How Do Insurance Companies Make Money? Business Model Explained

Insurance companies base their business models around assuming and diversifying risk. The essential insurance model involves pooling risk from individual payers and redistributing it across a larger portfolio. Most insurance companies generate revenue in two ways: Charging premiums in exchange for insurance coverage, then reinvesting those premiums into other interest-generating assets. Like all private businesses, insurance companies try to market effectively and minimize administrative costs.

Pricing and Assuming RiskRevenue model specifics vary among health insurance companies, property insurance companies, and financial guarantors. The first task of any insurer, however, is to price risk and charge a premium for assuming it.Suppose the insurance company is offering a policy with a $100,000 conditional payout. It needs to assess how likely a prospective buyer is to trigger the conditional payment and extend that risk based on the length of the policy.

This is where insurance underwriting is critical. Without good underwriting, the insurance company would charge some customers too much and others too little for assuming risk. This could price out the least risky customers, eventually causing rates to increase even further. If a company prices its risk effectively, it should bring in more revenue in premiums than it spends on conditional payouts.1In a sense, an insurer’s real product is insurance claims. When a customer files a claim, the company must process it, check it for accuracy, and submit payment. This adjusting process is necessary to filter out fraudulent claims and minimize the risk of loss to the company

Interest Earnings and RevenueSuppose the insurance company receives $1 million in premiums for its policies. It could hold onto the money in cash or place it into a savings account, but that is not very efficient: At the very least, those savings are going to be exposed to inflation risk. Instead, the company can find safe, short-term assets to invest its funds. This generates additional interest revenue for the company while it waits for possible payouts. Common instruments of this type include Treasury bonds, high-grade corporate bonds, and interest-bearing cash equivalents.

ReinsuranceSome companies engage in reinsurance to reduce risk. Reinsurance is insurance that insurance companies buy to protect themselves from excessive losses due to high exposure. Reinsurance is an integral component of insurance companies’ efforts to keep themselves solvent and to avoid default due to payouts, and regulators mandate it for companies of a certain size and type.For example, an insurance company may write too much hurricane insurance, based on models that show low chances of a hurricane inflicting a geographic area. If the inconceivable did happen with a hurricane hitting that region, considerable losses for the insurance company could ensue. Without reinsurance taking some of the risks off the table, insurance companies could go out of business whenever a natural disaster hits.

Regulators mandate that an insurance company must only issue a policy with a cap of 10% of its value unless it is reinsured. Thus, reinsurance allows insurance companies to be more aggressive in winning market share, as they can transfer risks. Additionally, reinsurance smooths out the natural fluctuations of insurance companies, which can see significant deviations in profits and losses.For many insurance companies, it is like arbitrage. They charge a higher rate for insurance to individual consumers, and then they get cheaper rates reinsuring these policies on a bulk scale.

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