Every month, you pay a premium to your auto insurance company to stay insured. If you are in an accident, the insurance company pays for the damages. If the insurance company pays out more in claims than it takes in premiums, many people would think the insurance company lost money, but that is almost never the case. Even if the insurance company pays more in claims, it could still be quite profitable. Read on to understand how insurance companies make money.
Two Sources of Profits
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. I'll never forget the gusto with which Dr. Gross derived complex profitability equations, but you don't need calculus to understand insurance company profitability. 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 paid out more than they brought in, but could still be making money from you and as a whole. The company tries to limit what it pays out in claims, but insurance company profitability is not that simple.
How Insurance Companies Make Money: Maximum Premiums with Minimal Payouts
Before we dive into the second way insurance companies make money, I want to emphasize that insurance profits are complex. Minimizing payouts while taking in as much as possible in premiums is a major aspect. Every time a customer files a claim, the company is at risk of having to pay out a substantial amount of money, which is why insurance companies employ claims adjusters and expensive lawyers to fight payouts whenever possible.
The insurers know they will have to pay claims on occasion. Nearly every driver has been in an accident and files a claim at some point, after all. But even if a customer costs more than they pay, it does not mean the company is losing money for two reasons. One of those reasons is a diverse risk pool.
Each time an insurance company signs up a new customer, they asses the risk that the customer will file a claim while insured under the policy. People who have lots of speeding tickets are more likely to cause an accident, which is why insurance costs more for people with tickets on their record. But the company is still willing to insure higher risk individuals because they risk is offset by lower risk customers.
If ten customers each pay $1,000 per year in insurance and two have claims that cost $2,000, the insurance company lost money on those two customers who had claims but still brought in $6,000 more than it paid out. Nearly all insurance companies operate under the assumption that claims will follow a pattern, which is how they decide rates and can typically predict claims and payouts with decent accuracy.
How Insurance Companies Make Money: Investing for Maximal Profits
But what happens if an insurance company pays out more in claims than it brings in? Major catastrophes like Hurricane Katrina, the 1994 Northridge Earthquake, and other major disasters can easily drain an insurance company of more cash than it took in over a year or even over many years. But the companies continue to operate and earn a profit. That is possible thanks to investments.
The second way insurance companies earn money is through profitable investments. In 2008, not long before writing the first draft of this article, I met with a manager at Pinnacol Assurance, Colorado's guaranteed workers compensation insurance provider. The manager was open 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.'Large insurers have billions of dollars in cash to invest at any given time.'Click To Tweet
Some insurance companies make most of their money through investments. To earn a profit, the insurance company must maximize the return of investment in the time between receiving a premium and paying a claim. The dollars the insurance company is holding that it can invest today but expects to pay in the future is called “float.” If you pay the company $100 every month from on January to June the insurance company pays you a $600 claim in July, it had a six month period to invest that $600 float for a profit.
Scale is very important to insurance company investments. With a large pool of customers, the company can keep a certain amount of cash on hand for projected payouts and invest the rest. Large insurers have billions of dollars in cash to invest at any given time. AIG, one of the largest insurance companies in the world, recently reported $1.8 billion in cash on hand and $294.9 billion in long-term investments. Clearly AIG is putting its dollars to work!
Warren Buffett's Entire Business Runs on Float
It's no secret I'm a fan of Warren Buffett. I've been to Omaha, Nebraska three times for the annual Berkshire Hathaway shareholder meeting to see Buffett live. I own a small stock market investment in the company that has gone up significantly in value and acted as my admission to the Berkshire Hathaway meeting. Each year, Buffett writes a detailed letter to shareholders in the annual report. In 2009, Buffett offered this gem of wisdom on float.
Insurers receive premiums upfront and pay claims later. … This collect-now, pay-later model leaves us holding large sums — money we call “float” — that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit. …
If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money — and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float.
Now that we know how float works, let's look at exactly how much float Berkshire had in 2009:
Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most — though certainly not all — future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.
Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry's overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses.
Paying Your Claim is Not Profitable
While you are a customer and the insurance company wants to keep you happy, keep in mind that it is never in your insurance company's best interest to pay a claim. They are best off if another insurance company has to pay. Barring that, they are best off if the claim is never paid at all!
Berkshire Hathaway owns several insurance companies including GEICO. GEICO produces a tremendous amount of float. The a profit in taking in more premiums than claims is called an “underwriting profit.” It's impressive that Berkshire was able to do that AND make massive amounts of money investing float.
Always stay on your toes and fight for your best outcome when dealing with an insurance claim. If an insurance company can deny a $1,000 claim, it has an extra $1,000 in its coffers and an extra $1,000 to invest. If that happens to 1,000 customers, they just kept $1 million in profits!
However, the best way to increase profits for an insurance company is to increase investment returns while keeping customers happy. As educated investors know, increased profits often come with increased risk. Insurance companies hire educated professionals to balance risk and return to ensure a well diversified investment portfolio. Those investors led AIG and others astray when we were struck with The Great Recession, but that is an article for another day.
The Educated Consumer Wins in the Long-Run
Insurance companies are complex financial institutions with powerful lawyers, massive customer service departments, loads of government regulations to contend with, and tens of millions of customers across the country.
You can't legally drive a car without insurance. You can't get a home mortgage without insurance. You can't live in America without health insurance (without facing a tax penalty). With insurance playing such an important role in our personal finances, it is important to not only understand how your policy works, but how the insurance company works. If you understand your rights and are willing to stand up for yourself, insurance companies are a great partner to work with in your quest for personal profitability.
First published October 8, 2009. Major update April 3, 2017.