Insurance Company Premiums
Although there are variations between insurance products and insurance companies, the basic principals they use to make money are the same. To provide insurance, insurance companies charge a premium, which is the price for the insurance. You can pay premiums in several ways, depending upon the type of insurance and your preference. For example, auto insurance was traditionally paid every six months. Now, many companies will allow monthly payments or annual payments as well. These premiums are the money the insurance company receives from its customers.
Insurance Company Payouts
An insurance company pays out money according to the terms of the insurance when a certain event happens to a policy holder. In the case of homeowner's insurance, the insurance company may pay if there is a fire. Typically, the maximum amount the insurance company will pay is stated in the policy. These payouts represent expenses to the insurance company.
Shared Risk and Large Numbers
If a customer pays $500 in auto insurance premiums, but does not have an accident, the insurance company keeps the $500. Likewise, if a customer pays $500 in auto insurance premiums and has an accident that causes $50,000 in damage, the insurance company will pay out $50,000 regardless of the fact that the customer paid far less.
This concept is called shared risk. In the example above, if the insurance company can get 100 customers to each pay $500 per year in premiums, but those customers have no claims for every one customer who has $50,000 in claims, the insurance company would break even. Every customer over 100 per one represents a profit, or every dollar charged over $500 represents a profit.
Of course, the real world isn't this tidy. However, over a large number insurance customers, statistical trends emerge. With bigger numbers, these trends become increasingly accurate.
Reserves
Because claims are not filed on any sort of regular timetable, there are times when the insurance company will have more cash come in reserve than it needs to pay claims. In our example above, if one out every five people file an average claim of $5,000 each year, that means that in one year, there may be five claims of $100 each (and other years where they are higher). In this year, the insurance company will have received $5,550 in premiums and paid only $500 in claims. The extra $500 charged over the required break-even amount is still profit. However, the company now has taken in $4,500 that the statistics say they will need later to pay claims. So, the company will keep that money as a "reserve." This money is not profit. Is is simply being held to pay expenses later.
Investing Reserves
An insurance company's reserves are not held in a savings account. Rather, the insurance company invests those reserves. If the insurance company makes a positive return on those investments, then that money would be a profit. So, if the company makes a 10 percent return on the $4,500 before it needs that money to pay out claims, then it would make $450 in "extra" profit just by holding its reserves.
The combination of charging profitable premiums, plus making money on invested reserves, is how an insurance company makes money.
Coverage Selection and Rejection
In order to make the models work, an insurance company must have a way to statistically measure the amount of risk involved in any insurance product. If it cannot measure such risk, an insurance company may not sell a certain product to a certain segment of the population or to a certain area. Furthermore, if an insurance company can project the risk, but cannot figure out a way to offer a product to cover such a risk in a way that is profitable, the company may again not offer that product.
For example, many companies have stopped writing homeowner policies in areas that are subject to a high frequency of hurricanes, such as some coastal areas in Florida. In this instance, the insurance companies have determined that there is no way to profitably offer such policies because the premiums would need to be so high that few people would buy the insurance, and then the model for spreading risk over large numbers will not work.
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