How does an insurance company make money?

Introduction to the sources

Are you scratching your hair because you aren’t aware of how an insurance company earns money? Does your answer just revolve around the premium they charge from the policyholders? Well, you are partially informed then. There are other ways too by which an insurance company earns money. But what are they? We will tell you all about the various sources through which insurance companies get their earnings.  Here we will see about How does an insurance company make money?

We thereby provide you with this article that is equipped with all the material knowledge you wish to know. The insurance companies do not as such earn any secret profits. It is just by the virtue of their business model that they earn income from a range of sources. So, let’s get into those sources and know more about them.

How does an insurance company make money

Understanding the basic working of an insurance company

Introduction to the concept of insurance

Before getting into their business, we desire to define the term of insurance for you. This will help you form an idea in case you don’t have any. Well, insurance can be stated as a contract whereby one party offers to pay the price called as a premium to another party (insurance company) is proportionate to the risk that this party bears to compensate in case of any unforeseen and unfortunate event. These events however should be certain and specifically mentioned in the insurance policy that has been taken. The party that takes insurance is called insured whereas the one who offers the policy is the insurer or insurance company.

The business model followed by the insurance company

As we mentioned above, the insured transfers his/her financial risk to the insurer, and the insurer agrees to bear the risk in exchange for the premiums paid by the insured. Now, these premiums are a part of the income for the insurance companies. Do you wonder how? Well, the insurance business works on the law of large numbers. This means that not all people will face the loss at the same time. 

For example, Mr. Bose has taken motor insurance and Mr. Paul has taken the same insurance policy. They both stay in different cities. Now, Mr. Paul meets in an accident and his vehicle gets severely damaged. He will approach the insurance company and make a claim. Now, is it that Mr. Bose had also met with an accident? Assuming a no, then that amount of premium received from Mr. Bose serves as earnings for the company. It will be payable only if he meets with an accident before the policy expires. We just took examples of two people for simplicity.

  • There are so many people out there who take insurance policies regularly. Does that mean that they all are compensated on the same day? Of course, not! This is the law of large numbers
  • They then reinvest the money on profitable businesses or financial instruments and earn profits on them
  • The insurance companies pool the premiums collected into securities that are less risk-prone and offer sound returns
  • By investing in real estate, money mark instruments, and other secured financial assets like bonds, they maximize their returns. 

We hope that you can understand the basic source of income for an insurance company.

The sources of income for the insurance business

The motley of opportunities to earn money

We assume that you have firmly grasped the important way insurance companies make their income. Apart from the premiums they charge and earn by reinvesting them, is there any other way they get their money? Yes, there are other sources too. Let’s have a look at those sources as well.

  1. Income generated from underwriting services. Underwriters are the ones who calculate and analyze the risk and the probabilities of that risk. On the basis of the observations, the premiums are calculated and charged from the policyholders. 
  • Now, insurance brings the policyholder to the same financial condition as he was before the loss took place
  •  This means that the compensation can be equal to or less than the amount promised
  •  It depends on the assessment of the loss and the reasons associated with it
  • Therefore, the difference between the premium that is collected and the claim amount paid, and other costs involved becomes the income for the company.

 Let’s understand this with an example. Suppose Mr. Ramaswami insures his house for $6 billion and he suffers a loss arising from fire. He immediately informs the insurance company and places his claim to be settled. The insurance company visits his house and surveys to find the actual loss he suffered. They come to the conclusion that the loss suffered is say, $4 billion. Hence, the amount which the insurer will pay to the insured is $4billion and the difference that is equal to $2 billion is the profit on the underwriting side. 

  1. Revenue is earned when the loss is not due to the occurrence of the proximate cause. 
  • The underwriters make sure that their estimations and forecasts are correct 
  •  always tend to work in the favor of the insurance company
  • It is actually tough to get compensated because the company makes proper surveys, investigations, calculations, and analyses to find out the reasons associated with the loss
  •  If that reason falls under the exclusions mentioned in the policy, then again the company will not compensate any amount.

For example; Mrs. Maya owns a house that is insured against the peril of fire. Due to an earthquake, the house collapsed and she suffered huge losses. Do you think it will be compensated? Well, it won’t be. The simplest reason is that under the fire policy taken by Mrs. Maya, the earthquake is not the covered peril. Therefore, the insurance company can refuse to pay the compensation.

  1. Income earned from the lapse of the policy. 
  • You should not get surprised to hear that insurance companies also benefit even when you fail to pay the premium,
  •  The default makes your policy go in vain
  •  If you make default in the payment of the premiums and you fail to do so even after being warned, then the company happily closes your policy
  • All the amount that you have paid till that period serves to be their revenue. 
  1. Money generated from a no-claim-making policyholder. If supposedly, you incur no loss then also it adds to the treasury of the insurer as it has no obligation to pay you since there was no occurrence of any loss event. All the premiums that you have paid till the policy lapse, become the revenue generated for them.
  1.  Misrepresentations made by the policyholder in the insurance contract also add to the treasury of insurance companies. 
  • Some people think they can fool others 
  • They thereby take up a policy by answering falsely to all the questions asked before taking a policy
  •  When the policy operates and the insured makes a false claim, the insurance company may find out or discover it and then cancel the policy and treat the premiums paid as their revenue. 

This can be understood with an example. So Mr. Vikram takes up a health insurance policy and states in his application that he hasn’t visited any doctor within the last two years. But actually, he did visit, and a few months after taking the policy, he had heart surgery and died. His wife claims the compensation to the company but, gets refused because the company found that Vikram has lied to them earlier and thereby the contract can’t be honored. 

  1. The income arises as to the difference between the policy taken and the current market value. Suppose that a person takes insurance for his car worth $10 billion and it suffers a complete loss since he meets with an accident. From the above examples, you must have understood that it is not true that he will get $10 billion. The person may have overvalued the value of the car or it may happen that the value of the vehicle has dropped severely. Therefore, the insurer will pay only the amount which is equivalent to the valuation prevailing at the time of making a claim. If this model of the vehicle is available for $7 billion in the market, then the person won’t be paid more than this amount.
  1. Failure of the insured to maintain his promise or warranty
  • The insured at the time of agreeing makes a promise which becomes a material fact 
  • based on this fact, the premium and policy are determined
  • If there is a breach of that warranty, insurers may refuse to make the compensation. Again, it serves as the income for the company.

 In case you face difficulty understanding this, here is an example. Mrs. Vandita takes a policy to cover her losses from the burglary on the commitment that her entrance door security lock and the alarm system is working 24*7. After obtaining the policy, the insured becomes negligent and doesn’t care to carry out repair works when the alarm system suffered a breakdown. Theft happens and she makes the claim. The insurance company can depend on the warranty and the breach of which gives it the power to make the contract void.

Observations drawn

From all the above case examples and stated facts, it becomes crystal clear that 

  • mainly an insurance company gets money from two sources
  • One is the number of premiums charged and that invested in financial instruments which gives substantial returns
  • The other is the difference in the amount claimed and the actual loss suffered
  •  The other lacunae arise from the insured’s side which leads to revenues for the company. These are the faults of the policyholders intentionally or unintentionally that drive profit-making for the insurance company. 

Point of advice

  • The policyholders must remember that whatever loss they suffer must have arisen from the peril that has been insured.
  •  The loss should be in numerical terms which means that it must be monetarily calculable. 
  • Also, all the terms and conditions must be read and understood before entering into a policy 
  • As far as possible, try to reveal all the material facts which are essential for the assessment of your risk and premium contribution. 

The bottom line

Can we now say that in a way an insurance company also takes a risk by insuring our risks? Yes, absolutely! However, they use calculations and proper assessment of the risk they insure. They work on the lines that they are profitable and the situation turns out to be in their favor. However, there are many instances when an insurance company has to bear the wrath of financial breakdowns and they eventually had to close their operations. For example the Great Depression. These are the uncertainties about which even the insurance companies aren’t aware of and they take the risk to profit from the non-occurrence of such happenings.

 But insurance is indeed a great way of relaxation in today’s life. It provides that mental peace and calmness which individual demand. Most of the companies have a claim settlement ratio of above 95% which means that they settle down the claims made. It is a complete misconception that the amount taken for insurance is actually wasted on non-occurrence. One never knows the mishaps that one may encounter in his/her daily routine. Therefore, insurance serves as a relaxation giving capsule. 

We hope that you can get all the details that you wanted to know and we have done justice to your appetite for knowledge. Thanks for reading till the end! We hope we have covered the minutest of the source through which money can inflow into insurance companies.

Frequently asked questions
  1. Does owning an insurance company profitable?

Ans: Yes, it is! Through the article, you can see there are so many ways how they earn money.

  1. Are insurance agents happy with their choice of career?

Ans: No. This is because of the lower pay and the difficulties in selling an insurance policy.

  1. Is working for an insurance company a good thing?

Ans: yes. The job is filled with enthusiasm and exciting steps that can help you make an impact on the lives of the people

How does an insurance company make money?

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