Insurance Q&A: How do insurance companies make money?

You know, dough, clams, bacon, cheddar, moolahbut first a little background.

An insurance policy is a contract, or a promise, between the insured (you) and the insurer (insurance company). The insurance company collects a premium from you for the issued policy and agrees to pay for any covered losses you suffer. It sounds like a pretty simple business model for earning money, but can be quite complicated.

Insurance companies are like any other business in the world. They have to make a profit to stay in business. There are two basic ways this can be accomplished. They can earn underwriting income, investment income, or both.

Underwriting Income

Underwriting income is derived from the difference between how much money is collected for all policies sold versus how much money is paid out in insurance claims for those policies in any given time period.

For example, Insurer “A” may collect $1,000,000 in premium for polices issued or renewed in a given year. If they pay less than $1,000,000 in claims, they have made a profit. If they pay more than $1,000,000 is paid in claims, they suffer a loss.

Insurers have a unique way to earn massive amounts of additional profit. Unlike many other types of businesses, insurance companies collect huge sums of cash throughout the year and may not have to pay on claims on those policies for many years.

Investment Income

This unique situation allows insurance companies to invest that money while its not being used. Huge profits can be reaped, or lost, as a result.

This is exactly why Warren Buffet formed the Berkshire Hathaway Insurance Company…so he could generate capital to invest in the stock market.

In fact, insurance companies can knowingly charge too little for insurance policies and plan for an underwriting loss if they believe they can make a profit from investing the money they receive before having to pay claims. In the early 2000s, when the stock market was booming, this practice was taking place.

On the flip side, insurance rates may be raised to make up for stock market losses.

Additionally, some insurance companies may enter a new line of insurance or a new state and purposely charge less than their competitors, causing an underwriting loss, simply to make a name for themselves. Then, the following year, raise their rates and hope to hang on to some of the business they wrote.

Taking all of this information into account, it is recommended that you shop online in order to be certain you are getting the best coverage at the lowest rate available to you.