how-do-insurance-companies-make-money

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.

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. 

Read Next: Next Insurance Business Model.

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