When you think about it, insurance is a funny business. You select a package, pay a premium for it, and when the need arises, you can withdraw a significant sum for recovery. So, the question is, where does this money come from? And if everyone is drawing double the amount they put in, how are insurance companies making money?
In reality, not everyone is withdrawing significant sums of money. In most cases, people go decades without making a single withdrawal. And the process of getting insurance also acts as a buffer for insurance companies. There is a reason why your uncle, who smokes a packet of cigarettes every day, had his insurance application rejected. Some insurance companies may outright reject insurance applications or charge high premiums for applications prone to disasters. But is that enough to run a multi-million dollar company? No, it’s not. So the question remains, how do insurance companies generate money?
The Transfer of Risk
The primary job of an insurance company is to take on the risk of their clients. This is called underwriting. The process of underwriting is a little different for every insurance company. But in general, it consists of two kinds: The first involves taking a close look at the applicant and his history of claims to determine whether he can make regular premiums payments.
The second looks into how much risk an individual poses to the insured population. If you live near a volcanic area that may erupt anytime soon, your application might get rejected outright because you pose too great of a threat. This step prevents companies from having tons of people withdrawing funds when needed most while still keeping their promises about covering everyone who wants coverage without charging exorbitant rates.
Once the insurance companies determine the level of risk, they charge premiums based on it. Clients with a high level of risk pay high premiums and vice-versa. For an insurance company, the greater the level of risk, the more they earn. But that doesn’t mean insurance companies like high-risk clients. On the contrary, insurance companies avoid high-risk clients because of the risks involved. They want low-risk clients who are less likely to get into accidents or develop a chronic disease and continue paying premiums for the long run.
Insurance companies collect premiums which is their primary source of income. But collecting premiums and keeping them in the bank is not enough to support its operations. Insurance companies use to invest the collected premiums in safe or relatively risk-free financial instruments and collect returns over time. One of the most popular ways insurance companies does this is by buying stocks, bonds, and risk-free securities. However, not all of the premiums go into stores. Some amount is kept for contingency purposes, so insurance companies don’t face a liquidity crunch.
Cash value Cancellations
Life insurers also sell cash-value policies where you can invest monthly funds towards your future needs, including retirement, education, etc. However, these plans often come with high costs associated with them. And some people might not be able to afford the cost. An average US citizen pays around $20,576 in insurance premiums every year. When you think about it, that’s quite an amount. And since there is no guarantee that your financial conditions will remain the same throughout your life, shelling out twenty thousand dollars every year on an insurance policy you have not used for years might not seem like a good investment. As a result, some insurers end up dropping their insurance policies.
Conversely, when people discover that a significant amount of money has accumulated in their cash-value policy, they want the money even if it means closing their account with the company. And insurance companies are happy to oblige. When an insurer closes their account with the insurance company, the company gets to keep the premium paid till that point. This is where the insurance company gets its money. When you choose to drop or close out your policy, the insurance company gets to keep the premiums you paid to date, and you lose your coverage.
There is more to insurance companies than that meets the eye. While their primary source of income is underwriting any risk their clients are unwilling to take; they do not depend solely on underwriting to keep their business afloat. The money you pay as an insurance premium circulates through every possible sector you can think of. Stocks, Bonds, T-bills, auctions, and insurance companies have more than a few sources for generating money.