How do Insurance Companies Make Money?

How do Insurance Companies Make Money?

As with most other companies, insurance companies primarily generate revenues through sales to customers. More specifically, insurance companies sell insurance policies and receive payment in the form of a premium. The main way that an insurance company makes a profit is by ensuring the premiums received are greater than any claims made against the policy. This is known as the underwriting profit. Insurance companies also generate additional investment income by investing in the premiums received. This is known as investment income.

Underwriting

Insurance companies generate underwriting income by selling insurance policies to customers. Insurance firms have both retail customers, which are individuals, and also corporate customers, which can be larger institutions. The insurance company provides an insurance policy to the customer, who then becomes a policyholder. In exchange, the customer pays a premium to the insurance company.

An insurance policy is a legal agreement between the two parties under which the insurance company bears the financial burden of certain events in exchange for regular payments from the policyholder. The regular payments made by the policyholder are known as premiums.

The specific event that the insurance has to cover is known as a loss event. The payout made by the insurance company in the event of the loss event occurring is known as a claim. The duration between the starting point of a policy and the expiration is known as the coverage period.

Using historical data and statistical analysis the insurance company can predict, with a certain degree of confidence, the loss events that may occur in the future and thus the approximate amount they may have to pay out in claims. Insurance companies employ actuaries to model the timing, likelihood, and value of future claims.  The analysis is also used to price insurance premiums. The ratio of premiums to claims is known as the loss ratio.

Insurance companies generate profits by ensuring that the amount paid out in claims does not exceed the amount collected in premiums.

Investment Income

Insurance companies invest the cash premiums they receive from their insurance customers in the financial markets to generate an investment income.

The process of investing premiums is generally not done on an individual policy basis, the policies are instead grouped together to create a portfolio.

The insurance company does this so that they can offset large claims made by certain customers with the total premiums in the portfolio. This allows the insurance company to better manage their risk.

Example

Below is an example of how the total profit of a policy is calculated. An insurance company has issued a policy with a coverage period of one year. The premium income over this period will be £1000 and the loss ratio is 80%. The insurance company is able to invest at a return of 15%.

In the example above the total profit is £350 which is made up of £200 underwriting profit and £150 of investment return. Since the claim is being made at the end of the year one coverage period, the insurance company can earn the investment return for the full period.

Download the accompanying excel files to practice a similar exercise for yourself.