How insurance companies make money
The Business of Insurance

Have you ever wondered how an insurance company makes money when premiums are pretty small compared to the amount they have to pay if you have an accident?

Take auto insurance, for instance. Let’s say you’re paying $500 every six months for your insurance coverage, and you have an accident that bangs up your car to the tune of $5,000.

Your insurance company has to pay for the damage. Let’s say your deductible (your share of the damages) is $500, so the insurance company has to come up with $4,500 to repair your car. It would appear they’re in a losing situation. From where does the remaining $4,500 come?

If every policyholder had an accident like this, the company clearly would go broke, however, insurance companies spend big bucks on exotic computer programs and high level mathematicians known as actuarial scientists whose job it is to predict the probability of accidents, disasters and catastrophic events. Different parts of the world are identified and assigned loss ratings. A company either declines to insure in high risk areas or demands higher premiums. Many factors come into play, and these factors establish a basis for setting policy premiums.

But we still have the question of how the insurance company comes up with the other $4,500 to pay for your accident damages. It isn’t only from other premiums collected from other policyholders, as most insurance companies regularly face claims in excess of collected premiums, known as an “underwriting loss”.  When there’s money leftover after all claims are paid, the remainder is called an “underwriting profit”.

Where an insurance company makes money – and the profits can be astounding – is through investing all of those premiums. The company takes advantage of “the float” (the time between when a premium is paid and when a claim has to be settled) by investing with the aim of generating enough income to cover excess claims and leave a little leftover for profit.

It may not sound like the greatest moneymaking scheme to those who have dabbled in the stock market, however, insurance companies consistently generate billions of dollars in income from their investments. Despite an underwriting LOSS of $142.3 billion from 1998 to 2003, U.S. property and casualty insurance companies still had an overall PROFIT of $68.4 during that same period. In other words, claims and expenses exceeded the amount of premiums paid to the tune of $142.3 billion, but investment profits made up the difference and left a $68.4 billion profit.

The real business of insurance is investing!

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