If you consider business models, some are easy to understand, whereas some are confusing. Like, a room cleaner charges for his time and accessories, or a store seller sells chocolates for more than he bought them. But when it comes to the insurance industry, you may wonder what their revenue model is.
Insurance companies make money by assuming risks. The risks involved that you will not die before the policy ends and claim the money, or your car won’t meet an accident. The concept may sound simple, but it’s not.
Generally, the insurer offers an insurance policy to the insured to cover his life, vehicles, business or other valuable assets. The insurer also promises to pay an amount for a particular asset loss until the policy ends. In return, the insured will pay a monthly or annual premium to keep that policy active. Neither the company nor the customer can bypass this contract.
Additionally, the company doesn’t hold onto the cash. Rather they re-invest it to gain more profit directly from the premiums.
However, a certain situation comes when the customer can’t pay the premium anymore. Or the investment goes down and the company faces loss. Also, sometimes unexpected natural disasters lead them to pay out more than the premium.
In every case, the company has the solution to keep the profit margin. Is this sound confusing? No problem. To understand how do insurance companies make money, go through the following article.
How Do Insurance Companies Make Money?
Companies offer several types of insurances like health insurance, car insurance, life insurance, property and casualty insurance, etc. Each of them covers different losses depending on the terms and conditions. Therefore, the revenue model is also different for every insurance company.
With this in mind, being a for-profit organization, it needs an internal business model that everyone can follow. Such a strategy focuses on collecting more cash than paying customers to obtain capital for the business.
Generally, insurance companies earn revenue through their annual premium charges and investing the payments. It sounds easy. But not. Though the concept is easy, there is more to understand. Let’s get into the details to know how do insurance companies make money.
Underwriting
Every insurer makes a good amount of money by underwriting, a monthly or annual insurance policy premium fee for taking on financial risks. An underwriting income can be determined as premiums collected minus claims paid and other expenses for operating the business.
Suppose XYZ is an insurance company, made $3 million from premiums in a year for policies issued or renewed. Also, in that same year, the company paid $1.5 million in claims. Hence, XYZ company made an underwriting profit of $1.5 million in that given year. Bt if they paid more than $3 million in claims, they would suffer a loss.
Therefore, to ensure everything goes in their favor, they focus on potential clients and financial risk evaluation.
- The insurance company goes through an underwriting process thoroughly to determine a potential client and whether he/she is eligible for the policy or not. The company properly examines the applicant and other key metrics like age, gender, health, income and credit card history. So, the life insurance company can set the premium cost to make maximum revenue. Typically this cost gets higher with the insured’s age.
- Additionally, companies hire actuaries to identify financial risks in different insuring schemes using mathematical and statistical models. Once they evaluate financial risks, companies create and set insurance plans with premium fees accordingly.
If the resulting data indicates high risk, an insurer charges its customers more for the insurance policy or won’t offer the policy at all. In contrast, if the risk of paying on a policy is low, the insurer happily offers it to the customer. As a result, insurers will have a fair chance to earn additional income rather than paying out on the policies they sell.
In short, with the underwriting process, the company pays only when the insurance claim is made. This makes a major difference between insurance and traditional business.
So, if a policyholder claims insurance, the company starts processing it. However, they need to check its accuracy to avoid insurance fraud and loss and then pay the customer.
Investment Income
Another way of making money for insurance companies is through investment income.
Sometimes, even with proper underwriting, the insurance provider may have to pay for claims or losses equal to or more than the premium charges. Moreover, retaining huge cash for a long time or putting it in a savings account may cause inflation risk.
To cover such risk, companies invest the premiums into stocks, bonds and other financial markets. Thus, it generates additional interest for the companies. So, they can pay insurance claims, administrative costs and commissions without losing profit.
In this case, the insurers don’t have to put their own money. They get it from the clients through policy payments and may not need to pay claims on these policies for years. So, they invest it in Wall Street to increase revenue. That’s how do insurance companies make money via investment income.
On the other hand, what if the stock market goes down? If it happens, insurance companies raise the premium rates. In short, policyholders pay the loss in the form of higher policy rates.
For this reason, companies charge too little for policies first and invest the earning. They can cover it before paying for the claims by chance they face an underwriting or stock market loss.
Apart from the underwriting and investment income, there are two effective ways to make money. Let’s know about them.
Cash Value Payout
Before proceeding, what is cash value? It is built up through investment and dividends from the insurer investments.
The cash-value life insurance policy offers the whole life coverage combining with an investment account. A part of the premium goes to that account in the form of cash value, and its interest increases with time. So, when the customer sees thousands of dollars sitting on their account, they take it and close the account.
Do you think that company loses the money? No, it’s nothing but an unexpected fortune for them. As the customer takes the cash value amount and cancels the policy, all liabilities end with it. Therefore, the insurance company happily approves that, keeps the premiums already paid, pays the customer some interest and pockets the remaining cash.
Insurance Policy Lapse Coverage
It is another windfall for the insurance companies. Sometimes, customers fail to pay the premium for their policies on time. Consequently, it triggers a lapse in the insurance policy.
In a word, the policy gets expired without a death benefit being paid out. Since it happens before the policy ends, the company earns a huge profit from it. The insurer keeps all the premiums paid already by the customer when there is no chance of being claimed.
For example, if you miss one payment for car insurance, the policy will remain active. Thanks to the insurance company’s grace period that is about 30 days. However, if you can’t pay within this time, the policy will lapse.
Moreover, according to the experts, only 2-3% of policies are timely paid out. Whereas the rest lapse because either the insured cancels/stops the premium as they can’t afford it or outlives the policy term. In both ways, insurance companies make a huge profit.
How Do Insurance Companies Reduce Risks?
Suppose an insurance company analyzes the low risk of flood in a geographic location and provides insurance accordingly. What if a sudden big flood hit that area? The company will eventually face a huge loss on the insurance policy.
To protect themselves against such natural disasters or casualty losses, insurance companies engage in reinsurance. Reinsurance is the insurance that an insurance company purchases from another to reduce risk during major claims.
By covering such risks, reinsurance provides insurers more security and allows them to stay solvent. Thus, insurers may resist single or multiple huge catastrophic losses.
Not to mention, insurance companies will have sufficient liquid assets to pay any exceptional or unusual loss through reinsurance. They don’t even have to hike premium rates or other administrative rates on their policies to cover solvency.
Conclusion
The insurance industry has spent a lot of time and effort analyzing the mortality rate and the number of active policies until they’re paid or expired. Moreover, the financial report shows, out of 100 customers, only a few claim the insurance. Others either stop the payments or get lapsed.
In that situation, companies take all the premiums and invest the amount. Thus, they make a profitable scenario without being paid out. Undoubtedly, the insurance companies have the system in their favor while making money.