How do Insurance Companies Make Money

WHAT IS INSURANCE?

Insurance is a mechanism by which an individual receives a financial security against a particular loss. It comes in the form of a policy strategy in which the company providing insurance pools a client’s risk together with other risks included. In this way, the insurer safeguards the risk of an individual.

Insurance policy consists of three main components which are considered as key components. Let us learn it in detail for a better understanding.

Three Main Components of Insurance Policy

1.Premium

It is the price of the policy, expressed as a monthly cost. Even though it is expressed as a monthly cost, it can also be paid as annual or semi-annual basis.

2.Policy limit 

Policy limit is the maximum total amount of money paid by the insurer under a policy for an incurred and covered loss.

3.Deductiable 

It is the specific amount that the policy-holder must pay from his pocket before the insurance company covers any occurred losses. The insurance company is compelled under the law of company to cover the costs about this amount but not exceeding the policy limit in case of the loss as defined in the policy.

WHAT IS A PREMIUM AND HOW IS IT CALCULATED?

 The premium is a product of three key components. They are:

  1. RISK – It is referred as the core part.
  2. Others- operating costs such as salaries, rent, IT etc.
  3. Margin or profit.

Each insurance company has actuaries, statistical modelling risk assessment areas.

Actuaries are nothing but they figure out the cost insurance companies expected to pay back in a long run. They assess how much money the company needs to collect so that they have sufficient capital to pay all the claims and still remain profitable.

HOW IS RISK DETERMINED?

Risk is generally calculated as the outcome of two factors. They are:

1. Frequency

It is a model that assess the probability or possibility of a special claim. The outcome of frequency will be in between 0 to 1.

2. Severity

It is a model that assess the amount of money that will be associated with that special claim mentioned above. The outcome could be any possible number unlike frequency which is limited from 0 to 1.

WHAT IS PRICE ELASTICITY?

Have you ever wondered how the prices for products are figured out? Have you ever wondered like how do large corporations like amazon or any sort of airways decide the right price for their products? Whether the product maybe any airway ticket or any loan or insurance, companies must use price optimization.

It is notably a vital process for pricing. But before that let us understand what is meant by price elasticity. It is nothing but the customer’s sensitivity to change in price. As the price increases, your demand for it decreases.

WHAT IS PRICE OPTIMIZATION?

Price optimization is a technique which is based on the price elasticity of demand over the entire client’s portfolio. Using this price optimization strategy, it can grow the profit and the business conversion rate as well. This strategy is uses by the insurance fields for earning money and still remain profitable.

TYPES OF INSURANCE POLICIES

Now let us discuss about types of insurance policies in brief.

1.MEDICAL INSURANCE 

Are you expecting a little one? Or are you in a state with significantly poor health conditions, due to age or lifestyle or whatever it maybe. Medical insurance effortlessly stands out among all kinds of insurances when compared. As we all believe “HEALTH IS WEALTH.” Your great wellbeing is the real thing which enables you to work and make money and live a life you wished. 

Medical insurance is nothing but the insurance that is taken out to cover the medical care. Nowadays hospital bills make a person even sicker than the disease in actual. So, health insurance should be taken mandatorily by every citizen including the family members.

2.LIFE INSURANCE

Life insurance is the most crucial insurance policy. You definitely get yourself a life insurance, especially if your family is solely dependent on you. Life insurance has many categories like whole life insurance policy, term insurance policy, endowment policy and many more. 

These above-mentioned life insurance policies are the most widely used. Life insurance not only safeguards your family but also protects them from future budgetary crisis. So, make sure you have one.

3.MOTOR INSURANCE 

Motor insurance does not only mean for cars. It is also meant for bike and any other vehicles. If you own any kind of vehicle, you should go for this kind of motor insurance. It has its own benefits. 

It not only works in the case of accidents, but also covers in the case of theft of the vehicle. Motor insurance also covers the vehicle in case of damage to it due to any natural calamities or fire accidents.

4.HOME INSURANCE 

If you own a house, then you definitely know how much efforts and money it takes to buy or build a home. By getting home insurance policy, you can cover your home from any damages that are occurred due to any kinds of natural calamities or fire. 

Not only this, home insurance policy also covers the case of stealth of your home. It also covers floods. To be on the safe side, get yourself a home insurance policy, while buying a house.

These above-mentioned insurance policies are the most widely covered from people all over the world. There are also many other insurance policies apart from those mentioned above and are used widely now.

How do Insurance Companies Make Money

Here are the key metrics used by Insurance Companies to make money.

(A)UNDERWRITING.
(B)PROFITABILITY.
(C)INVESTMENT INCOME.
(D)CASH VALUE CANCELLATIONS.
(E)COVERAGE LAPSES.

(A) UNDERWRITING

Underwriting is an essential requirement for a successful insurance company. It depends on the quality of underwriting of an insurance company, how it stands out of others. This quality is further assessed by two ratios. Let us know in detail about them.

1. LOSS RATIO.

It is the crucial and basic metric which shows and tells us that how good the premiums collected covers the claims that are expected and will be paid out. Loss ratio is generally calculated to keep note of the relationship between the losses and premiums in terms of percentage.

The lower the loss ratio of an insurance company, the greater it’s risk management. If the loss ratio is high, it shows that the insurance company needs to focus on better management of risks in their policies.

2. COMBINED RATIO.

Combined ratio is also like the loss ratio. In addition to loss ratio, combined ratio has added part that is, it also accounts for all other expenditures related to the underwriting processes like fees, salaries, and many such. 

If the combined ratio is above 100% it shows that the insurance firm is losing the money on its own insurance related operations. Therefore, insurance companies need to keep an eye on both ratios for its own good.

(B)PROFITABILITY

In the insurance business, it can take so much time before an issuer knows how much amount of money it earned during a given period of time. Profitability is assessed as a rate of return of equity, assets, and others.

(i) RETURN ON EQUITY[ROE]

ROE: Return on Equity measures the profitability of the insurance company for the investors willing to invest in it. Return on equity can be easily explained by a simple mathematical note.

RETURN ON EQUITY = (NET OPERATING INCOME – STOCK DIVIDENDS) / AVERAGE COMMON EQUITY.

(ii) INVESTMENT YIELD(IY)

Investment yield measures the profitability of the assets related to insurance.

INVESTMENT YIELD = NET INVESTMENT INCOME / AVERAGE INVESTMENT ASSET VALUE.

(C)INVESTMENT INCOME

Insurance companies make a great amount of money through Investment income. When a customer pays their prompt premium to the insurance company, the company uses this money and invests it in the stock market to increase its revenues. 

If in case the investments go in any unfavorable manner, they will just rise the premium price and put off the loss load to the customers, in the form of increased cost policy.

Here the thing to be noted is that, there is no way an insurance company faces loss through investment income. In this way, the insurance companies plays off the game and still remain profitable.

(D)CASH VALUE CANCELLATIONS

Cash values are generated through investments and the dividends of insurance company’s investments. When the customer who has taken an insurance policy for whole life, they have lots of money through cash values, they need money even if it means to close off the account. When the customer does this and closes off the account and takes off the money, all the liabilities are ended up with the insurer. 

The insurance company keeps all the previously paid premiums and pays the customer with the money they earned through the interests obtained from the investments invested by the customer. The company keeps the remaining cash too and get profits.

(E)COVERAGE LAPSES

When the consumer does not pay premium on time and keep a track on their insurance policies, this situation turns out to be the utmost beneficial situation for the insurance companies. 

Under the contract of insurance policy, without any claims being paid out, the actual policy expires in case of a policy lapse.

In such situations, all previously paid premiums are kept by the insurer and this again is a benefit for the insurance company. In this case, the claim will not be paid at any cost.

WRAPPING UP

Despite of all the misconceptions, the ultimate goal of an insurer is to not make money from the premiums. Instead, insurers use their float(policyholders) to make money. If they managed to make money from the premiums, it is completely a good bonus. 

To sum it all up, the insurer collects money in the form of premiums and invest this money in various assets like stocks, real estate and many more. 

Then, from the profits obtained by these assets, the insurer uses this money to cover up claims and other expenses. If in case any money is remained, this is left to stockholders and the taxes. 

This money is again invested into assets, these in turn increase the value of the insurance company. In these ways the insurance company plays off the game and make money.

I hope my article provided you some basic and fundamental knowledge of the insurance industry. Hope you find it useful and helpful as well. Feel free to respond and share your feedback. 

Hope you liked reading this article, any suggestions regarding the article are welcomed. We will keep note of all the valuable suggestions and your feedbacks and always strive to serve you better. Happy Reading.

Thank you!

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