Back in the good old days of classes like Financial Institutions Management, I learned quite a bit about how banks and insurance companies make money. The way insurance companies drive their profits is not what you might expect.
Insurance companies have two sources of profits. The first, and most widely known source of profits, is bringing in higher revenue from insurance payments than is expended in claims. If you pay $150 per year for renters insurance and never make a claim, the company keeps all of that as profit. If you pay $800 per year for car insurance and the company has to pay out $900 per year in claims, they are not making money. This is how insurance companies get the reputation of being stingy. They try to limit what they payout, even if it hurts their customers. However, it is not quite that simple.
The second way insurance companies make money is through investments. I met with a manager at Pinnacol, the Colorado guaranteed workers compensation insurance provider. He was very up front in explaining that Pinnacol's investments performed so well and the overhead was so low that even if Pinnacol paid out 100% of its income, it would still be profitable.
Insurance companies make most of their money through investments. To earn a profit, the insurance company must maximize the time between receiving a payment and making a payment. This spread is the investment period that the insurance company uses to make money. If you pay the company $100 on January 1st and they pay it out on July 1st, it had a six month investment period. If the company had an investment gain of an annualized 10% during that period, it made $5 in profit, before taxes and related expenses.
The scale comes with having many customers and extending the investment period and minimizing payouts. If the company has 1 million customers in the same situation, it makes $5 million. You can see how fast the scale can increase profitability, even if everything you pay in gets paid back out.
To extend the investment period, the company will delay claims processing. Some companies expedite claims for customer service reasons to bring in new clients, but some have waiting periods and processing periods that delay check writing.
The best way to increase profits for an insurance company is to increase investment return. As any educated investor knows, increased profits often come with increased risk. Insurance companies hire educated professionals to balance risk and return to ensure a well diversified investment portfolio.
AIG's investment professionals did not appropriately manage the company's risk. AIG invested into highly risky securities hoping for a very high return. It worked, for a little while. However, when the markets turned sour the company had record losses.
If any of the terms here were confusing, be sure to read this well written glossary of insurance terms. If you think I missed something or have any questions, please say so in the comments.
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