How Insurance Companies Make Money

The insurance industry survives on premiums, but it thrives on float. Most insurance companies hope to just break even when they write your policy; the upside comes from the investment returns they earn while holding on to your money. 

In this segment from the Industry Focus: Financials podcast, The Motley Fool's Gaby Lapera and Jordan Wathen discuss why the insurance industry loves taking in your premiums -- it's all about the "float."

A transcript follows the video.

This podcast was recorded on April 4, 2016. 

Gaby Lapera: There also are other types of insurers that are super niche-y, I guess. There's an insurance company called Markel (NYSE:MKL). And if you go to their website, they have this whole list of things that they insure. They insure everything from your children's birthday party to blacksmith shops and boats and RVs and all that normal stuff too. It's crazy, they're all over the board.

Jordan Wathen: Right, right. Insurers especially tend to make better investments in some of the more common types of insurance, because they tend to be specialized, so there's fewer competitors. Markel is a great case in investing insurance companies, because they've absolutely trumped every other ... I shouldn't every other, but they trump most insurance companies. It's not because they're great at underwriting, they also have a spectacular investor, Tom Gayner.

Lapera: Okay, let's actually talk about that. Insurance companies make their money in two different ways. I think the most intuitive ways that most people would guess that insurance companies make their money, is by paying out less in claims than they take in in premiums. I think that's pretty standard, run of the mill. Premiums, just in case you don't pay insurance for whatever reason, maybe you're 16 and don't pay insurance, but you do invest. Your premium is what you pay to the insurance company so that you are insured every month, and then claims are what the insurance company pays out to people.

Wathen: Right, absolutely. I think most people do assume that insurance companies make money from their underwriting, as in they generate more in premiums than they pay out in losses and expenses, but for the most part that's absolutely not true. Most insurers are happy to break even on their underwriting and make their money by investing the premiums and keeping the investment returns, which Buffett calls "float", for example.

Lapera: Yeah. This is how insurance companies end acting a little bit like banks.

Wathen: Right, yeah. They basically are banks. Most of them have a huge balance sheet of assets that they've invested in with the premiums that they have received from their policy holders.