How Do Insurance Companies Earn Money?

The insurance policy sold to you is actually a contract signed between you (insured) and the insurance company (insurer). This insurance policy makes sure that the company pays for the expenses if anything happens to you. But how do insurance companies earn money to stay in business?

How Do Insurance Companies Earn Money?

Insurance companies have two sources to make money: They can earn through underwriting income or investment income or both.

Underwriting Income

Underwriting Income is earned through the difference between the money collected from all policies sold against the amount paid out in insurance claims for those policies in a given period of time.

insurance company

For a layman, an insurance company collects $10,000 in premiums paid by people for policies issued or renewed in a year. If the company pays in that year is less than $10,000 in claims, then they made a profit. If they paid over $10,000 in claims, they have incurred a loss.

To make a business successful, the income must be greater than the outgoing. The main expense of an insurance company is paying for covered losses. Taking the example of Wellpoint (one of the largest health insurance companies), it made nearly $57 million in revenue from premium collected in 2008. And the total amount of health benefits paid out to customers the same year was nearly $44 million, about 84% of their revenue from premium.

Investment Income

An Investment Income lets insurance companies invest the collected money when it is not being used. Investing money can lead to huge profits or losses.

The Berkshire Hathaway Insurance Company formed by Warren Buffet is the result of the same idea- to generate capital in order to invest in the stock market.

Many of the insurance companies sometimes knowingly charge a meager amount for insurance policies and prepare for underwriting loss if they think a profit can be made from investing the money they get before paying for claims.

Investment Income

On the other hand, the insurance companies can raise the insurance rates to cover the losses incurred from the stock market.

The job of an insurance company is basically risk management. The fact holds true for independent agencies and also for the big and established insurance companies. But there will be moments when they feel they have too much to risk. This is when the term reinsurance comes into the picture. Reinsurance is actually “insurance for insurance companies”.

Certain insurance company might one day realize that there are too many risks in their portfolio and thus, chooses to assign it to another party, i.e. the reinsurance company. This company will take a portion of the risk for a swap of cash the original company got. As the original company spreads its risks between different companies, it makes sure that a small section of the portfolio doesn’t ruin the whole finances.

Insurance is something that everyone needs in their lives. This means interacting with insurance companies at some point and this makes important to understand their working.

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