Back to the Basics: How Insurance Companies Make Money

Takeaway:

Wondering how insurance companies make money? Just like any business, they need to carefully ensure they are bringing in more than they spend.

You get your insurance package in the mail. The envelope is thick, full of policy wordings and fine print. But, as you rip open the top of the envelope, your eyes are scanning for just one thing: the price.

You may look over your coverages and premiums to make sure you’re paying for what you need, but the question has surely crossed your mind:

“What is the insurance company doing with all the money I give them!”

Especially if you've had a bad claims experience where you didn’t get the payout you expected, it’s easy to ask this. So, how do insurance companies make money? What are they doing with your hard-earned cash?

The Business Model

The general principle with insurance is that everyone pays into one single pot of money. Then, when a consumer (like you) makes a claim, the insurance company pulls from the pot everyone paid into to provide that payout.

One factor that determines how much you have to pay into the pot is your personal level of risk. Do you get into a lot of accidents? Do you live in an area that has a higher rate of theft/fire/vandalism? Your premiums may be higher if the probability of you receiving a payout within the policy term is high. However, that doesn’t mean the amount you get from the pot will be lessened when you require a payout for a claim.

There are also external factors that play into the rate everyone pays into the pot. For example, if there was a large hailstorm or forest fire that devastated your province or state, the insurance company likely took a hit paying out those massive claims. As a result, the company will increase the premiums for everyone in that province.

How Insurance Companies Make Money

If a company has to pay out more in claims than the total consumers paid into the pot, then they are in big trouble financially. So how does the insurance company make money to ensure they say above water? Your premiums and investments.

The insurance industry isn’t a non-profit, and as such, your premiums are underwritten so that a portion for the business to make a profit. Within the payment of your premium, the insurance company may make additional profit from administrative fees such as cancellation or premium financing.

With some of the money that consumers pay in premiums, insurance companies will place the funds in short term investments. These investments usually take the form of corporate or treasury bonds. Where they invest depends on the company and what kind of return they need to make sure the business stays out of the red.

Read: How to Choose an Insurance Company That Won't Go Out of Business

Additionally, while the insurance company does not have many physical manufacturing compared with other product sellers (like the expenses an electronics manufacturer has), they also factor the administrative and legal costs of running the business into their profit margins.

To protect themselves, Insurance companies can also purchase reinsurance. This is insurance for the insurance company helps them by distributing financial risk, so they take less of a hit in the event of a massive payout.

Your Coverages

Insurance companies often find themselves running out of funds because they pay out too many claims, despite their prediction of risk or how they invest some of the premiums. These claims increase for many reasons. However, in recent years, many insurance companies have had to pay out massive amounts for natural disasters that are becoming more frequent due to climate change. Currently, flooding accounts for 50% of property & causality claims paid out in Canada. In the United States, hurricanes and flooding are the cause of the largest claims.

As a result, the insurance companies will bump the cost of specific coverage they frequently pay out on or they may remove the coverage availability in high-risk areas altogether. For example, if you live in an area known for summer hailstorms every year in the last 10 years, your cost for hail coverage may be increased or you may be denied that coverage altogether.

Conclusion

It might seem frustrating in regard to a business profiting off of state- or provincially-mandated insurance, but it’s just that—business. Much in the same way you would expect your local gas station to factor in profit from the gas you put into your car, insurance companies do as well.

Ultimately, the insurance company is there to provide you peace of mind—if something happens, it’s their contractual responsibility to help you get back to where you were before your loss. And for that peace of mind, there’s a price.