As a consumer, have you ever wondered how insurance companies are able to turn a profit? While the core purpose of insurance is to mitigate losses, insurance companies are still for-profit businesses with shareholders and investors to satisfy. Insurance companies are able to generate profits through several mechanisms. First, they charge policyholders premiums that on average exceed the total costs of claims and expenses over time. Insurance companies invest the premiums they collect from policyholders in the financial markets to generate investment income. They are also able to turn an underwriting profit when the total premiums collected in a year exceed the costs of claims and expenses. Finally, some insurance companies generate profits through additional fees and riders. By understanding how insurance companies generate revenue and profits, you can make more informed choices as a consumer.
Premiums – The Main Source of Revenue
Insurance companies generate the majority of their revenue from the premiums paid by policyholders. Premiums are the amounts policyholders pay in exchange for insurance coverage. Insurance companies use actuarial science to calculate premium rates based on the level of risk for the policyholderInsurance agencies make investments the charges they accumulate to generate extra revenue. The premiums are invested in low-risk, interest-generating vehicles like government bonds, certificates of deposit, and blue chip stocks. The investment income is used to pay insurance claims and operating expenses. If there is excess investment income after paying out benefits and expenses, insurance companies retain the surplus as profit.
Policyholders pay premiums regularly, either monthly, quarterly, semi-annually or annually depending on the policy. As long as the premiums are paid, the insurance policy remains in effect and the insurance company is obligated to pay claims covered under the policy. If a policyholder stops paying premiums, the insurance company can cancel the policy.
Insurance companies use the law of large numbers to calculate the level of risk for a pool of policyholders. By insuring a large number of individuals or assets engaged in a similar activity or with a similar risk profile, the insurance company can predict with high accuracy the overall level of claims that will be submitted and the investment income that will be generated. The key to profitability is accurately pricing premiums to cover costs and generate an underwriting profit.
Synonyms for premium include payment, fee, charge, assessment, contribution, dues. Related terms include claims, benefits, coverage, policies, risk, liability, loss.
Investments – Generating Returns on Premiums
To generate returns on premiums paid by policyholders, insurance companies invest a portion of the premiums in low-risk investments like government bonds, certificates of deposits, and blue-chip stocks.
The premiums collected from policyholders are pooled together to form the company’s investment fund. Typically, a large percentage (often over 80%) of premiums are invested in low-risk, interest-bearing securities like Treasury bills and highly-rated corporate bonds. These fixed-income investments generate predictable interest income with little risk of losing principal value.
In addition to bonds, insurance companies invest in stocks and mutual funds to achieve higher returns. However, strict regulations limit equity investments to a small percentage of assets (usually less than 15%) to minimize risk. Dividends and capital gains from stocks provide insurance companies a higher return potential over the long run compared to bonds.
By prudently managing investment portfolios and generating solid returns, insurance companies are able to pay out claims and still make a profit. The investment income is a significant source of revenue for insurers. In fact, for some policies like whole life insurance, investment returns constitute a large part of the benefit payments to policyholders.
Minimizing Claims Payouts – Keeping Profits High
Insurance companies are able to remain profitable and minimize claims payouts through various methods.
Insurance companies carefully screen applicants to determine their level of risk before issuing a policy. By assessing factors like age, health conditions, location, and driving record, the insurer can determine if the applicant is a high-risk or low-risk customer. Lower-risk customers typically receive lower premiums because they are less likely to file claims. Higher-risk customers may be denied coverage or charged much higher premiums to offset the increased chance of claims.
Policy Limits and Deductibles
Insurers place limits on the total value or number of claims they will pay out for a policy. They also often require policyholders to pay an out-of-pocket amount, known as a deductible, before the insurance coverage begins paying claims. Higher deductibles and lower policy limits reduce the insurer’s financial responsibility, allowing them to offer lower premiums while still making a profit.
Insurers implement care management programs to reduce unnecessary or excessive medical care and claims costs. These programs include pre-authorization for certain procedures, preferred provider networks, and wellness incentives. They aim to avoid unnecessary treatments, steer customers to lower-cost yet qualified providers, and promote healthier lifestyles
Investment of Premiums
Insurance companies do not simply hold the premiums they collect from customers in cash. Rather, they invest the funds in the financial markets to generate additional revenue. As long as the insurer receives higher returns on their investments than the cost of claims and expenses, they are able to profit and remain financially stable. Investment income provides another means of offsetting costs and keeping profits high.
As you have learned, insurance companies are able to make sizable profits due to their business model. By collecting regular premiums from a large pool of policyholders and only paying out claims for a small percentage of them, insurance companies are able to invest the rest and generate returns. They are also able to increase profits over time through calculated adjustments to premiums, deductibles, coverage limits, and by denying claims when justified. While policyholders benefit from the financial protection and risk mitigation that insurance provides, insurance companies benefit by profiting from the premiums collected. By understanding their key strategies and operations, you as a consumer can make more informed decisions about the types and levels of insurance coverage that suit your needs.