Insurance companies make money in two main ways: 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.
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.
Related investing topics
Two other important metrics to consider related to an insurance company's underwriting health are the combined ratio and the loss ratio. The combined ratio reflects the total of the insurer's losses and expenses divided by its earned premiums. A level below 100% indicates underwriting profitability. The loss ratio is the dollar value of claims paid out divided by premiums collected. A company can't succeed with a loss ratio above 100% for too long.
You can learn a lot about an insurance company's competitive position by checking out its market share. The higher the market share, the more dominant the company is in its industry. Customer retention rates can help you assess how well an insurer is holding onto its market position. You can also research an insurer's complaint index score, which is available on the National Association of Insurance Commissioners (NAIC) website. A complaint index well above the national median of 1.0 could indicate potential underlying business problems.
If you're considering investing in an insurance stock, the metrics used to evaluate any stock also apply to insurers. Key metrics to check out include the stock's return on equity, return on invested capital, and price-to-earnings (PE) ratio compared to its peers.
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