How Insurance Companies Make Money

Investment Spread

Insurers became so good at investing money for their clients that they can actually take a spread spread on the investments they earn. For example an insurer might guarantee a flat 6% annual return on an annuity holder’s premium, if the insurer does a great job and earns 7% then they might keep the 1% spread (or share some of it with their client). Traditional insurance products can have a spread in them too. A whole life policy might be priced assuming a 4% investment gain in policyholder reserves each year, if the company earns 4.5% they can pocket the 0.5% difference.

Underwriting Gains

Underwriting gains are similar to the house edge that a casino has over a player. You’ve got policyholders depositing premiums in the pot and anteing up and getting their claims paid, meanwhile the insurer gets a small percentage of the pot as their take due to proper underwriting. Underwriting is the process of measuring and adjusting prices for risks inherent in individual policies. Let’s say you pay $30 in monthly premium for your dental plan, well based on your unique risk you might only need to pay $29.95, but the insurer adds a nickel to your price to account for the excess risk inherent in the pool of policyholders. When priced properly the insurer knows that over time and across millions of policyholders it will gain a bit of profit.

Profitability by Product

Not all products find profit equally! Some use all possible methods to make money, others just one or two. By general product it goes like this:

• Individual Life – Insurers make money in all the ways described above
• Group Life & Disability – There are no fees associated with most group products and profit is earned through underwriting margin and investment spread.
• Group Administration – I take the last bullet back, there are some group products that are fee based. For example large companies can by Administrative Services Only products in which the insurer does not pay the claims, instead they advise the company on what claims are valid for payment and sometimes administer the payment of those claims for them.
• Asset Management – Like an investment bank, the only way insurers make money here is on charging fees.
• Individual Annuities – Annuities charge a lot of fees for their base guarantees and additional riders. There is also usually an investment spread although it’s very small since the market is highly competitive.

Expense Management

Like any other company, insurers can also boost profits by managing expenses. This could mean grabbing the meat ax and firing people, or it could be more subtle. For example if management found out that sales office A was spending 40% of its time servicing policies they can optimize expenses by instructing that office to route all service calls to the customer service department, where they handle these situations routinely, and focus more time on selling. It’s impossible to cut expenses forever so this is only a short term way to boost profits and can be tricky if you accidentally eliminate a person or function of serious long term value.

Source: http://www.grameen-info.org/how-insurance-companies-make-money/