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How Do Insurance Companies Make Money? - How does the business work (financially)?

I will focus on two types of insurance. For the first type, we're basically talking about money management, which I would consider to no "real" insurance.

You can see that the insurance company receives money (premium) before it knows how much it will have to pay to anyone.

How does the business work (financially)?


Let's assume we're talking about a company that wrote the contract with annual guarantee-that is, the client pays a premium for protection against accidents that occurred during the 12 months ahead. To simplify the problem, I would assume the premium paid on 1-Jan-but you can keep the same principles of pro rata temporis for the fraction of a year.
We face two problems:
  • How soon will a claim for the contract is filled?
  • When will the payment be done? In the case of multiple payment, how much and how long?
This is where we introduce the concept of Claims Ratio-the ratio between the claimsactually pay more than the total premiums because of, at a particular time.
Insurance companies has historical data on the evolution of the Claims Ratio over time.


For example, of all contracts written in 1996, for total premiums received of €120 (vast majority in 1996 plus a few clients who only paid in 1997 after the company chased them):
  • €40 actually paid out in 1996 (33%)
  • €20 actually paid out in 1997 (50% cumulative)
  • €10 actually paid out in 1998 (58% cumulative)
  • €5 actually paid out in 1999 (63% cumulative)
  • €1 actually paid out in 2000 and 2001 -- nothing since (64% cumulative)

Thanks to a variety of statistical tools -- of which a simple average! -- insurance companies can figure out the best estimate for the sequence of pay-outs for the current year. It can also estimate the "ultimate" claims ratio for the current year. This is often called the Loss ratio.
Add overhead/claims management (for example, claims adjuster salaries + warmingheadquarters company) and the total pay-out will usually about 98%-generate a margin of 2% for the company.

It is also the main technique for determining product price/premium to be paid by the client. Actuary estimates possible loss, then adding the estimated cost management and distribution fee (Commission for brokers and agents), and a little margin. Statistical models help tailor a specific risk premium (possibility of having the damage, the amount of damage) of the client, of course.

On 31 December, the insurance companies set aside enough money to cover all anticipated losses (sometimes with a margin of prudence, i.e.setting aside more than the best estimation) into accounting reserves. The amount of this loss ratio which is expected to end multiplied by total premiums because (the end with a margin of prudence).
Then, year by year, the insurance company compare actual pay in hopes of original-customize accounting backup up or down as needed. If the actual losses were below expectations (usually, below the historical average), this creates profits. If not, it creates a loss.

As mentioned above, the margin of 2% to 5% would be typical.
Another important aspect is that the insurance company will not allow that money collected as premium beds at 0%-interest bank account. As mentioned above, some of the money will remain "in the coffers," less than one year, but a small percentagewill still be 5 + years.

So insurance companies invest this money in the financial markets-primarily in Government and corporate bonds. The entire expertise asset management obligations ensure that we are right "match" in the time-stream and out-money flow.

How investment income is shared between the client and the insurance company will depend on the product itself and local regulations. Most of the time, the investment income is taken into account to determine the price of the product-that is, a small discount vs "premium" pure "so that clients get several benefits. But it really can vary a lot.



Continue to how does it (Insurance Company) work operationally? 

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