So you think you know how insurance companies make money? Guess again. Most companies do not make a profit on the premiums they get from you, in fact many have an operating loss. It’s all about something called the ‘combined ratio’. I worked in investment accounting of a large insurance company so I know what is going on with the income statement and balance sheet.
Insurance companies make money on investment assets
The combined ratio is a measure of profitability from the core business. Many insurance companies have combined ratios of greater than 1.00, (1.07 for example) which means they in theory are paying out more than they earn. The way insurance companies make money is this, they have a large pool of investment assets. These assets are held in case of a payout. They are from your premiums and kept safe by the insurance company’s investment manager.
Further they are highly regulated by state insurance commissions so they can not get crazy with the policy holders assets, but still there is a lot of latitude they have about how they manage these assets.
Take any garden variety insurance company. They might control over 10 billion dollars of assets. This company might even lose on their P&C business, if they have a combined ratio greater than 1, but they will still make a profit. How will this insurance company make money if they are making a loss from operations? What they do is invest their these assets in the stock market or high yielding fixed income, then interest, dividends and capital gains from these investment assets more than make up for the operating loss.
They are using leverage or borrowing from their policy holders to invest and get a nice return.
The insurance companies are really investment companies, which leverage the policy holders. They take your money and invest it. So Insurance companies make money by taking your premiums and investing it, not from collecting more than they payout.
Growing up in insuranceland
In theory the Insurance business should be market neutral, affected very little by an economic downturn. In fact, Hartford, CT was known not only as the insurance capital of the world but also one of the most boring but stable economies. I remember when I was growing in the suburbs of Hartford, all my friend’s parents would get home before 4pm in the afternoon; even during a recession. My father would reply, oh, they work for insurance companies. Since insurance companies are now really investment companies life has changed a bit in insuranceland.
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1 responses to How insurance companies make money
3 levers, how insurers make money
Correctly stated, you explained what I typically call lever 3 – investment income. You briefly mention lever #1 grow the portfolio (attract & retain) customers, and yes many carriers operate underwater not collecting enough premium to cover payouts, but the upside on unexpected loss ratios (aka hard-markets) is that insurers can plead their case for a substantial premium increases from insurance commissioners. This usually provides good strong follow-on revenue stream to backfill cash reserves as well as new investment capital (#3). During soft-markets, competition increases, premiums drops and lever #2 evokes operational efficiency. Carriers can reduce staff, send work overseas, and trim lines of business that either provides whip-saw revenues (That AM Best hates) or just eject non-core valued products and services.
So there you have it, all three levels of how an insurance company makes money.
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