Insurance companies make money in two main ways: Charging premiums to the insured and investing the insurance premium payments. Sounds simple, right? It both is and isn't.
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The concepts behind how insurers generate their big bucks are straightforward. But the details of how they make money can be more involved. Here's what you need to know.
How insurance companies make money
There are several types of insurance:
- Health insurance pays for part or all of individuals' medical costs.
- Life insurance provides money to one or more designated beneficiaries when the insured person dies.
- Property and casualty insurance pays for damage to cars, homes, and business properties.
- Specialty insurance covers types of risks that other insurers don't cover and is also known as excess and surplus (E&S) insurance.
- Reinsurance provides insurance for insurance companies to cover losses above certain amounts.
Companies that provide any of these types of insurance make money in the same two ways:
1. Underwriting
Every insurer makes a significant portion of its revenue by underwriting, which is basically charging a fee (called a premium) for taking on financial risk.
Insurers employ actuaries who use statistics and mathematical models to evaluate the financial risks involved in insuring different scenarios. Once the financial risks are assessed, specific insurance plans can be created and premiums set for each type of insurance plan.
For example, actuaries for a property and casualty insurance company consider the probabilities of natural disasters in determining how much money in premiums that homeowners in different geographical regions should pay. Actuaries for life insurance companies might use age, sex, and medical histories to calculate estimated life expectancies to determine how much different customers should pay in premiums.
When a person enrolls in an insurance plan, he or she agrees to pay a set premium to the insurer in exchange for the insurer taking on a certain level of risk. With many insurance plans, the amount of liability that remains the responsibility of the individual is called the deductible amount. Your auto insurer, for example, might require you to pay the first $1,000 of any damage costs before the insurance company is willing to pay anything.
2. Investment income
All of that money in premiums generates a lot of money for insurance companies. The companies don't have to pay out any money until or unless an insurance claim is submitted, such as a claim for a hospital visit or damage to a home during a tornado.
What do insurers do with the often huge sums of cash generated by premium payments? The companies put some aside in reserve to ensure that they'll have enough to pay all claims anticipated over the near term. But then they invest the rest of the money.
Investment income tends to be a lot smaller than underwriting revenue. Many insurers invest relatively conservatively, perhaps by investing in bonds or stable blue chip stocks. However, insurance companies can still significantly pad their top and bottom lines through their investments.
Investing in insurance companies
There are two primary reasons why you might want to consider investing in insurance stocks. First, insurance companies can deliver solid long-term returns. Second, the business models of insurers tend to make them resilient during economic downturns.
Of course, some insurance companies are better than others on both of these fronts. Health insurance giant UnitedHealth Group (UNH 0.42%), for example, has handily outperformed specialty insurer Markel (MKL -0.64%) over the past 10 years. Markel also fell much more than UnitedHealth Group did during the market contraction caused by the COVID-19 pandemic.
Insurance stocks are usually seen as good picks for conservative investors. However, even aggressive growth investors might like certain insurance stocks. Trupanion (TRUP -5.89%) especially stands out as a potential choice for growth investors. The company provides medical insurance for cats and dogs. Its stock skyrocketed as the North American pet medical insurance market took off (though like many other growth stocks, has dropped in 2022).
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Investing in Financial StocksTake advantage of the changing finance industry, and invest in its most promising stocks. Here's what the landscape looks like. Keith Speights has positions in Trupanion. The Motley Fool has positions in and recommends Markel Group and Trupanion. The Motley Fool recommends UnitedHealth Group. The Motley Fool has a disclosure policy.
FAQs
Here's what you need to know about the two ways insurers generate revenue. Insurance companies make money in two main ways: Charging premiums to the insured and investing the insurance premium payments.
How do insurance companies get so much money? ›
The essential insurance model involves pooling risk from individual payers and redistributing it across a larger portfolio. Most insurance companies generate revenue in two ways: Charging premiums in exchange for insurance coverage, then reinvesting those premiums into other interest-generating assets.
Why are insurance stocks doing well? ›
NYSE: BRK.
Insurance is all about putting a price tag on risk, which makes it one of the most inflation-resilient business out there. After all, as costs go up, so do premiums, even if those premiums remain fairly consistent in terms of the percentage of value of the assets being insured.
Do insurance companies make huge profits? ›
On average an insurance company earns 20% profit per year, and structure their policy costs to maintain that level.
How can an insurance company make a profit by taking in premiums and making payouts? ›
How can an insurance company make a profit by taking in premiums and making payouts? The value of the premiums the company takes in is higher than the value of the payouts it makes.
What makes insurance companies the most money? ›
Underwriting
Every insurer makes a significant portion of its revenue by underwriting, which is basically charging a fee (called a premium) for taking on financial risk. Insurers employ actuaries who use statistics and mathematical models to evaluate the financial risks involved in insuring different scenarios.
Why is the insurance industry so lucrative? ›
Insurance companies generate revenue through the insurance policies they write and through returns generated by investment activities. Insurance companies incur typical business costs including losses due to insurance claims.
Why buffett likes insurance companies? ›
Insurance companies are cash-generating machines with pricing power -- a vital trait, especially during periods of higher inflation. Much of Berkshire Hathaway's long-term success can be credited to its various insurance businesses. Insurance stocks can be a great source of income and stability for your portfolio.
How do insurance stocks do in a recession? ›
Insurance companies tend to do well during a recession because they offer something that people need whether the economy is good or bad. Case in point, Markel saw earned premiums increase 17% year-over-year in the first quarter to $1.7 billion.
Why do asset managers buy insurance companies? ›
Buying or launching primary insurers gives financial sponsors direct access to long-term capital that they can deploy through their lending arms.
Life insurance is the most profitable—and the hardest—type of insurance to sell. With the highest premiums and the longest-running contract, it brings in cash over a long period of time. In the first year, agents make the largest annual sum on a policy, bringing in anywhere from 40–120% of the policy premium.
Why are insurance agents so rich? ›
One of the primary reasons insurance agents can accumulate wealth is their commission-based income structure. Unlike salaried employees, agents earn a percentage of the premiums they sell to clients. As they build a client base and generate more sales, their income potential increases.
What insurance makes the most money? ›
While there are many kinds of insurance (ranging from auto insurance to health insurance), the most lucrative career in the insurance field is for those selling life insurance.
What is the profit margin for insurance companies? ›
However, net income increased 6% to over $18 billion for the first six months of 2023 compared to the same period in the prior year. The industry's profit margin decreased modestly to 3.3% from 3.4%, while the combined ratio increased by a modest one-half basis-point.
What do insurance companies do with the premiums people pay? ›
Insurers use the premiums paid to them by their customers and policyholders to cover liabilities associated with the policies they underwrite. They may also invest in the premium to generate higher returns. This can offset some costs of providing insurance coverage and help an insurer keep its prices competitive.
What is the $75 payment Nelson must make each month? ›
Now, the premium payment amounts for various insurance policies typically vary based on a variety of circ*mstances. The premium, however, will increase in direct proportion to the level of risk covered by the insurance policy. Nelson is required to pay $75 per month, which is referred to as the Premium.
How do insurance companies afford to pay out? ›
One way companies make sure they can cover all the payouts is to charge higher premiums for these policies. Companies also use the underwriting process to determine how risky each policy applicant is based on their health, lifestyle, hobbies, and other personal traits.
Why are insurance companies so expensive? ›
Your particular driver profile, which includes factors like where you live, your age and your driving record, influences what you pay for car insurance. But rising car repair costs and an increase in disaster-related claims are significant reasons why car insurance rates are surging for many drivers.
How do insurance agency owners make money? ›
How does an agency make money? Most insurance agency revenues come in the form of a paid commission. An agency is paid a percentage of the total cost of the policy offered. The total cost is the premium and the percentage the agency earns is typically called, agency revenue.
