Understanding how insurance companies make money can be a bit of a mystery for many people. It’s a key question for consumers who want to know where their premiums are going and whether they're getting a fair deal. In this article, we will dive into the inner workings of insurance companies, breaking down how they generate revenue, and answering some of the most frequently asked questions about the industry.
Insurance companies make money primarily through underwriting profits and investment income. They collect premiums from policyholders, which are used to pay claims and operating expenses. If the premiums collected exceed the expenses and claims paid, it results in an underwriting profit. Additionally, insurance companies invest the collected premiums in various financial instruments, generating income through interest and dividends. This investment income is a significant part of their revenue, especially when underwriting profits are low.
While the basic principles of earning through premiums, investments, and underwriting profits apply across all insurance sectors, health and life insurance companies may have different risk assessment models and investment strategies compared to other types of insurance, reflecting the unique nature of their coverage and claims.
Insurance companies are one of the pillars of Canada’s financial system. Alongside banks, credit unions, investment firms, and mortgage companies, the entire system could not function without insurance backing it and providing confidence in the markets with peace of mind. Without insurance, you wouldn’t be able to get a credit card, a home, a car, or a loan. Most consumers find insurance, especially car insurance and home insurance to be a mysterious concept, fraught with misunderstanding. This leads to the question: How do insurance companies make money, and how much do they make? Is it even fair, or is insurance just a big scam? Let’s take a look at their revenue and expenses.
The concept of insurance is to spread the risk from one person to many. People pay money into a pot which grows larger and pays out for the losses of the few from the contributions of the many. Each risk is assessed individually to try to charge a fair price. This sounds like a very good idea! However, if you’re not the one impacted by a loss, you may feel like you are not benefiting from this investment. Over time, as you accumulate more assets and face more risk, insurance becomes something you not only need but will want to have. So where does your money go?
When insurance companies collect your premiums, they generally go towards two areas: Losses and Operating Expenses. In general, insurance companies pay 55% of the premiums toward claims. This is called a “Loss Ratio”. Anything under 55% of the premiums is generally a good number for an Insurance Company. The other 35% of the premium dollar goes toward Operating Expenses and is called the “Expense Ratio”. Common expenses include salaries of their staff, marketing, rent, technology, taxes, and payment for their distribution force, whether it be a broker or agent selling their products. Source: IBC
If an Insurance Company pays less than 65% in claims or 35% in operating expenses, it makes an “Underwriting Profit”. Depending on the year, insurance companies can make either an underwriting profit or a loss. Both profits and losses occur with regularity. On average, insurers in Canada make 8% - 9% Underwriting Profit. However, the trend is going down in recent years, especially in auto insurance. Source: Insurance Canada
In addition to an Insurance Company’s underwriting result, they may reinvest the premiums they have collected to earn investment income. With large cash reserves sitting in the bank, Insurance Companies earn interest but also invest in other securities such as bonds or reliable stocks. They may also invest in the acquisition of competitors and distribution to grow market share. Although rare, it has happened where insurers have taken an underwriting loss and made an even larger investment profit, netting out to an overall profit.
If an Insurance company is doing well, or perhaps even if it isn’t, it will want to take out its own insurance as well. This is where they will pay a premium to reinsure their risk even further. The reinsurance market itself is very large and complicated. In general, it is a good idea for an even greater spread of risk in the markets. However, this can lead to some speculation. As we saw in the 2008 worldwide economic collapse, it was the reinsurers like AIG who were left holding the bag of all the bad risk, mostly generated in the U.S. housing market. In the end, everyone lost money on that, including the insurance companies and the public at large.
The perception is that insurance companies charge too much money and make too much profit. The question is, is that true? The best data we could find shows that Insurance companies in Canada compare similarly to the banking industry, although, anecdotally, the perception is that insurers make more profit. Read more about it at Consulting.ca
It is important to note that as an Insurance Broker, we work for the consumer, not the Insurance Company. We are here to get you the best coverage at the lowest price. So when you search for "car insurance near me" or “home insurance near me” next time, think of Begin Insurance. We are dedicated to finding the right fit for you, regardless of the profits or losses of the Insurance companies. In a market that can be difficult to navigate, we are your trusted partner, always putting your needs first.
If you found this blog helpful, be sure to explore our other articles, where we cover topics ranging from car insurance to home insurance and more. Whether you’re a new driver looking for affordable car insurance or a homeowner seeking comprehensive coverage, our blogs have valuable insights and tips for everyone. Explore our blog section and get the information you need to make confident insurance choices.
Posted May 10, 2019