How Do Insurance Companies Make Money
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Revenues:
Net Premiums - ~36b
Investment income (includes interest, dividends and accretion, but not capital gains on sales of securities) - ~1b
Gains on securities (capital gains on security sales) - ~1b
Fees - 0.5B
Service revenues - 0.2b
Total revenue: 39b
Expenses:
Losses and loss adjustment expenses (i.e. payouts to policies) - ~25.5b
Policy acquisition costs and other underwriting expenses - ~8b
Other - 0.4B
Total expenses - ~34b
So that's about 5 billion in net income before taxes.
Overall, about 80% of profits in this case come from collecting more premium than paying out in claims. About 20% come in from investment income. This is because they collect your premium upfront, but don't need to pay out until you have a claim. So that money can be invested in the meantime. Notably, an insurance company can be profitable if they invest well, even if they take a loss on claims.
[0] https://s24.q4cdn.com/447218525/files/doc_financials/2019/an...
Insurance is also a weird product from a consumer stand-point: for most people (at least in Canada) there is little to no difference between company offering. If you take P&C, there is a lot of competition for pricing, and a lot of the "end-stream" innovation is about containing costs (fraud, company-owned repair shops, avoiding litigation). Loss ratio is probably the word I heard the most from my actuarial friends.
P&C and group insurance, since everything is renewed every year, see a lot more disruption and effervescence in the market. It's harder to disrupt life insurance when you're on the hook for 10, 20 or even 70 years. I think that participating life was a game changer, and even then, its popularity is really tied to the market. There is a lot of research being done as well to better assess risk without being invasive (fluids, extensive questionnaires, etc.). But when you're on the hook for a long period of time, your mistakes along the way tend to stay for a long time. And going under is -- I think -- worse than any other industry. You pay premiums to insurance companies because you trust they'll be alive in the future!
Speaking of loss ratio, most companies are also now heavy towards automation, again to reduce costs. I know this has been over-played elsewhere in the industry, but here a lot of the key-players are massive and slow moving, and at their scale, little movement can mean a lot of change.
If the company does a good job estimating risk and pricing policies, they will make a profit on the policy itself. If that happens, they are effectively being paid by their customers to hold their customers' money and get to keep any investment returns on it!
https://www.businessinsider.com/warren-buffett-insurance-flo...
Insurance companies do not crave float (aka reserves and required capital). Capital requirements in the life insurance business are onerous and interest rates are at historic lows. Regulatory requirements encourage diversified, highly-rated, fixed income investments, so the spread on what products are crediting (e.g. whole life, universal life, etc) vs. what bonds are earning is greatly diminished.
Companies and investors would rather have minimal capital requirements with high income cashflow from underwriting profits. This is the reason that the main benchmark of insurance companies is Return on Equity (ROE).
I guess it's life insurance that's a special case here, in that customers sign up to pay a flat rate for (say) 20 years but the chance of payout is much higher towards the end. When you close down & sell your insurance business to your competitor, a policy that's half-way will surely count as a liability, and so it may be very expensive to wind things up: you'll have to hand over a lot of the float to get someone to take the contracts.
There are various values for "you" here: The professional who manages the fund day-to-day needs to be paid no matter what the company says it does. The owners have a choice of whether to sell the car-insurance side of their business. And people looking to start a new business from scratch have different concerns.
1. Take in $100 of premium, and put up $10 of your own money. Use that money to buy $110 of assets.
2. Set up $100 of reserves. Your $110 of assets is now backing $100 of reserves plus $10 of regulatory capital.
3. A year later, your assets are now worth $113, and you owe a claim of $100. Sell the assets, use $100 of proceeds to cover the cost of the claim, and keep the $13 that's left over.
Congratulations - you've earned a 30% annualized return on your $10 investment, despite the fact that you purchased assets yielding ~3% and didn't make an underwriting profit, because you were effectively able to lever up 10:1 at 0% interest.
The catch is, if claims had been ~3% higher than expected you would have broken even, and if they were ~10% higher than expected you'd have lost all your money. If you were a hedge fund instead, you wouldn't have to deal with that risk (or with any of the other aspects of running an insurance company), and you'd have much more flexibility in terms of assets. But you could only lever up maybe 3:1 instead of 10:1, and your cost of debt would be much higher.
Maybe it's a function of zip code, sex, age, profession, hobby, weight, etc... while another company will add a question about exercise level and put different multipliers on each of those.
They are constantly refining their statistical models to gain an pricing advantage over the competition without taking on more undo risk.
This applies to all kinds of insurance.
Combating fraud is ALSO a big thing. So they often share lists of customers they believe have defrauded their policies in the past, and are starting to use AI to find which patterns reduce the risk most, as well as getting around certain metrics they aren't allowed to ask about - like ethnicity.
For individual life products (term, whole life, etc), it's much less about gaining an advantage from an underwriting perspective. A lot of it is marketing, product design, and investment strategies. State farm's products are pretty expensive compared to the rest of the industry, but their "one-stop-shop" approach and bundling discounts have given them a pretty good marketing niche. Other carriers have their own niches, e.g. using tax-havens to reduce capital requirements. Some invested in very long duration bonds at the right time, and are reaping the benefit of higher yields (on reserves aka float) compared to their peers.
And if the article is still down, the answer to the question of how life insurance companies make money is underwriting profits (charging more than they pay out in claims) and investing in high-quality fixed income investments. Sometimes less scrupulous companies (often owned by private equity firms) create tax arbitrages via offshore havens and tax loopholes.
Or consider a SPIA with a return of premium guarantee. The total claim payments will always be greater than or equal to premium on a nominal basis, so investment income necessarily funds over 100% of the profit.
It's possible they are buying other derivatives to reduce their risk - or maybe other types of CDO's, etc... But if you're suggesting they are stock-picking with premiums - I find that very very hard to believe. ...and it's likely illegal.
What happens is at some point new entrants or firms that want too grow will offer lower rates and/or loosen underwriting criteria. This forces incumbents to do the same to some extent to stay competitive (soft market).
Over time, risk and eventually losses, accumulate. This stops the loose underwriting practices as firms can no longer sustain additional losses. This allows incumbents to raise their rates (hard market).
These cycles vary by insurance product but can cause huge revenue swings year to year.
- Like any other financial services company, insurers' primary concern is risk management. In contrast, a retailer knows exactly what its profit margins are before the product is sold - its primary concern is to sell as many products as possible profitably. However, insurers and banks can sell infinite policies/loans so long as the price is low enough. They also don't know their margins for sure until the policy/loan is complete.
- The average insurer makes more than half their profits from investment income. Most insurers are garbage at writing policies, with the P&C industry averaging around mid-single digit ROE in a year with average catastrophe losses. When I checked a few years ago, aggregate combined ratio (sum of losses & expenses divided by premiums) is in the high 90's percentage.
- Loss costs are getting ridiculous these days (trial lawyers, social inflation), almost across the board, so you're seeing insurers start raising prices across the board. Add to that zero interest rate policy courtesy of our unaccountable central bankers, and insurers are forced to push premium hikes.
Aside from structuring the policies there is little room for innovation. And the competition can easily copy them. What remains is to reduce the sum of the expected claims. This is where blackboxes and stop smoking campaigns come from. But again this is not really that successful.
IMO the most obvious strategy is vertical integration. After all, most people are not interested in insuring against hospital or car repair invoices, but to obtain good health-care or a repaired car.
So insurance companies should try to operate their own hospitals or repair shops, operating them with little profit and stash the savings.
There is a fair amount of vertical integration happening already. Finding ways to reduce "retail" pricing for claims for insurance companies is a pretty big deal.
Anecdotal example: Metlife was our auto insurance provider until last year. I dropped them for GEICO solely because their digital offerings were unacceptable. Extremely difficult to create claims and get our insurance ID cards online.
I don't know how it is in the US, but in the UK, the people you buy insurance from are usually just brokers for the actual insurance companies. Brokers may put together a compound policy for multiple risks aggregated across multiple insurance providers. Insurers themselves spread their risk by purchasing reinsurance, there's another level up on the chain too.
Clickbite title? Traditionally companies make money by spending less than what they receive...