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How Do Insurance Companies Make Money?
Buying insurance is a way to protect yourself against the unexpected: a car accident, for example, or a sudden and very expensive illness. Policyholders pay premiums for this protection, and in return insurance companies pay claims. In the meantime, the revenue from the stream of monthly customer payments allows insurers to pay expenses, earn income and reinvest. The income stream has several tributaries, some of them more profitable than others.
The insurance industry relies on premium income and two major categories of expenses. When a greater sum is taken in premiums than is paid out in claims and expenses, an insurance company generates underwriting income. Different insurance classes–health, life, auto, homeowners–have optimum underwriting income, and it s the job of an underwriter to assess risk, set premiums and attain these optimum ratios. The percentage of money paid out in claims as a percentage of premiums earned is the loss ratio, and the percentage of premium income paid toward expenses is the expense ratio. The lower these combined ratios are, the greater the net underwriting income.
The assets raised by an insurance company can be invested for additional income. The company can buy securities such as US Treasury bonds, or real properties like land and buildings. To protect the industry against high-risk investments, insurance companies have agreed to asset risk limits set by the National Association of Insurance Commissioners. Insurance companies have also branched into financial services, such as annuities, brokerages and mutual fund companies. An investment portfolio can work in tandem with underwriting to strengthen the financial position and market share of the company. An insurer can compensate for investment losses by raising premiums, or use investment profits to develop new business by lowering premiums. Some states regulate investment risks as well as premiums charged by insurance companies.
The insurance industry uses a variety of metrics to measure its performance and profitability. Investment yield is the return on financial assets, which results from capital gains on the sale of securities as well as dividends. Return on revenues is net income as a percentage of all revenue, including premiums and investment income. Return on assets is net income as a percentage of all financial instruments and property owned by the company. As with other established public companies, a portion of the net earnings is paid out to shareholders in dividends, which can rise or fall each quarter.