How do insurance companies make money?

Here’s a question you’ve either heard before or have asked yourself: how do insurance companies make money?

Ever wonder how insurance companies are able to advertise nonstop and hire the top athletes in the world as spokespeople? How does insurance make money the same way that physical goods and everyday items do? It seems outrageous that their average costs wouldn’t be higher when they can afford such top-dollar advertising.

You might be really surprised by the answer. We’re here to let you know how insurance companies make money, but first, a little background information to set the stage.

Is an insurance policy like a contract?

An insurance policy is basically a promise between you and the insurance company, where they have to pay for any covered losses you incur in exchange for either an annual premium, or a monthly premium if you choose to pay per month rather than once a year. How kind of them to offer payment choices!

The insurance policy itself is a contract, or if you want to think of it a different way it’s like a promise, between the insured (you) and the insurer (insurance company).

The insurance company collects a premium from you for the issued policy and agrees to pay for any covered losses you suffer. Seems like a pretty good investment option; you pay them money and they prevent you from losing anything in the future. They can even offer you whatever type of policy will best suit your lifestyle.

It sounds like a pretty simple business model for earning money, but can be quite complicated and expensive to operate.

Ultimately, insurance companies are like any other business in the world. They have to make a profit in order to stay in business. This can be said for a wide range of companies too – from health insurers to auto insurers, they all have to somehow recover the costs that they’re protecting you against in order to turn a profit.

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There are two basic ways this can be accomplished. They can earn underwriting income, investment income, or both.

What does underwriting income have to do with paid claims and premiums?

This is the basic way of looking at the business: an insurance company basically strives to collect more in total premium dollars. Then they pay out in total insurance claims; they also have to consider operating costs.

Underwriting income is derived from the difference between how much money is collected for all policies sold versus how much money is paid out in insurance claims for those policies in any given time period.

For example, Insurer “A” may collect $1,000,000 in premium for policies issued or renewed in a given year.

If they pay less than $1,000,000 in claims, they have made a profit. If they pay more than $1,000,000 in paid in claims, they suffer a loss.

Fortunately, insurers have a unique way to earn massive amounts of additional profit. Like most business owners, they’re going to want the outcome that provides them with the most gain.

Unlike many other types of businesses, insurance companies collect huge sums of cash throughout the year and may not have to pay on claims on those policies for many years or ever.

This differs from a traditional business that buys and sells goods, where they must pay upfront for inventory and then need to recoup their costs via a sale. As far as financial products are considered, they have the better end of the deal.

Investment Income: When They Put Your Dollars to Work

This is perhaps the real moneymaker for insurance companies. Similar to financial institutions that hold onto your money like banks, insurance companies will invest the premium dollars they hold in the hopes of turning an even bigger profit on Wall Street.

This unique situation allows insurance companies to invest that money while it’s not being used. Huge profits can be reaped, or lost, as a result.

This is exactly why Warren Buffet formed the Berkshire Hathaway Insurance Company, so he could generate capital to invest in the stock market.

In fact, insurance companies can knowingly charge too little for insurance policies and plan for an underwriting loss if they believe they can make a profit from investing the money they receive before having to pay claims. In the early 2000s, when the stock market was booming, this was a common practice.

On the flip side, insurance rates may be raised to make up for stock market losses. Additionally, some insurance companies may enter a new line of insurance or a new state and intentionally charge less than their competitors, causing an underwriting loss, simply to make a name for themselves.

In the following year, raise their rates and hope to hang onto some of the business they wrote, typically because customers don’t take the time to argue, comparison shop, or even take notice.

The Bottom Line

So how do home, life, and car insurance companies make money? By having a cycle of consumers and policies, hoping that they’ll stay on top of the dollar they’re making. Hopefully now you should have a better idea as to why insurance is such a massive industry. Aside from turning a profit on the policy itself, insurers can deploy massive amounts of capital into the stock market and elsewhere for exponential returns.

This is the beauty of the insurance model – taking cash upfront before having to pay a claim in the future (or never) means insurers can put your money to work for them immediately.

And they’re smart enough to know exactly how to invest that money for the best returns. But if things don’t pan out, they can just charge you more for insurance coverage in the future.