This world we live in is so unfortunate sometimes. We face several incidents daily, and sometimes it can cost us a lot. Sometimes we are unable to have instant cash back up for covering up that loss.
What is an insurance company?
Insurance is a contract or a policy contract between the customer or the person filing for insurance and the company that provides the insurance contract. It will have multiple terms to which the customer has to agree to before he acquires the insurance.
After the contract is signed, the individual is eligible to receive instant cash payments after he faces any accident or an unfortunate event.
To cover up those instant payments, the customer has to pay the company yearly or monthly. These are called installments. Damage coverage is decided in the contract, and so if a person faces an accident or unfortunate event, he will receive either full coverage or partial coverage. The monthly payments are called premiums. Coverage losses are determined after looking into factors and assessing the probabilities. As a result, the company also determines the monthly payments the customer has to pay, either monthly or yearly. For instance, if a person files for car insurance, the company will assess the area where the car is used, and other factors such as driver history and age of the driver.
How do insurance companies make money, and how are they so profitable?
So how is the insurance company make money even though they have to pay for the damage? Insurance companies have a complex business model so hear me out with concentration. The risk factor is the reason why they make so much money. The risk that if they are receiving premiums, the object or property they are receiving premiums for will never get into an accident, or they will never be damaged.
It is common sense. If you apply for insurance for your car, what are the chances that you will crash it the very next day? Next to 0, I bet. Let us agree that there might be around 1 out of 10 people who will crash it on the very next day, but what about the remaining 9-people. Those remaining nine people will have to pay premiums even though they haven’t damaged their cars. The property that has insurance is safe and with no damage, so the insurance company keeps on receiving the premium amount and does not have to pay for any losses yet. Now multiply that number with the population of the United States and you can imagine how much they earn. Multiply with the population means the people who have any insurance. The company is liable to pay only if the property is damaged, according to the contract.
However, the above was just an explanation of the actual process and it involves many factors and is very complex. Every insurance company is made on a basic business model, and without following that specific business model, insurance companies cannot survive. It is called a for-profit internal business model. This business model ensures that they receive more payments than the payments that they pay out to customers. The premiums paid by the customers over the cost of running the company and generate a hefty amount of profit for them.
There are two types of ways of how insurance companies make money. One is underwriting income, and the other is investment income.
So what is underwriting income? Underwriting income is based on a simple formula. The company receives monthly payments in the form of premiums, but the company also has to pay if the property that is insured is damaged. The claims paid are subtracted from the premium amount that is received, and the money that remains is considered as the profit that the company earns.
For instance, a company receives 5 million dollars in premiums from customers of the same area. Due to varying factors such as traffic, those customers damage that property and to cover those damages, the company pays out around 4 million dollars. If we subtract 4 million from 5 million, the remaining amount is 1 million dollars. So we say that per year the company made a profit of one million dollars.
It was just an example, and often insurance companies may go to any extent to make sure underwriting income is favorable for them rather than the customers. Most companies follow tips and tricks to lure customers and make them agree to an insurance contract.
The insurance company looks into multiple factors and provides the customer with a suitable insurance contract. The word suitable is not for the customers, but it is for the company. The company has two main tasks: The first one is to satisfy the customer and the second one is to plan out a profit for themselves in each contract.
Several other key factors are considered when the customer is offered an insurance contract. The insurers make sure they make a hefty profit out of the deal. These insurance companies work extra hard on collecting data and carrying out numerous algorithms just to assess the cost so that they can receive the maximum profit out of it. Sometimes, the data they collect tells them that the risk is too high and they will not earn enough profit or might receive minimum profit. When this happens, they call off the contract or do not provide the specific package to the customers. Another solution to this is that they ask for higher monthly premiums to recover their profit.
Some people compare insurance companies to traditional business companies, but insurance companies are very different from those. I will explain this by giving you an example of a car manufacturer company. The car development process is very plenty. All parts of the car are not produced in one factory. All components have different factories. The car manufacturers order those parts and assemble them onto the vehicle. Upfront payments are made to purchase these parts, and advance payments are made in the overall manufacturing.
The car companies do not earn profit unless their cars are sold. It is not the case with insurance companies. They start receiving monthly payments in the form of premiums as soon as the contract is signed.
Other than undertaking income, insurance companies make loads of money from investment too. After contracts are signed, customers start paying their monthly premiums. The insurance company takes this amount and invests it somewhere else for maximum profits. Some of you might be thinking that monthly payments are too little to be invested. Monthly payments of a pack of customers are collected and invested as a whole.
Insurance companies also have backup accounts. These accounts provide customers with money if they damage their property. Since insurance companies do not have to put amounts of money on the table, they are allowed to as much money they want and earn the desired income.
This business model is highly efficient as investment companies may or may not have to pay damages to the customer and when they don’t need to pay damages, they invest a sum of money and multiply their profits. In general, these companies invest in Wall Street and the stock market.
You might be wondering what happens if the company starts to receive losses. That is extremely easy for them. While signing contracts, the customer agrees to permit insurance companies to increase the number of monthly premiums. So if the company faces losses, they just increase the price of their premium and make the customers pay for their losses.
This is the reason why billionaires and businessmen like warren buffet started their journey of success after investing in an insurance company. Berkshire Hathaway owned by Warren is a very successful insurance firm.
Some other sources of revenue and profit:
Undertaking income and investment income are the two major sources of income for them, but they have other sources of income too.
Cash value cancellations:
Most people do not know what cash value payments are. When the insurer applies for a light insurance contract or life insurance, he is not aware that side by side insurance companies add up small amounts of cash backs. It is a very sly move from the insurance companies. When customers find out that they have a bonus prize waiting for them, they are ready to do anything to retrieve that cash prize. However, the company places a condition on this.
Customers may only receive the added-up cash only if they cancel their insurance contract. in most cases, customers move towards canceling their contract, and the insurance companies cooperate. So what happens is that the company keeps all the premiums paid by the customer throughout the years and pays the customer only a small portion in the form of cash back. The company gains profits as the premiums paid throughout the years account for a sum of money. The cash paid to the customers is the interest earned by the companies when they invest it.
It is another method of how insurance companies make money. In some cases, customers fail to pay the monthly premiums. The company allows for missing two or three monthly payments but not more than that. The nonpayment of premiums by the customers gives the insurance companies a financial advantage.
When an insurance contract is signed, a condition Is set that if the customer is unable to pay monthly premiums, the policy will be automatically canceled. So when monthly premiums are skipped, the contract automatically expires before the expiry date. The company keeps all the claims that are due to the customer, and the customer leaves without being given any money. A higher margin of profit is earned when the insured object does not receive any damages.
Sometimes, customers fail to keep current on their insurance policies and this leads to a policy lapse. What is a policy lapse? Policy lapse is when the contract expires, and claims are not paid to customers.
Steps insurance companies take to minimize risks:
Most insurance companies carry out the process of re-insurance. This method allows them to reduce the risk of losses at a greater level. The risk of Losses that occurred due to high exposures is controlled by reinsurance. It is a vital part of their business model, and it keeps them safe from the bankruptcy of huge losses. This method involves avoiding due payouts.
Sometimes insurance companies compile data in a region to provide the customer with the rate of monthly premiums. Historically, there might have been no natural disasters in that region, and the premium amount would be less. If conveniently a natural disaster hits the region, the company has to pay for the huge amount of losses and can also shut down the insurance company.
The insurance companies plan out a policy in which they state that the company has to pay only 10 % of the property value if a natural disaster happens. It gives insurance companies an upper hand in winning the market share as this procedure allows them to transfer risks. Moreover, reinsurance destabilizes the fluctuations in insurance companies due to natural disasters that can cause variations in profits and losses.
Some insurance companies charge customers a higher rate of premium, and it helps the companies in getting cheaper rates when re-insuring the same policies in a bulk.
Like other companies, insurance companies are also evaluated according to market demands. Evaluation occurs on certain factors such as growth rate, risk, payout, and profit margin. Insurance companies abstain from making investments in fixed assets. It gives them an advantage as they experience lesser depreciation and smaller capital expenditures.
The capital flow of the insurance company is also difficult to calculate as these companies do not have capital accounts or producers to check the capital flow of the companies. Analysts are hired to manage these capitals. They refrain from using metrics and focus on equities such as price to earnings and price to book ratios. Companies are evaluated by calculating insurance-targeted ratios.
P/E ratios vary from company to company. P/E ratios are higher for companies that have higher expected growth. Other factors such as high payout and low risk also determine P/E ratios. Everything is held constant, and as a result, equity return gives a higher P/B ratio.
When comparing P/E and P/B ratios, analysts play a major role as they have to deal with additional factors that are very complicated. P/B and P/E ratios determine the fate of the company. If the company is conservative and or aggressive in decisions, these ratios can go very high and very low.
This variation in rations can be either extremely beneficial or extremely damaging to the insurance companies. Most insurance companies are diverse and deal in providing multiple insurances such as life insurance, auto insurance, and property insurance. The risk factors companies face depending on how many facilities they provide.
There is no doubt that the system is designed in a way that the insurance companies receive maximum profits. Statistical data shows that out of 100 insured customers, only 3 of them apply for a claim. The remaining 97 people keep on paying their premiums without going for claim payment. The company invests this money and keeps on earning profit and interest from it, hence multiplying their profits.
The insurance companies have a clear path of profit and success, and the business model is simple to follow. Moreover, there is a very low-risk factor, and even if the company faces losses, they have thousands of customers who can compensate for their losses. The customer have no authority to question the companies or do something about it, they have to pay their monthly premiums.
The best insurance companies:
The USA is home to many insurance companies providing facilities ranging from life insurance to auto insurance. The following are the well-known and top insurance companies:
- For health insurance: united health care take the top spot with a market cap of 91.8 billion dollars and offers a wide range of health care facilities. Other well-known health insurance companies include Humana, Aetna, and Cigna.
- For property insurance: state farm group takes the lead in property insurance and has a market cap of 64.6 billion dollars. Berkshire Hathaway owned by warren is also a great insurance company with a market cap of 46 billion dollars.