How Insurance Companies Make Money would be explained in the easiest way possible in this article.
Profit is one of the aim of any business, no matter how much value they offer or what they represent.
A business may have other goals but if they do not make profit in the business then they will have to end the business. Insurance companies are not an exception to that. The question how does insurance companies make money is what I will be answering in this article.
Several people have pondered and pinned on this; if they make money or not. Why won’t a business earn profit? Why won’t an insurance company have a favorable way of generating profits. The risk surrounding the profit is another great concern to so many.
What Is Insurance?
It is an arrangement or package, whereby a company guarantees to provide compensation for illness, accident, loss, damage, death of an individual or entity etc. In return for a specified premium, paid by the insured.
- The company that insures, i.e the insurance company is called the Insurer.
- The customer or client is called the Insured
- Premium is the amount to be paid for a contract of insurance.
- The insurance policy is a contract between the insurer and the insured, which determines the claims which the insurer is legally required to pay.
- Claim is a formal request by a policyholder to an insurance company for coverage or compensation for a covered loss, damage etc.
- The policyholder is the person in whose name the insurance contract is written, also known as the insured.
How Does Insurance Work
Understanding the business model and how insurance companies work will give you a background insight of how they make their profits. Insurance, of no doubt is a risk business, More like insurance companies betting on risk. The risk that there won’t be peril, death, damage, loss and expect the insurer to pay out.
This requires expert risk assessment, sophisticated algorithm and proper use of statistical tools, this helps them calculate the risk and know the level of profit they can make. The experts ascertain the likelihood of a risk and perils, the costs associated with the event of a loss, damage, death etc. or claim and then, have to create projections and guidelines based on this scrutiny and information.
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.
For instance, when a healthy person or a younger person who is likely not going to be in the hospital for the whole year because of ill health applies for health insurance the risk is comfortably low, and the insurer can charge a comfortably less premium. But, when a smoker or an old person applies, the risk is high and the insurer can reject or accept but with a higher charge of premium.
Now, with the above example, it simply means that not all insured, applies for a claim, and not all claims are paid, it has to be validated first before payout. for every 100 insurance customers paying their premiums every year, only three to five of the insured make a claim according to industry data.
The business model is the arrangement where the insurer guarantees a compensation payment to the insured for his loss, damage etc and requires a monthly payment from the insured, it is sealed in an insurance policy.
So, let’s dive into how Insurance Companies really make their money.
How Does Insurance Companies Make Money 2020
There are two major channels insurance companies make profit, ways Insurance companies make money include;
1. Underwriting Profits
This is just like gross profit. The deduction of the premium(money paid by the insured) from the claims against the insurer. It is the difference in the amount of money gotten from different people as premium, and the payouts of claims and expenses.
The insurance company makes money after this calculation. Just like in business or sales, profit is determined after the total number of goods bought are calculated with the expenses made, whatever is left becomes the profit.
The money the insurance company (insurer) makes after deducting the expenses they made and the amount of payouts on claims of the insured is their underwriting income it can also be called Net
Another question is, does every insured or policy holder request for a claim?
This is most times where the adoption of expert risk calculation comes in. It’s true that not everyone who applies for an insurance package claims it, no wonder insurance is like a pool of money, insurance companies help the pool get to the right people.
The underwriting profits is obtained when the risk and payouts are less which also happens in most cases.
2. Investment Income
This is profit made from paid premium to accrue interest.
When an Insurance customer pays their monthly premium, the insurance company collects the money and invest it in different sectors, financial markets to increase their revenues. Insurance companies have diverse means of investments. It varies from high to low risk, high return equity markets, assets, Treasury bills, bonds, private equity, real estate etc.
Hence they are not like banks that each deposited money requires interest, they can invest the money until a claim is placed. Most times they only use the profits from investment for payouts. However, every business has operations, expenses etc, and a profit can only be determined after all the income and expenses has been calculated. Just like Administration, Operations, and expenses differs in different companies so does the level of profit in different insurance companies.
Conclusion on how insurance companies make money
To sum it all up , insurance companies make money from two sources: Premiums collected from their customers( Underwriting Income) and earnings from investing a small portion of those premiums(investment income).Hence, while it’s true that insurance companies often make profits from insurance, they have to prepare for the worst and they never know when that will happen. That is why insurance is such a mega factor.
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