing the risk of an individual policy. Generally speaking, they bet that the policyholder will continue to pay for insurance coverage and never be required to make a claim.
Insurance companies make a profit by collecting more in insurance premiums than they pay out in insurance claims. Strict criteria are used to determine the risk of each applicant making a claim in the future, with high-risk applicants subject to higher premiums or refused cover.
To maximize revenue, insurance companies invest their underwriting profit in more conservative investments such as bonds and cash equivalents. Some also sell reinsurance to other insurance companies to protect them against insolvency.

Key Highlights about the Insurance Company Revenue Model:

Revenue Generation: Insurance companies generate revenue by providing compensation to policyholders in the event of accidents, illnesses, deaths, or damages. They charge premiums in return for insurance coverage.
Premiums and Underwriting: Premiums are the regular fees charged to policyholders. Underwriting revenue is the profit earned by subtracting claim payouts from premium collections.
Risk Assessment: Insurance companies carefully assess the risk associated with each policyholder. Factors like age, medical history, claim history, and credit history are evaluated to determine the likelihood of future claims.
Risk Management: High-risk applicants might face higher premiums or be denied coverage altogether to manage potential future claims.
Investment Income: Insurance companies invest their profits in financial markets to maximize returns. Their significant capital allows for substantial investments in assets like corporate bonds, treasury bonds, and cash equivalents.
Reinsurance: Some insurance companies also engage in reinsurance, where they sell coverage to other insurers. Reinsurance protects insurers from excessive losses in situations where they face a surge of claims that could lead to financial trouble.
Example: For instance, if a car insurance company earned $15 million in premiums and paid out $9 million in claims, they would have $6 million in underwriting profit.
Investment Strategy: Due to not needing to manufacture physical products, insurance companies often have substantial funds available for investment in the financial markets.
Reinsurance Importance: Reinsurance helps insurance companies manage large-scale risks, such as those arising from catastrophic events like hurricanes, by spreading the risk across multiple entities.