How do Insurance Companies Make Money?
Insurance companies typically don’t make money on your premiums. The money collected from premiums helps insurance companies pay out on claims. The time in between collecting the premium and paying claims is when the money making occurs for insurance companies.
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Keep reading to learn how this works.
Let’s cover the assumption that people often make about insurance companies and premiums. Most people assume the premiums create a profit for the insurance company. In some cases they do, but not always. Insurance companies can’t predict beyond a reasonable doubt when and how much it will pay out on claims. Some years are years of large losses while other years are years of profit.
Some insurance companies end up paying out on life insurance only a year or two after writing the policy. A year or two of premiums won’t give an insurance company the balance they must pay out for the claim (at least in most cases). In this case, it would look like a total loss when this happens.
In other cases, though, insurance companies take in premiums for years (10, 20, or 30 years) and never pay a claim. Granted, the two situations typically balance one another out, but it helps insurance companies stay afloat. Will they make a profit this way? They probably won’t, but they will at least be able to stay in business.
Investing the Premiums
The real meat and potatoes of an insurance company’s profits lie in the investments they make. They take your premiums and the premiums of every other policyholder and invest them. Insurance companies typically invest the premiums in stocks and bonds. Insurance companies then use the investment income that they make to pay out claims, cover administrative costs, and commissions.
Insurance companies strive to bring in large amounts of money and pay out only a fraction of that amount. This allows them to invest the remaining funds, earning interest or dividends on the investments, which helps them stay afloat or profitable during times of high payouts.
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Insurance companies often count on lapsed coverage plans too. The insurance underwriting process helps companies know if this will work. Any policy that ends without a payout, such as a term life insurance policy, is a lapsed policy. The insurance company made all of the premiums on the policy but never had to pay out on a claim.
Insurance companies can’t rely on lapsed policies because they only make up a small portion of their income, but they do happen. This helps further an insurance company’s profits and/or help it to stay in business.
Following the Industry
Insurance companies also make money by following the industry. For example, the most expensive insurance company in the area probably won’t be the most profitable. If clients know they can go elsewhere for cheaper premiums, they will typically do that.
If an insurance company keeps its premiums competitive with the other companies in the area, though, they can make themselves profitable. While insurance companies need to keep their premiums high enough to cover their own costs, they have to find the perfect balance to ensure that they stay competitive.
If an insurance company strategizes appropriately, they should have reserves on hand that allow them to stay profitable even during times of high payouts. As discussed above, if an insurance company invests the money too, they compound what they can make, increasing their chances of making a profit.
Insurance companies create a perfect balance between charging competitive premiums and making a profit. They hire underwriters that can effectively assess risk so that they assign the proper premiums and avoid excessive payouts. Because no one can effectively predict the future, though, insurance companies rely on investment income to help him or her make a profit while making good on the agreements they provided clients to pay out in times of loss.
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