Insurance companies make money by betting on risk - the risk that you won't die before your time and make the insurer pay out, or the risk your house won't burn down or your SUV won't be totaled in a crash.
The concept that drives the insurance company revenue model is a business arrangement with an individual, company or organization where the insurer promises to pay a specific amount of money for a specific asset loss by the insured, usually by damage, illness, or in the case of life insurance, death.
In return, the insurance company is paid regular (usually monthly) payments from its customer, for an insurance policy that covers life, home, auto, travel, business, and valuables, among other assets.
Basically, the insurance contract is a promise by the insurance company to pay out for any losses to the insured across a variety of asset spectrums, in exchange for regular, smaller payments made by the insured to the insurance company.
The promise is cemented in an insurance contract, signed by both the insurance company and the insured customer.
That sounds easy enough, right? But when you get down to how insurance companies make money, i.e. earn more revenues than they pay out, things get more complicated.
Let's clear the air and examine how insurance companies make money, and how and why their risk-based revenue has proven so profitable over the years.
How Insurance Companies Make Money
As an insurance company is a for-profit enterprise, it has to create an internal business model that collects more cash than it pays out to customers, while factoring in the costs of running their business.
To do so, insurance companies build their business model on twin pillars - underwriting and investment income.
For insurance companies, underwriting revenues come from the cash collected on insurance policy premiums, minus money paid out on claims and for operating the business.
For instance, let's say ABC Insurance Corporation earned $5 million from the premiums paid out by customers for their policies in a year's time.
Let's also say that ABC Insurance Corp. paid $4 million in claims in the same year. That means on the underwriting side, ABC Insurance earned a profit of $1 million ($5 million minus $4 million = $1 million).
Make no mistake, insurance company underwriters go to great lengths to make sure the financial math works in their favor.
The entire life insurance underwriting process is very thorough to ensure a potential customer actually qualifies for an insurance policy. The applicant is vetted thoroughly and key metrics like health, age, annual income, gender, and even credit history are measured, with the goal of landing at a premium cost level where the insurance company gains maximum advantage from a risk point of view.
That's important, as the insurance company underwriting business model ensures that insurers stand a good chance of making additional income by not having to pay out on the policies they sell. Insurance companies work very hard on crunching the data and algorithms that indicate the risk of having to pay out on a specific policy.
If the data tells them the risk is too high, an insurer either doesn't offer the policy or will charge the customer more for offering insurance protection. If the risk is low, the insurance company will happily offer a customer a policy, knowing that its risk of ever paying out on that policy is comfortably low.
That sets insurance companies far apart from traditional businesses. An auto manufacturer, for example, has to invest heavily in product development, paying money up front to build a car or truck that consumers want. They only recoup their investment when they sell the car.
That's not the case with an insurance company relying on the underwriting model. They put no money up front, and only have to pay if a legitimate claim is made.
Insurance companies also make a bundle of money via investment income.
When an insurance customer pays their monthly premium, the insurance company takes the money and invests in the financial markets, to increase their revenues.
Since insurance companies don't have to put cash down to build a product, like an automaker or a cell phone company, there's more money to put into an insurer's investment portfolio and more profits to be made by insurance companies.
That's a great money-making proposition for insurance companies. An insurer gets the money up front 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 south - they just hike the price of their premiums and pass the losses on to customers, in the form of higher policy costs.
It's no wonder that Warren Buffet, the Sage of Omaha, invested so heavily in the insurance sector, buying Geico and opening its own insurance firm, Berkshire Hathaway Reinsurance Group.
Buffet knows a sure thing when he sees one.
Other Ways Insurance Companies Come Out Ahead Financially
While underwriting and investment income are far and away 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 only too happy to oblige, with full knowledge that 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 sense, cash value payouts are actually a financial windfall for insurance companies.
All too often, consumers fail to keep current on their insurance policies, which triggers a profitable scenario for the insurance company.
Under the insurance policy contract, a policy lapse means the actual policy expires without any claims being paid out. In that situation, insurance companies cash in again, as all previous premiums that are paid by the customer are kept by the insurer, with no possibility of a claim being paid.
That's another cash bonanza for insurers, who allow the consumer to take on all the risk of keeping a policy active, and walk away with the money if the customer either outlives the coverage timetable or doesn't keep up with premium payments.
The Takeaway on How Insurance Companies Make Money
No doubt, insurance companies have rigged the system in their favor, and keep cashing in as a result.
Industry data shows that for every 100 insurance customers paying their premiums every year, only three of those consumers make a claim. Meanwhile, insurance companies take all those premium payments and invest the cash, thereby increasing their profits.
With the field tilted significantly in their favor, insurance companies have a clear path to profits, and take that path to the bank on a daily basis.
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 hope for the best.
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