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How Insurance Companies Make Money

Updated on February 8, 2018

How Insurance Companies Work

The “insurance industry” is as rich if not richer than the banking industry. The key to their success is to capitalize on peoples fears.

The primary insurance policies most people buy are for their motor vehicles, their home or business, and their health (including life insurance). They buy it because they want to ensure their needs will be met if an incident were to happen. A motor vehicle accident, a fire in your home, or a serious illness can put a significant dent in your budget. The average person does not have enough cash available on hand to recover from such an event. So, they buy insurance to provide the financial resources needed if an event occurs.

The key phrase in the proceeding sentence is if an event occurs.” And that is a big if!

Every single insurance company on the planet relies on that big if. They gamble that you won’t file a claim, and you pay them to provide for your needs if a claim is necessary. Obviously, based on the financial success of insurance companies, they have the odds stacked in their favor.

Many insurance companies have a risk factor that they use to determine your premiums. The higher the risk factor the more you pay. For example, drivers under the age of 25 pay a higher premium because statistically they are involved in more accidents. For homeowners who live in a flood zone, insurance companies charge additional premiums for flood coverage because they have a higher risk of damage from flooding. There are all sorts of different risk factors the insurance companies use to calculate their premiums. If the risk factor gets too high, then the insurance companies may not offer a policy for that category.

The scope and variety of insurance policies is almost limitless. There are the obvious ones such as health, homeowners and automobile insurance as well as life, liability, malpractice, accident and disability to name a few more. All of them work under the same basic principles. They receive premiums from you in exchange for a promise to pay if you file a claim based on the terms of your policy. If you don’t file any claims, then they keep your premiums.

Ultimately, in order for insurance companies to remain profitable, they need to make sure the income from their premiums exceeds their operating expenses and claims payouts. Since it is impossible to determine when customers will file a claim, there are times when an insurance company will have more cash come in from premiums than it needs to pay in claims. Insurance companies will calculate the funds needed to hold in reserve for large claims to be placed in an investment account. The profit or loss from those investments is another revenue stream that directly affects their bottom line on their income statements.

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