We have discussed countless insurance firms here on Buy Shares In. These companies are usually a good bet for investors, but why is that? Are these companies actually profitable in a world where they seem to be handing out huge payments, getting sued and falling foul of legal restrictions and fines?
How Do Insurance Companies Work?
The insurance industry was formed hundreds of years ago when merchants were provided with a way to safeguard their ship’s cargo against loss. They were transporting vast sums of goods across huge oceans and it wasn’t uncommon for these ships to get pirated or wrecked. Insurance was therefore a way for them to minimize risks and it’s the same today, only you can get insurance for everything you own against most eventualities.
You pay money based on a factor of risk determined by the insurance company and they agree to pay you a lump sum in the event that something untoward happens and you suffer major financial loss. It seems like a risky business for them to get involved with. After all, the money they pay out is far higher than the money you will put in and surely there will be enough claimants for them to run at a loss? Well, yes and no.
How Do Insurance Companies Make Money
Insurance companies have three major expenditures and all of the money they receive is pushed into one of these three areas.
The first is the pool of money put in standby to pay for all of the claims made against them. They have a fairly good idea of just how many claims there will be and how much will be claimed over the course of a year and they always have more than enough to cover these costs, as you would expect.
The second expenditure is marketing. Customers don’t just rock-up to their door and start paying them money. They need to spend to bring them in and there is a marketing budget for this. The final pool of money is used to invest. This means they operate much like a bank does, knowing that their actual operation may lose them money from time to time but that they will always have that investment cash to turn to and that it will continue to turn over a big profit.
Do Insurance Companies Make Money on Premiums?
Every year is different. Insurance companies that underwrite for home content loss and residential properties will suffer bigger losses in years where there have been particularly damaging storms. Generally, they will spend between $0.90 and $0.98 of every $1 they receive on paying for claims.
As you can imagine, once you add the marketing costs into this then there isn’t much left. In fact, most insurance companies do not make money from the very thing that they were setup to do. Their earnings come from the investments they make. If you give them $10,000 over the course of 30 decades and then pass away leaving $150,000 to your family, then it looks like a sizable loss on the surface, but that $10,000 could have been doubled or tripled fairly easily and once interest is added, it grows quite quickly.
All insurance companies need to very delicately balance the books in order to make sure that fraud and underwriting doesn’t leave them deeply in the red at the end of the year. This is where premiums come in. They will offer you a figure based on the condition of your health or your home, as well as the amount of fraud that they can expect to receive over the course of a year. This is a complex process and while it’s not an exact science, it means they can predict what kind of payments they are expected to make over the course of a year and even a decade and adjust all future premiums accordingly.
These premiums are changed individually and across the board. So, if you have been an insurance paying homeowner for 20 years without incident then you can expect your prices to come down. If you suddenly make a homeowner claim then you can expect future premiums to increase. However, factors such as a year of bad storms and an increase in fraud will have just as much of an impact on your premiums.
It might not have anything to do with you, but they still need to make money and so they factor these things in. That’s why you see so many claims about cases of fraud sending everyone’s premiums up. It’s not just a scare tactic, it’s actually happening and because they are only earning a couple of cents on the dollar they have very fine margins to work with and will do what it takes to maintain these.
So, Do Insurance Companies Make Money?
As mentioned already, this is a somewhat yes and no answer, but the same can be said for many big businesses. There is a strange trend for them to lose money and focus instead on growth. Amazon is known to lose money on countless products just so they can be the cheapest retailer of said products and they are also known not to draw major profits because they invest them back into the company. The same can be said for Google, albeit to a lesser extent.
Then you have the banking industry which runs on margins that are as fine (if not finer) than the insurance industry. After all, they may make money from credit card interest and overdraft charges, but when you factor in all of the money they pay out in interest on saving accounts and current accounts, it’s easy to see how those margins are so fine.
That’s because their goal is just to get you money and essentially reward you for giving it to them. They then take this money, invest it and try to make significantly more investing it than they will ever pay to you in interest. Insurance companies operate in a similar way, even if the setup is a little different.