Where do insurance companies get the money to pay for losses suffered by their customers? Have you ever wondered how insurance companies make money? Insurance companies have been around since ancient times, as early as 4000 to 3000 BCE. Back then, it was known as a bottomry contract by Babylonian merchants. They would grant a loan to merchants and protect their shipments. However, if the shipment was lost at sea, the loan would not be repaid. This shows the risky nature of insurance, as they bet on risks in exchange for regularly paid premiums.
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So, how do insurance companies make money out of these risks? Let’s explore. Insurance is a contract in the form of a policy that provides protection or reimbursement against losses. Insurance companies distribute risks among the members of the company. It is an agreement between an individual and the company, offering security from possible losses.
What is Insurance?
Insurance is a contract in the cloak of a policy. It provides protection or reimbursement against losses. Insurance companies distribute risks among the members of the insurance company.
To paint a clearer picture, insurance is an agreement between an individual and an insurance company. The agreement involves security from possible losses.
Before we explore how insurance companies make money, first, we let’s dig into the common types of insurance. This will give us insights into the types of insurance that share the same principles in making money.
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Health Insurance
Health insurance is often integrated by employers to invite quality employees. This type of insurance has the following coverage:
- Payment for medical, surgical, and dental expenses
- Hospitalization expenses
- Daycare procedures
- Treatment of critical illness
- Maternity
- Pre-existing diseases cover
Health insurance can refund the insured on the accumulated expenses from the aforementioned coverage provided it is stated in the policy agreed on.
For example, my friend John is a healthy person who exercises regularly. Even with his healthy lifestyle, he availed of health insurance. Since he is a healthy person, the insurance company is confident in offering him wide coverage with a reasonable amount for his premium payments.
John timely pays his insurance premiums, but one day, he becomes sick, gets hospitalized, and is short of cash. Luckily, his health insurance covered all of his medical expenses.
In the case of John, his health insurance coverage saved him. It must make you wonder how insurance companies make money even if they grant such coverage to their policyholders.
Keep reading this article to know more about how insurance companies make money. The next example is Life insurance.
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Life Insurance
Life insurance arranges a contract between the policyholder and insurer where the insurer guarantees payment of death benefit. In other terms, the insurance company promises the policyholder a death benefit as long as the premiums are paid.
According to Investopedia, the following conditions shall be considered upon availing of life insurance:
- Parents with minor children
- Parents with adult children that have special needs
- Adults who have joint properties
- Elderly parents who want to leave money to their children
- Young adults who have parents that incurred student loan debt
- Young adults who have parents consigned a loan for them
- Young adults who wanted to avail low premiums
- Wealthy families expect estate taxes
- Families who foresee difficulty paying for funeral expenses
The following agreements are part of life insurance:
- Child plan
- Endowment policy
- Money-back policy
- Pension plans
- Term insurance
- Unit-linked insurance plans
- Whole-life insurance
With the advantage displayed on the part of the policyholder, insurance companies still earn from these arranged agreements.
Life insurance gives assurance to the policyholders that in case of death, the people who are left behind would receive assistance.
To make things clear, let us go back to John’s example. He also has life insurance. In case his illness becomes worse and results in his death, the beneficiary of John as stated in the policy can claim a certain amount of money.
Another thing to consider, why is the insurance company where John is a policyholder willing to cover such expenses. How do they make money?
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Motor Insurance
Another common insurance is car or motor insurance. It is also known as vehicle insurance. It offers protection for vehicle owners. It provides security from accidents that caused damage to their vehicles. Motor insurance covers 2-wheeler vehicles and other types of vehicles.
The following are the types of motor insurance:
- Third-Party Insurance
- Comprehensive car insurance
Motor insurance includes in the policy the following coverage:
- Collision coverage
- Medical payments coverage
- Personal injury protection
Take note that the coverage varies depending on the agreement between the insurer and the policyholder.
To visualize the picture, let us have Paul as an example. Paul is a simple guy who drives his motorbike to his workplace.
He also takes long rides as a hobby during his day off. It is a must for every vehicle to get insured. In case Paul crashes, he is confident that the expenses for repairs are covered by his insurance. Just like John, Paul pays his premium on time.
With this, insurance companies still make money. What if Paul crashes and uses his insurance? How does his insurance company patch things in order to cope?
Property Insurance
In the event of loss of property due to fire and other unwanted circumstances, property insurance has it covered. Property insurance also covers security against theft, this includes insurance of the person, the owner, renter, or any other person injured in the property.
The following insurances can be included in property insurance:
- Homeowners Insurance
- Renters Insurance
- Flood Insurance
- Earthquake insurance
For sure anyone who owns a property wants it to be protected. Property insurance can offer such protection.
For example, you own a grocery store. One day, one shopper gets injured due to a collapsed ceiling. It was an accident since your establishment is well-maintained. Upon investigation, the insurance company agrees to cover the medical expenses of the shopper.
In this instance, the insurance company shouldered the expenses of the shopper. Meaning, you, as the grocery store owner do not have to pay a large amount of money to pay the medical expenses of your injured customer.
Travel Insurance
As the name suggests, it is an insurance that covers the costs and losses involved in traveling. It serves as the protection of the traveler whether domestic or international travel.
Travel insurance has the following coverage:
- Trip cancellation
- Baggage or personal belongings protection
- Short and Long-term medical coverage
- Accidental death coverage
The coverage of travel insurance companies depends on the agreement between the insurer and the policyholder.
Traveling is one of the stress relievers and an escape from the busy schedule. But it is hard to travel with an idea in mind that you might encounter unexpected events such as accidents.
For instance, Linda, an office worker, had a trip with his high school classmates. During the trip, she lost her baggage at the airport.
Linda could have been hysterical, but she has insurance which eases the situation. Fortunately, her baggage was just in the lobby.
What if Linda really lost it and the insurance company agreed to reimburse the worth of the baggage? How do insurance companies make money through this scheme?
How do insurance companies make money?
As a policyholder, you are oriented on the agreements you had with your insurance company. There is sometimes a “wow” moment when you get amazed by the coverage of the insurance.
Given the situations illustrated above, the people who are policyholders are confident in case an unexpected event would happen.
Here are all the ways insurance companies make money given the coverage they offer to their policyholders.
Essential key terms to remember
The following are operational terms defined in simple language to further understand how insurance companies make money.
- Asset loss – the loss of property due to an accident or unwanted situation
- Bond – the agreement that is backed up by legal force
- Contract – the formal arrangement intended to be enforced by law
- Policy – a contract of insurance
- Premium – the agreed amount to be paid for the insurance policy
- Profit – the obtained financial advantage from an investment
- Revenue – the income generated from business operations
- Risks – the possibility that the actual gains will differ from returns
Income from investments
Let us not forget that insurance companies are also for-profit companies. Like any other form of business, insurance companies make the best moves in order to generate profit. This financial advantage provides stability for the insurance companies to support their operations.
Without engagement in other investments, insurance companies will not grow and advance their operations.
For example, an insurance company XYZ collected premium payments. XYZ insurance company would use the collected premium payments to invest in other financial firms.
Some examples of insurance companies’ investments:
- Bonds
- Stocks
- Mortgages
- Short-term investments
Insurance companies do not manufacture products just like other businesses. In order to generate profit, insurance companies resolve to invest the collected premiums into other business forms.
Also, there is little chance that all policyholders would claim their insurance at a time. Insurance companies are experts in filtering their policyholders’ information. They are experts in assessing risks.
Underwriting
Revenues from underwriting come from the collected premiums of the insurance companies subtracting the money paid out on claims and other operational expenses.
Let us view this perspective, insurance company XYZ collected $20 Million from paid premiums from policyholders. The company spent $15 Million on its operation and payouts. Looking at the equation, collected premiums minus expenses, which makes insurance company XYZ earn $5 Million.
Insurance companies are experts in underwriting, they make calculations in their favor.
Insurance companies ask questions about your profile. They will consider your age, income, health status, lifestyle, credit history, and any other information they could get. These are considered risks on the part of insurance companies.
With this, your information plays an essential role in underwriting. It serves as a basis for you to land at a premium cost level at the advantage of the insurance companies.
It gives insights into whether the insurance policy could deny a specific coverage or offer additional protection. All these decisions are from the risk point of view.
The underwriting business sets insurance companies apart from other businesses.
For example, you are a soap manufacturer. You distribute your product in various department stores within the locality.
You can only claim that you earned a legitimate income when somebody buys your soap. You even spend on operational expenses in order to sustain your production.
Unlike insurance companies, they use collected premiums and release money when a legitimate claim should be paid. Meaning, the money paid by customers rolls over in favor of the insurance companies.
Other means of generating money
Investment revenues and underwritings are the main sources of income for insurance companies. They also have other means of generating profit.
Closing down of accounts
Although it is not good to lose a customer, closing down accounts is beneficial on the part of insurance companies. This is especially when the written policy states that in the case of account closure, the insurance company would reimburse a certain percentage of premium payments made.
In other situations, the insurance companies pay the policyholder the interest and retain the outstanding cash.
Lapses in premium payments
Lapses in premium payments initiate profit for insurance companies. Under the contract, a lapse in payments results in the expiration of the policy. This leaves the insurance companies at an advantage.
All paid premiums will remain at the insurance company without a claim being paid to the policyholder.
Wrapping up
Insurance companies make money out of your paid premiums. Remember that the insurance company runs a business. The policies are carefully crafted in reference to your profile measured as risks. Being insured brings a sense of security. More than that, it can provide help in emergency situations where you are caught off-guard by circumstance.
As for me, as long as you are faithful to the policy, the relationship between you as the policyholder and the insurer can be defined as mutualism. Both entities can benefit from each other. As the policyholder, you should be responsible for the agreements stated in the agreement.
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