#20 How do Insurance Companies make (so much) money?
Underwriting, Investments and buying another insurance on your insurance
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Insurance companies make money by betting on risk - the risk that you won't die before your time and make the insurer pay out, or the risk your house won't burn down or your SUV won't be totalled in a crash.
The concept that drives the insurance company revenue model is a business arrangement with an individual, company or organization where the insurer promises to pay a specific amount of money for a specific asset loss by the insured, usually by damage, illness, or in the case of life insurance, death.
The questions still remains - how do they make SO MUCH money - i.e. earn much more in revenues than they pay out.
How Insurance Companies Make Money
Underwriting (the obvious model)
For insurance companies, underwriting revenues come from the cash collected on insurance policy premiums, minus money paid out on claims and for operating the business. For instance, let's say ABC Insurance Corporation earned $5 million from the premiums paid out by customers for their policies in a year's time and paid $4 million in claims in the same year. The underwriting revenue is $1 million.
Unlike other businesses, an insurance company puts no money up front, and only has to pay if a legitimate claim is made.
Make no mistake, insurance company underwriters go to great lengths to make sure the financial math works in their favor. As they say, the house always wins.
Investment Income
When an insurance customer pays their monthly premium, the insurance company takes the money and invests in the financial markets, to increase their revenues.
Since insurance companies don't have to put cash down to build a product, like an automaker or a cell phone company, there's more money to put into an insurer's investment portfolio and more profits to be made by insurance companies.
That's a great money-making proposition for insurance companies. An insurer gets the money up front from customers, in the form of policy payments. They may or may not have to pay off a claim on that policy, and they can put the money to work for them right away earning investment income on Wall Street.
Reinsurance Arbitrage 🤯
Reinsurance is insurance that insurance companies buy to protect themselves from excessive losses due to high exposure.
Arbitrage - Insurance companies charge a higher rate for insurance to individual consumers, and then they get cheaper rates reinsuring these policies on a bulk scale. ie. if 100 customers buy policies for $1000 from an insurance company, the insurance company then re-insures this package of $100,000 worth of premiums for say $90,000.
Cash Value Cancellations
Sometimes customers cancel their insurance policies to earn “cash value” - ie. dividends from the investments that the insurance company made.
When a customer takes cash value money and closes the account, all liability ends for the insurer. The insurance company keeps all the premiums already paid, pays the customer with interest earned on their investments, and keep the remaining cash.
Coverage Lapses
Under the insurance policy contract, a policy lapse means the actual policy expires without any claims being paid out. In that situation, insurance companies cash in again, as all previous premiums that are paid by the customer are kept by the insurer, with no possibility of a claim being paid.
This happens either when the customer either outlives the coverage timetable or doesn't keep up with premium payments.
Industry data shows that for every 100 insurance customers paying their premiums every year, only 3 of those consumers make a claim. Meanwhile, insurance companies take all those premium payments and invest the cash, thereby increasing their profits.
Fun Fact: Due to cancellation of large-scale events, Wimbledon received $141 million from Pandemic Insurance payout 🤯🤯
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