Skip to Content

How Do Insurance Companies Make Money? (4 Smart Ways They Profit)

How much do insurance companies make on average monthly or yearly? How do insurance companies make money? Here are 4 clever ways insurance companies make money. Insurance involves transferring of the risk of a loss from one entity to the other. It is a risk management strategy used to guard against future uncertainties which may lead to losses.

Insurance companies are part of a very large financial industry and their business entails helping business owners and individuals reduce risks and providing a soft landing for them in the event of future occurrences. People buy insurance policies as a form of risk management in order to reduce the consequences of a potential future loss. The insurance company collects a certain amount of money from the insured known as the insurance premium and hands out a written agreement to the insured known as the insurance policy.

This insurance policy document would contain all the terms, conditions and clauses of the insurance contract. It would also spell out the obligations of the insurance company if such event happens in the future. Now, whenever there is an unfortunate incident, the insurance company would compensate, replace or repair damaged property depending on the terms of the contract.

4 Clever Ways Insurance Companies Make Money

There are different types of insurance companies offering different kind of products but the way they make their money is the same. Insurance companies make their money through-:

1. Insurance premiums

Insurance companies are ‘risk poolers’. This means that they bring together, people who are willing to protect their businesses or property against potential future losses under one umbrella. Let’s say an insurance company has 1,000 clients whose vehicles it has insured for $5,000 each, the insurance company would have all 1,000 customers pay a certain amount as insurance premium.

In this case, let’s assume that the premium is set at $250 each in exchange for insuring those vehicles for $5,000. Now it’s almost impossible that all 1,000 would make claims that year. So, let’s assume that out of the 1,000 insured, only about 200 made claims, the company pays out claims to the 200 and what is gotten from the remaining 800 who did not make claims is kept as profit. This kind of profit is known as underwriting profit.

2. Investments

Insurance companies get a lot of money from premiums and instead of leaving the money lying around fallow, they invest it in different assets that would yield profits for them eventually. Such investments are mostly real estate, government bonds, treasury bills and private equity so that when the insurance company has claims to deal with, it not only has enough to settle the claims but also has enough profit left to keep.

Insurance companies are always careful with investments which is why most of their investments are in government bonds and low-risk investments.

3. Reserves

Due to the nature of its business, an insurance company would usually have more money than it needs most of the time. These extra funds are usually kept as reserves and used to pay claims when the need arises.

4. Risk Measurement

An insurance company also makes money by measuring risks. If a business or area is prone to high levels of risks, an insurance company may elect to avoid offering insurance coverage for that type of business. For instance, if an area is prone to earthquake, insurance companies may avoid insuring homes in that area.

So an insurance company makes money by measuring risks and covering property or business that pose low level risks and that way the number of people that would file claims would reduce and that would also lead to an increase in the company’s profits.

Basically, an insurance company does three things-:

  • Risk Control-: Insurance companies help their clients to reduce and control risks.
  • Risk Financing-: If a client is still unavoidably exposed to risk, an insurance company takes the risk off him by accepting to bear the costs of the damage whenever it occurs.
  • Risks Sharing-: An insurance company also brings together different people who are willing to insure themselves or property against risks together.

Types of Risk That Insurance Companies Cover

a. Personal risks

These are health and safety risks that may affect an individual such as illnesses, diseases, accidents or death.

b. Property risks

This involves risks that an individual or business would lose its property due to natural or unforeseen circumstances like fire, floods, earthquakes etc.

c. Liability risks

A person or business might be found guilty of negligence when they cause other people to lose their property or lives through careless or willful acts. For instance, a doctor may be found guilty of negligence if he engages in acts that put his patients at risks like giving wrong prescriptions or not carrying adequate tests.

In such a situation, if something bad happens to the patient and he decides to sue the doctor, he may be found guilty of negligence and asked to compensate the patient; this is where the insurance company would come in and take up the responsibility of compensating such patients.

An insurance company accepts risks from the insured and so that it can make profit, the insurance company has to estimate the extent to which losses may occur and then the insurance company sets an amount known as the premium which would cover for losses, expenses and also leave enough for profit.

How Insurance Companies Determine Premium

Determining insurance premiums are a very complex process. The insurance company has to take a lot of factors into consideration. First, the company takes into consideration a factor known as the company’s loss experience. The loss experience is arrived at by dividing all the premiums collected by losses recorded. Then it also takes economic trends into consideration to determine expected future claims and costs of running the business.

Also, it takes into consideration the loss experience of a particular insurance policy before it sets its premium. For instance, if drivers in a certain area record more auto accidents than in other areas, the insurance company may set a higher premium for insuring motor vehicles of people living in that area. Premiums are set based on a number of individual factors like age, lifestyle, income, medical history and risk exposure.

Premiums are also set based on the type of insurance policy. For instance, the way premiums are calculated on health insurance would be different from auto insurance.