With the high increase in natural disasters in the world, companies buy insurance to reduce such risk from totally affecting them.
Insurance involves sharing risk. By distributing the risk of a disaster within a group of people, insurance offers an easy way to provide financial security over unanticipated events.
Basically, an insurance policy is a contract between individuals and insurance companies. The contract specifies that the insurance company will cover any significant losses to the insured based on the contract terms.
To gain income, insurance companies figure the risk on every policy and set the expense appropriately.
It might sound easy, but figuring out how insurance companies make money can be so complex.
Let’s make it easy for you as we analyze how insurance companies make money, and why their revenues seem more than they pay out to companies.
Table of Contents Hide
- How Insurance Companies Works
- How Insurance Companies Make Money
- Other Ways Insurance Companies Make Extra Money
- How Do Life Insurance Companies Make Money?
- How Do Health Insurance Companies Make Money?
How Insurance Companies Works
Most companies can strategize to address the risks from poor management to non-compliance from their customers, but they can’t plan for the cost of natural disasters like fire, earthquake, or accidents. To avoid such a big loss, they buy insurance.
Companies that buy insurance policies transfer their risk to the insurance company in return for paying their premiums.
Insurance companies survey the risk and charge premiums for different kinds of insurance coverage. In a situation when an insured event happens and they incur damages, the insurance agency pays up to the concurred measure of the insurance policy.
Basically, insurance companies operate in three different ways; they evaluate risks, share risks, and base on re-insurance.
#1. Assessing Risks
Insurance companies evaluate risks by defining the insurance risk they have to take. They arrange questions to evaluate a particular risk.
Depending on your answers to the questions, the insurance company cites you a premium.
If your risk is higher than expected – for instance, in the event that you are not almost a fire hydrant, at that point your fire insurance will be higher.
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#2. Sharing Risk
Insurance companies also operate on the concept of shared risk.
Most times, companies’ premiums are always lower than their possible damages, but it is the duty of the insurance company to pay them. This can be possible because they receive premiums from many customers.
Although customers pay little amounts to share their risk with insurance companies, unforeseen event doesn’t occur often. The insurance companies calculate the premiums so that the total they receive from lots of customers can cover the few damages.
By so doing, they can have extra money left as their profit.
Most small insurance companies put re-insurance into consideration.
This often arises when natural disasters occur and they have a lot of insurance policies in one area, most customers will demand payment.
If the insurance companies haven’t collected enough premiums to cover such damages, they give a portion of the risks to other large financial firms that offer re-insurance.
These financial firms assume control over the additional risk from the insurance agency that holds the policies.
For crucial natural disasters, the re-insurance companies pay for a portion of the damages through the local insurance companies that sold the policies.
How Insurance Companies Make Money
Insurance companies make money by taking on risks.
The risk can be that you won’t die before your time to make the insurer payout, or your house won’t burn down, etc.
The idea that drives the insurance company income model is a business plan with an individual or company. This happens when the insurer vows to pay a particular amount of money for a particular asset loss by the insured, normally by damage, sickness, or on account of life insurance, death.
Insurance companies set up their business model on two structures: underwriting income and investment income.
Most insurance companies underwriting income comes from the money they collected from insurance policy premiums, then substracting the money paid out on claims and costs of running the business.
Underwriting Income = Premiums Collected – Claims Paid – Expenses
For example, Merchants Insurance Group earned $7 million from the premiums paid out by their customers in the year 2019. They paid out $5 million that same year as claims.
The underwriting income becomes $2 million, that is $7 million minus $5 million = $2 million.
Don’t ever feel that insurance companies are losing, because they make sure that their calculations work for them.
Another way insurance companies make their money is through investment income.
Insurance companies takes the money they earn from customers’ premium and invest it in notable markets to raise more income.
Mostly, insurance companies invest in real estate, stocks, bonds, cryptocurrency, etc. It is one great money-making proposition for insurance companies.
Other Ways Insurance Companies Make Extra Money
Underwriting and Investment income are the first and best practical ways insurance companies make money, but there are other ways they generate revenues as well.
Cash Value Payouts
Individuals that have life insurance dividends that accumulate to cash values are always enticed to get their money out. Even if it means closing their account, it doesn’t matter to them.
If such a request comes to any insurance company, they oblige immediately since they know if a customer takes cash value money and closes the account, all liability ends for the insurer.
To insurance companies, the cash value is a great benefit to their income.
Insurance companies also get great revenues from lapses.
This means when individuals or company abandon their policy because they can’t afford to continue with their payment.
In that circumstance, insurance agencies make more money, as all past charges that are paid by the client are kept by the guarantor.
How Do Life Insurance Companies Make Money?
It is often difficult to understand how life insurance companies make their money.
However, life insurance companies make money just like every regular insurance company. They get revenue from two major ways: underwriting and investment income.
The life insurance underwriting process is very meticulous in ensuring a particular customer actually qualifies for an insurance policy.
The life insurance companies vets each applicant thoroughly with key factors like age, health, yearly income, gender, and sometimes loan history. The goal is to get a premium cost where the insurance company gains an actual advantage from a risk.
For instance, if you buy a 30-year term life insurance policy for $500,000 and pay $1,000 annually then pass away after 25 years, the insurance company will pay $500,000 although they collected $25,000.
It sounds like life insurance companies are really on a loss, but they always do their math.
The truth is, no life insurance company will sign a contract if they stand to lose money. They play their math before accepting any policy because they are certain they will gain from it.
How Do Health Insurance Companies Make Money?
Most healthcare policy demands that you pay the monthly insurance premium.
The health insurance companies collect the premium from thousands of customers. If another customer needs coverage for medical care, the insurance company uses the money they have in form of claim.
Health insurance companies adopt the ACA policy and the law demands insurance companies to spend 80/85% on claims and 20/15% on administrative expenses.
In summary, insurance companies make a profit in two different ways; underwriting and investment income. However, insurance companies don’t earn more in profit because claim costs have risen dramatically in the last few decades.