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How Insurance Companies Profit (And What It Means for You)
Any person who occupies a professional or personal life that involves a contract has a working relationship with the insurance industry. Seldom do people take the time to understand the reciprocal relationship that exists when the status of things has them paying recurrences and praying that the time will never come when they are called upon to utilize the services that they have insured themselves for.
At the most basic level, the insurance business operates on a contract of trust. This trust, as has been proven repeatedly over time, is mutually beneficial to both the insurance business and the customer. The insurance industry is a critical, and very profitable, component of the global economy. Among the numerous industries that provide financial security to individuals against the unknown, the insurance industry is one of the most economically successful and self-sustaining. It has withstood the test of time since its inception.
From how much you have to pay on your premiums, to how you have to adjust your lifestyle in order to decrease the number of claims you will have to make, understanding how insurance companies make a profit is imperative. It has an effect on everything and you, as a policymaker, will have all the incentive to make the right choices when you are making a purchase. At a most basic level, the relationship and understanding of the industry will serve you best.
At the most basic level, insurance companies make a profit when the revenues of premiums are greater than the outflows of claims. The difference between the two is called the underwriting profit. At the most basic level, premiums are collected to pay claims. Your premiums for car or home insurance are pooled together with the other premiums and claims. Once the insurance company has survived the first year of business, the rationale that only a small number of policyholders will make a claim in a given year is a statistical fact. The claims are expected to be less than the premiums.
The process described sounds simple, but it is actually very challenging. Setting premiums too low means not bringing in income; setting premiums too high means losing policy holders. This means a lot of income is lost until risky pricing is worked out. This is one reason we see the amount of effort insurance companies put into data/statistics/understanding of the risks of underpricing premiums.
Investment Income — The Hidden Profit Engine
Most people with insurance policies do not know this, but premium income is usually not the most important factor in determining the profit of an insurance company. Insurers are actually quite wealthy because, between when premiums are collected and when claims are paid, they hold a lot of cash reserves (which can be several billion dollars for large companies) and have put that cash into investments in stocks, bonds, real estate, and government-issued investments.
This is called the float, as was first noted by Warren Buffett when he was speaking of the insurance companies of Berkshire Hathaway. The float is actually one of the most important ways insurance companies earn money. Even though claims have to be paid, insurance companies are still able to earn a profit. Tub of insurance companies charge premiums which do not cover the costs of making the policies, and therefore earn a loss, but think they have enough of an investment profit to overcome that loss.
How Insurers Keep Profits While Managing Claims
Managing claims creates polarizing pros and cons that affect both profits and policyholders. Because of this, many insurance companies hire people in specific trades who focus on managing claims so that the insurance company pays for claims that are the most appropriate and within limits.
Though it may feel unfair, this method of claim management actually protects policyholders in the long run. The friction for legitimate claims exists in the delays, requests for required evidence, and/or disputed estimates of the claim. As a policyholder, knowing this protects you and allows you to manage your claims more appropriately.
Insurers Protecting Themselves
A not-so-well known part of ensuring that an insurance company stays profitable is purchased insurance; also known as reinsurance. It is basically purchasing insurance to protect insurance companies from taking on a large portion of the financial risk. Some larger insurance companies, like Munich Re, Swiss Re, and General Re, are large firms that provide this catastrophic insurance to protect companies from large financial losses caused by large catastrophic events such as natural disasters.
Insurers can keep profits even through catastrophic loss events by stabilizing maximum loss exposure through purchasing reinsurance. Insurance products you purchase contain a reinsurance purchase cost in the premiums, which demonstrates the funding of reinsurance through premiums you pay. This explains why your homeowners or auto insurance premium significantly increases in the aftermath of a natural disaster despite the disaster not affecting you personally. The reinsurance market loss cost spreads to all insureds.
Profit Sharing with Policyholders
You gain tremendous negotiating power as a consumer by understanding the profit mechanisms of the insurance market. You gain additional negotiating power as a consumer by understanding the basis for profit, which are the market inefficiencies. For example, as an insured, you are expected to lose financially if you choose to auto-renew, and you are expected to gain financially if you choose to renew your coverage through a competitive rate. Additionally, an insurance company knows an individual insured is financially losing incentives to switch if they are offered a lower premium for the same or better terms.
You have a unique power as a policyholder to maximize profits by understanding that purchasing insurance is essentially a hedge and that the insurance company seeks to profit the most when a claim is not made. Claims are a loss to the insurance company. Some insureds are financially better off making claims, and if a claim is of high value, the insurance company seeks to profit the most through a voluntary excess of loss reinsurance.
That doesn’t mean you should assume insurers are acting in bad faith. Insurance is crucial for society. It is necessary to protect people against the financial destruction that can happen in a single instant from events that people have little control over or to absorb a total financial risk. Insurance accomplishes that as a business entity. Insurance requires you to expect that people’s financial interests are involved even as they protect your financial interests against the worst.
Final thoughts
Insurance companies are better than the rest when it comes to selling insurance. Their success can be attributed to the optimal mixture of planned restocking, investing of insurance money, insurance guarantees, and safety precautions. Each of the steps of the model is intended to guarantee profitable insurance business.
As for you, the customer, it is necessary to alter this. Keep your insurance interests at the front of any decision. Doing so will ensure the entire money that the insurance is supposed to protect you from will not be shot in the dark. This insurance will be a valuable asset, as something bad won’t happen to your money.
This is right now and your attention is free. You can consider it right now, you can think about it from your perspective and take it from your perspective. You won’t be shot in the dark. You’ll be shooting in the investment.
