Insurance companies make money by both charging premiums to the insured and investing the insurance premium payments. Sounds simple, right? It both is and isn't. 

The concepts behind how insurers generate their big bucks are straightforward. But the details of how they make money can be more involved. Here's what you need to know.

Man wearing a coat and tie pointing to images of dollar signs

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How insurance companies make money

There are several types of insurance:

  • Health insurance pays for part or all of individuals' medical costs.
  • Life insurance provides money to one or more designated beneficiaries when the insured person dies.
  • Property and casualty insurance pays for damage to cars, homes, and business properties.
  • Specialty insurance covers types of risks that other insurers don't cover and is also known as excess and surplus (E&S) insurance.
  • Reinsurance provides insurance for insurance companies to cover losses above certain amounts.

Companies that provide any of these types of insurance make money in the same two ways:

1. Underwriting

Every insurer makes a significant portion of its revenue by underwriting, which is basically charging a fee (called a premium) for taking on financial risk.

Insurers employ actuaries who use statistics and mathematical models to evaluate the financial risks involved in insuring different scenarios. Once the financial risks are assessed, specific insurance plans can be created and premiums set for each type of insurance plan. 

For example, actuaries for a property and casualty insurance company consider the probabilities of natural disasters in determining how much money in premiums that homeowners in different geographical regions should pay. Actuaries for life insurance companies might use age, sex, and medical histories to calculate estimated life expectancies to determine how much different customers should pay in premiums.

When a person enrolls in an insurance plan, he or she agrees to pay a set premium to the insurer in exchange for the insurer taking on a certain level of risk. With many insurance plans, the amount of liability that remains the responsibility of the individual is called the deductible amount. Your auto insurer, for example, might require you to pay the first $1,000 of any damage costs before the insurance company is willing to pay anything.

2. Investment income

All of that money in premiums generates a lot of money for insurance companies. The companies don't have to pay out any money until or unless an insurance claim is submitted, such as a claim for a hospital visit or damage to a home during a tornado.

What do insurers do with the often huge sums of cash generated by premium payments? The companies put some aside in reserve to ensure that they'll have enough to pay all claims anticipated over the near term. But then they invest the rest of the money.

Investment income tends to be a lot smaller than underwriting revenue. Many insurers invest relatively conservatively, perhaps by investing in bonds or stable blue chip stocks. However, insurance companies can still significantly pad their top and bottom lines through their investments. 

Investing in insurance companies

There are two primary reasons why you might want to consider investing in insurance stocks. First, insurance companies can deliver solid long-term returns. Second, the business models of insurers tend to make them resilient during economic downturns.

Of course, some insurance companies are better than others on both of these fronts. Health insurance giant UnitedHealth Group (NYSE:UNH), for example, has handily outperformed specialty insurer Markel (NYSE:MKL) over the past 10 years. Markel also fell much more than UnitedHealth Group did during the market contraction caused by the COVID-19 pandemic.

Insurance stocks are usually seen as good picks for conservative investors. However, even aggressive growth investors might like certain insurance stocks. Trupanion (NASDAQ:TRUP) especially stands out as a potential choice for growth investors. The company provides medical insurance for cats and dogs. Its stock has skyrocketed as the North American pet medical insurance market has taken off.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.