How do Insurance Companies make money? Understanding their Business Model

Insurance companies operate on a business model involving a contract/agreement between the insurer (insurance company) and the insured (policyholder/customer), wherein the former agrees to compensate the insured for any damage or loss he/she suffers on a specific asset (home, car, etc.) or on his/her life (life or term insurance).

This guaranteed compensation is ‘bought’ by the insured, by paying the insurance company a fixed amount known as the premium (renewal premium rate can change). Policyholders have to pay premiums for their purchased policy at regular intervals, so that insurers can assume the financial responsibility to make good the losses or damages suffered by policyholders.

The income of insurance companies comes from the premiums paid by the insured. These premiums can be paid at one go that is in case of single premium policies or paid at regular intervals – monthly, quarterly, bi-annually or annually.

Business Model of Insurance Companies

Like other businesses, insurance companies also thrive on a profit, which in the particular case of insurance can be classified as follows:

1) Underwriting income: This income is earned from the difference between the amount of money the insurance company collects for all policies sold (premium) and how much they pay out in case a claim arises (final settlement) from those policies in any given time frame.

For Instance: Over a Year an insurance company collects Rs 1 Crore in revenue from premium of policies issued & the amount spent for settling claims is say Rs 50 Lakh then the underwriting income for that year is Rs 50 lakh.

2) Investment income: The premium money collected by insurance companies from policyholders is usually invested in bonds, stocks, other businesses, sometimes even in other insurance companies. Investing premium in capital markets generates a residual income which is known as investment income.

An insurance company invests the premiums to ensure that some returns are earned on the money instead of letting it sit idle, until a claim actually comes forth and has to be settled. Overall, most insurance companies have a well-diversified portfolio. They invest money their money in fixed Income securities at lower risk & also invest in equity markets at high risk to generate significant returns.

business model of insurance companies pic how insurance companies work

What is loss ratio?

Using various statistical tools, insurance companies can get an estimate of the ultimate claim ratio for a particular year. This ratio, referred to as the loss ratio, is the ratio of total losses (reserved and paid) incurred in claims, plus all adjustment expenses – this final sum is then divided by the grand total of all premiums earned.

For instance:If an insurance company pays Rs 60 in a claim for every Rs 100 collected as premium, the loss ratio amounts to 60% and the gross margin/profit ratio is 40%. Some part of this 40% will cover expenses incurred by the company towards its operating costs, while the rest of it will be the company’s net profit.

(Read : ‘Best Health Insurance Cos & Latest Incurred Claims Ratio 2015‘)

Fixing insurance contract price and premium amount

Based on the above principle, an insurance contract’s price as well as the premium to be paid by the insured can be evaluated. While working out the contract cost and premium, the insurance company takes into account all estimated possible losses, along with the estimated management, distribution, commissions and various other costs, over and above which, a minimum margin of 2 to 5% is kept. The premium amount to a specific risk is calculated using certain statistical tools.

At the end of the year, the insurance company sets aside a certain amount to cover anticipated losses, claims and also keeps some amount as margin (more than the estimate)into an accounting reserve. Later, actual payouts are compared with the original evaluations and the account reserve is accordingly adjusted higher or lower.

Premium loading

Some customers may hold risky jobs (Air Force, Army, Pilot, etc.), some may be smokers and/or drinkers, others may be obese, while some others may be suffering from pre-existing diseases. All these customers are considered ‘high risk’ customers for an insurance company, in case of which, the company may increase the premium for these customers. This is called ‘loading’ the premium.

Are policyholders actually paid at the time of a claim?

Genuine cases with all necessary documentation, proof and other paperwork in place definitely get paid the due amount at the time of a claim. The insurance business is based on volume. A few individuals making claims will not translate to losses for the insurance company, because claims being made are already factored in while calculating overall costs/losses. Just like a few people claim, thousands of others do not file a claim but continue paying their premiums, which collectively get carried forward and re-invested year-on-year, helping create a more-than-sufficient buffer.

How different categories of insurance companies fix premiums

Life insurance: Life insurance companies are aware about the average life span of people. If a huge number of people pay their premiums for at least a few years, the funds collected will be sufficient to cover those who actually file a claim.

Health insurance: Health insurance companies have all the necessary information about:

  • The probability of people in a certain age bracket falling ill or getting hospitalized in a certain number of years.
  • Present hospital charges.
  • What future medical inflation is likely to be and what effect it will have on medical treatment, hospital costs, etc.
  • All other related expenses.

Health insurance companies price their policies in line with the above information. While health insurance companies offer policies that benefit their clients, it is also true that they factor in their profits as well and ensure they do not make any losses.

Auto insurance: These companies are equipped with data that helps them understand that if a car is a certain number of years old, then how will it perform, what is the wear and tear, what is the likelihood of the car getting into an accident or being damaged, etc. Accordingly, companies decide the premium to make their business profitable.

Credit Card insurance: Insuring credit cards is also a kind of insurance business. These companies are aware about how many credit cards out of 100 are lost and what is the loss therein. Bearing this in mind, the insurance company fixes the premium so they are able to make profits.

This is a guest post by Tarun of Policybazaar.com.

About the Author:

Tarun Mathur Director Policy Bazaar

Tarun Mathur serves as the Director of Life Insurance at PolicyBazaar, India’s largest online insurance aggregator. He is also a part of the co-founding team at the company.

He has over 15 years of experience in sales, analytics and project management and has worked in companies such as eBookers PLC and Hero ITES, bringing in his expertise to the table at PolicyBazaar.com. When not working, he loves reading and watching superheroes movies.

Kindly note that Relakhs.com is not associated with Policybazaar. This post is for information purposes only. This is a guest post and NOT a sponsored one. We have not received any monetary benefit for publishing this article.

(Image courtesy of fantasista at FreeDigitalPhotos.net) (Post Published on : 08-July-2016)

  • Rupali R. Mithbaokar says:

    Sir,

    IRDA has made Benefit Illustration Statement mandatory before logging in New Insurance Policy. But it is very difficult to read through the numbers. Please guide as to how to read it.

    For example, I have one ULIP policy which I bought it for 20 years. According to 4% assumed growth rate, IRR works out to be merely 1.35% and at 8% assumed growth rate it works out to be 5.91%. So is the difference between assumed growth rate and IRR is cost of the plan? In this case it would be 2.65% and 2.09% respectively. Please guide.

    Although, I could roughly be able to calculate Policy Allocation Charges, Policy Administration Charges, Mortality charges and Fund Management Charges. But IRR excluding Mortality Charges is 6.69%. Now if Fund Management Charges itself are 1.35% (excluding service tax), how could IRR be 6.69%? This is very confusing.

    In case of traditional plan, IRR works out to be much lower at 4.98% at 8% assumed rate. So is the cost of this plan is 3.02%? Further there was not mention of other costs which were shown in ULIP Illustration statement.

    Please guide as it is very confusing

  • soudagar says:

    Sree,
    Which car insurance is better for any car?? Please suggest. My first insurance is near to expire at the end of August 16. Which type of car insurance & of which company’s will be better for me??
    Thanks.

  • >
    Scroll to Top