We have been seeing a steady rise in the emergence of insurance companies locally over the past few years. Most of the local insurers are mainly into funeral policies, whilst life insurance & other policies still seem to be very scarce. Insurance is a framework by which an institution guarantees to cater for your loss, illness, death or damage compensations in exchange for premiums paid over time. An insurance policy is simply a contractual pact between two parties where one guarantees to compensate for any incurred losses for the other party whilst getting upfront premiums in return. So the big question on many people’s minds is how exactly insurance companies make their money. This article endeavours to do justice to that question.
Why do people wonder?
Well, an insurance policy is characterised by one paying way less than what they can claim. For instance, suppose you sign up for a life cover insurance policy of $100 000 which you become eligible for a full pay out after 25 years. Let’s consider that your total annual premiums are fixed at just $2000; meaning by the turn of 25 years you would have paid a total of $50 000 in premiums. Question: how exactly does the insurance company manage to pay you double your premiums? Plus how then does it make profit given this disparity?
How Is The Money Made?
Obviously the first way to make money is the actual premiums themselves. There are a lot of considerations made here to make this workable. There are some surveys that have shown that after claims are made, expenses are incurred & taxes are deducted, on average insurance companies can make 5% to 8% profit on the total premiums paid. This is achievable when the projected income from premiums far outweighs the likelihoods of claims being made. That’s why you’ll find that policies are meticulously packaged to ensure high-liability (those most likely to claim a lot) are avoided. Lots of research is done here to ensure premiums are strategically calculated & people are properly screened. This happens covertly without the people even noticing. You see, what happens is that the combined premiums are used to cater for only a minority of the total clientele (it’s basically about shared risk). The calculations and research done to attain this are rigorous and very intricately complex.
Investing The Premiums
This is one of the key ways in which money is made by insurance companies. Surveys have even shown that most insurance companies are big on making investments. Very smart decisions on making short-term, low-risk investments are made. The idea is collect money (from premiums), invest it in the short-term, quickly get returns and ensure money is available when claims are made. Some investments can be in the form of buying shares in other high performing companies or opening interest-earning bank accounts. The crux of this methodology is to get returns that will yield profits after claims, operating costs, remunerations & taxes have been covered.
This is basically the difference between total pay-outs/claims & total premiums. This results in profit if claims turn out to be less than the total premiums paid. This is a gamble though, remember basis for claims are incidental and circumstantial i.e. that things might not turn out the way you want. Therefore you might actually experience a loss as total claims can actually outweigh the total premiums paid.
If premature claims are made that means one won’t get the full cover amount. This obviously translates to money saved plus the bonus of risk aversion. Don’t forget I mentioned that the insurance business is mainly pivoted on shared risk. If someone then ceases to be your responsibility, empirically you have reduced the odds of possible failure or loss. This point subsequently brings the next one to mind:
So a lapse is when some fails to consistently follow through on paying their premiums. Insurance companies &/or policies come with different stipulations in this regard. Some can say, for instance, if you fail to pay your premiums for 2 months in a row, your policy is discontinued. Discontinuation of the policy means you don’t get any pay-out and the insurance company gets to keep all prior premiums that you paid. Interestingly, quite a considerable number of people get to lapse on their policies & this is a plus for the insurance company.
Other Key Issues To Note
Earlier on I mentioned about shared risk. There is this statement which says “teamwork divides the effort & multiplies the effect”; it’s a perfect analogy for this. When an insurance company collects premiums from people, its modus operandi is to spread out the risk amongst the many clients. Ultimately you’ll find that the total premiums of the major segment of the clientele service the claims of a minor segment of the clientele. That’s why a lot of actuarial analysis is done before determining premium amounts & signing up people.
You have probably noticed that insurance companies go to great lengths to sign people up. Most actually employ agents who are paid on commission so as to drive sign ups. This is because insurance companies push for volumes; remember the operating framework is highly probabilistic & risky. This makes sense when you realize that the higher the volumes the lesser the odds.
So in a nutshell that is how insurance companies make their money. Any insurance company, no matter what their niche is, operates in the framework I just explained herein. Some might think it unfair but not many have the discipline to handle personal finances in such a way that they always have money when disaster strikes. Insurance companies aid people in doing the discipline part for them whilst having your back when need arises.