How Do Insurance Companies Make Money?
1. They Make Money Through Underwriting.
Insurance companies make money in two ways. First, they make a profit through underwriting, and second by investing leftover money called a float. One of the most important but most difficult aspects to understand in insurance is underwriting.
What is Underwriting?
Underwriting is the process of accessing an entity’s risk and deciding how much to charge as a premium. The main goal of a successful underwriting operation is to earn more money in premiums than they pay out in claims. Underwriting is a very difficult concept to grasp. There is a whole science devoted to it called actuarial science.
What is Actuarial Science?
Actuarial science uses statistics, math, and probability to determine the likelihood of something getting damaged or destroyed. An insurance company needs to earn more money from the premiums than what they pay out in claims. This can seem simple, but there is a lot of probability that goes on in determining how much your premiums will be.
2. They Make Money Through Investments.
The other method that insurance companies use to make a profit is investing their money in various markets and accounts. The money they collect from premiums that they aren’t paying out in claims is called the “float”. This money is similar to the money a bank would get after getting deposits from customers but before lending out the money to other customers.
The insurance companies invest this money in a variety of areas, such as the stock market, mutual funds, bonds, securities, and other forms of investment. Insurance companies often pull their money out of these investments when the economy turns south. When insurance companies do this, they must raise their premiums in an effort to increase profits. People call it the insurance cycle, and it mirrors the general business cycle.
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