Most of us have some sort of insurance protection. Whether it’s health insurance, car insurance, homeowners insurance, life insurance, or something else, we all are paying a premium (or someone is paying it for us) to reduce the potential financial burden in the case that something bad happens to us. When insurance companies are paying out for all those claims, how do insurance companies make money? Read on to find out.
What Is Insurance?
Before we can talk about how insurance companies make their money, it’s important to have an understanding of what insurance is. Insurance is when a policyholder pays another entity (the insurance company) a payment in exchange for the insurance company reimbursing the policyholder in the case of a financial loss.
For instance, if you own a home you pay homeowners insurance. If your home burns down, the insurance company will pay for the damages according to the details of the insurance contract.
With health insurance, you pay your premium, and in exchange you do not pay as much for an orthopedic surgeon as you would without insurance.
What if you never suffer a loss? Well, the insurance company keeps your premium. However, I will happily go the rest of my life paying out insurance premiums on my house, even if I never suffer a loss. Because that means my home was never burglarized, burned, etc. But if those things do happen, I can rest easy knowing that I will not be responsible for repairs or rebuilds.
How Do Insurance Companies Make Money?
An insurance company sets their premiums based on how much they expect to pay out in claims. Underwriters and actuaries do the math and predict an amount of financial loss that they will pay out to policyholders.
After they predict the amount of claims, they have to add in other things such as administrative costs, premium taxes, broker fees, and other costs of doing business. Then, after that, they add in their margin, or profit.
They take all of those figures and divide by the number of policyholders to get a premium.
That actual formula for determining premiums is more complicated than that, but those are the basics. As you can see, if the claims come in higher than expected, the insurance company’s profit goes down. If the claims come in lower than expected, the insurance company’s profit goes up. A lot rides on the accuracy of the underwriters and actuaries.
Shop Around When Buying The Best Insurance Rates
When insurance companies are battling for your business, it is usually the amount of profit they are willing to give or take that determines how competitive they will get with their pricing. Most of the other aspects of an insurance premium is fixed. Whether you are an individual or a group, insurance companies will many times come down on their premium if you press hard enough.
So when wondering how do insurance companies make money, it comes down to the profit they are taking on top of claims and fixed expenses.