How Do Insurance Companies Make Money? Business Model Explained

Insurance companies base their business models around assuming the financial risk of an event on behalf of an individual or business. Most insurance companies generate revenue in two ways: Charging premiums in exchange for insurance coverage and then reinvesting those premiums into interest-generating assets. Insurers also diversify risk by pooling the risk from customers and redistributing it across a larger portfolio.

Premiums and Pricing Risk

The revenue model for insurance companies may vary among the different types of insurance, including auto, health, and property insurance. However, the insurance industry generally operates by assuming a financial risk from their customers and transferring it—partly or fully—to the insurer. The insurer writes up a policy stating the terms and covered events for which they pay the customer if a claim gets filed. In return, the insurance company gets paid a premium by the customer.

A key task for insurers is to price the risk of an event occurring and charge an appropriate premium for assuming that risk. Suppose an insurance company offers a policy with a $100,000 conditional payout. The insurance company must assess the risk that the policy might get triggered and a claim payout occurs. From there, the insurer must determine the level of risk they're willing to assume and the premium amount to charge the customer to adequately compensate them for taking on the risk. This analysis is called underwriting.

If a company prices its risk effectively, it should generate more revenue in premiums than it spends on claim payouts. However, if the underwriting team miscalculates the level of risk, the insurance company might charge some customers too little and others too much. If the insurer charges too little of a premium for the risk in a particular policy, the company could lose money if a claim gets filed. Conversely, if the insurer overcompensates for the risk, charging too high of a premium, they could lose prospective clients to the competition.

In a sense, an insurer's actual product is insurance claims. When a customer files a claim, the company must process it, check it for accuracy, and submit payment. This due diligence helps filter out fraudulent claims, minimizing the risk of loss to the company.

Interest Earnings and Revenue

As mentioned earlier, insurance companies invest a portion of their premiums to generate income. Rising market interest rates can boost earnings by providing insurance companies with a higher return or yield on interest-bearing investments like Treasury bonds, high-grade corporate bonds, high-yield savings accounts, and certificates of deposit (CDs).

Conversely, as rates fall, so too does investment income. A low-rate environment can lead insurers to invest in riskier assets to hit their earnings forecast. Conversely, higher market interest rates can help insurers avoid investing in riskier assets. Insurance companies often look for safe, short-term investments to generate additional interest revenue while waiting for potential claim payouts.

Reducing Risk Through Reinsurance

Some companies engage in reinsurance to reduce risk. Reinsurance is insurance that insurance companies buy to protect themselves from excessive losses due to high exposure. Reinsurance helps insurers maintain solvency and avoid default due to too many claim payouts.

For example, let's say an insurance company had underwritten hurricane policies based on models showing a low probability of a hurricane occurring in a particular region. If the inconceivable occurred with a hurricane hitting the region, considerable losses for the insurance company could ensue. Without reinsurance taking some of the risks off the table, insurance companies could go out of business whenever a natural disaster hits.

Regulators mandate reinsurance for insurance companies of a certain size and type. For example, an insurance company must only issue a policy with a cap of 10% of its value unless it is reinsured. Thus, reinsurance allows insurance companies to be more aggressive in winning market share, as they can transfer risks. Additionally, reinsurance smooths out the natural fluctuations of insurance companies, which can see significant deviations in profits and losses.

For many insurance companies, it is like arbitrage. They charge consumers a higher rate for insurance and obtain cheaper rates, reinsuring these policies on a bulk scale.

Evaluating Insurance Companies

Evaluating the financial performance of insurance companies can include an analysis of their profitability, expected growth, claim payouts, and risk. Analysts often perform financial ratio analysis using insurance-specific ratios to evaluate the companies.

Also, there are industry-specific characteristics of insurance companies. For example, many insurance companies don't invest in fixed assets like manufacturing equipment. So, little depreciation and capital expenditures are recorded.

Before investing, please get in touch with a financial professional or broker to help you analyze the insurance company's financial performance to determine the best investment opportunity for you.

Combined Ratio

The combined ratio measures an insurance company's profitability by comparing revenue from premiums, claims paid out, and expenses incurred. Sometimes, the ratio substitutes the phrase losses incurred instead of claims paid since insurers consider paid claims as losses.

The formula to calculate the combined ratio is:

• (Claims Paid + Expenses) ÷ Premiums

For example, let's say an insurer has the following:

• Claims paid: $1 million
• Expenses: $200,000
• Premium revenue: $1.4 million

The combined ratio equals 86% or ($1,000,000 + $200,000) ÷ $1,400,000.

Ideally, an insurer wants a combined ratio of less than 100% since it means the claims paid and expenses are less than revenue. In the example above, the insurer's expenses and claims represent 86% of the firm's revenue. In other words, they earned more revenue from premiums than they paid in claims and expenses.

Conversely, a combined ratio of over 100% means cash outflows of claims and expenses exceed revenue from premiums.

Equity Ratios

If the insurance company is publicly traded, meaning its stock is listed on an exchange, equity metrics, such as price-to-earnings (P/E) and price-to-book (P/B) ratios, can be helpful, especially when comparing the ratios to other insurers in the industry.

The P/E ratio measures a company's stock price relative to its earnings or profit. Insurance companies tend to exhibit higher P/Es due to expected growth, high claim payouts, and low risk. An excessively high P/E might mean the price is too high versus the earnings. Conversely, a lower P/E can mean an insurer is undervalued.

A price-to-book value measures the market value of an insurer relative to its book value, whereby the book value represents the net value of a company after all assets have been sold and all liabilities have been paid off. A P/B ratio of under 1 demonstrates an undervalued company. Insurance companies tend to have higher P/B ratios due to expected earnings growth, low-risk profile, high claim payouts, and high return on equity (ROE).

Challenges

When comparing the financial performance across the insurance sector, analysts must deal with additional complicating factors. Insurance companies make estimated provisions for their future claims expenses. If the insurer is too conservative or too aggressive in estimating such provisions, the financial forecasts and ratios may be inaccurate.

The degree of diversification also hampers comparability across the insurance sector. It is common for insurers to be involved in one or more distinct insurance businesses, such as life, property, and casualty insurance. Depending on the degree of diversification, insurance companies face different risks and returns, making it challenging to compare the financial performance of one insurer to another.

The Bottom Line

An insurance company assumes the financial risk of a covered event on behalf of an individual or company. The insurance company underwrites a policy, stipulating the covered risks and conditions for paying for an insurance claim. In return, the insurer gets paid an annual or monthly premium from the individual or business. Besides earning money from the premiums collected, some insurers pool the premiums into interest-bearing investments.