How Do Insurance Companies Make Money?

Posted on July 21, 2021

Insurance companies make billions of dollars every single year. From collecting premiums to rejecting claims, insurance companies may not surprise you with the amount of money that they rack up.

In fact, you may hear stories about CEOs who have a six-digit salary. Or, you may hear about insurance companies rejecting claims in order to save a buck or two.

Insurance companies are often the punchline at the end of a financial joke. But, some people think it's just financial intelligence.

How does it really work? How do insurance companies make money? And, is it legal?

Premiums vs Claims

Insurance premiums are the amounts of money that clients pay so that insurance companies have enough money to pay their future claims. Insurance companies collect these premiums in order to pay existing claims or save the money to pay in the future.

As you may be able to tell, a claim is an instance where a client files a problem with the insurance company. Depending on the type of insurance, the claim may be different.

For example, A health insurance plan may see claims for medical supplies, appointments, and medications. Depending on the insurance plan that the individual has, their insurance may or may not cover these claims.

So, a premium is what the client pays. A claim is what a client submits to the insurance company to (hopefully) get financial support.

Keep in mind that insurance companies do not approve every claim. And, there may be limits on the amount of money that an insurance company is willing to pay out to each client.

How Do Insurance Companies Make Money from Customers?

Insurance companies make money from the claims that clients are paying. But, they lose a little more than half of those premiums to people who are submitting claims. 

You should also keep in mind that premiums pool up. This means that one client's premium may go towards paying for another client's house fire.

You do not get to keep the premiums that you're paying in your own personal bank account to tap into. Insurance companies depend on all clients paying premiums so that they can cover all claims.

And, most of the time, insurance premiums don't change with changing claim rates. In fact, car insurance premiums continued to rise during the lockdown.

Investing Income

Insurance companies tend to invest the incoming money that they're making. It's not all of their revenue, but they do invest a fixed amount. This money comes from the annual premiums that their clients pay.

Most insurance companies opt for low-risk investing portfolios that are more likely to offer additional profit over time. This extra money helps them balance their budgets, but the money that they're earning isn't a lot.

In fact, interest rates have been at an all-time low for the past several years. So, most insurance companies haven't been making a significant amount of extra money from this tactic anyways.

The Canadian government heavily regulates insurance companies. Thus, there are strict standards around how insurance companies use the money that they making:

  • There is a standard amount of money that insurers need to keep in their bank accounts to be able to cover potential losses
  • There is a standard amount of investment risk that insurers are allowed to take

The point of these requirements is to ensure that all insurance companies can still protect their clients even if the company is investing. You wouldn't want your insurance company to invest all of its money while leaving none for you to lean on when times get tough.

In the end, insurance companies have the freedom to invest some of their earnings while still saving enough of their profits to support their clients. It's a win-win.

Additional Sources of Revenue

Underwriting and investing are the two main sources of income for insurance companies. But, there are still other ways that insurance companies can make money. Mainly, there are two popular sources of income:

  1. Cash value cancellations
  2. Coverage lapses

Let's learn more about them.

Cash Value Cancellations

Consumers who have whole-life insurance plans may discover that they have hidden cash values. This is money that the insurance company has generated through investments and dividends. 

If a client discovers that they have a large amount of money in cash values, they may ask for that money back. This involves closing the account with the insurance company.

Although it may be a large sum, the insurance company is likely to give up that cash value. This is because it takes the liability away from the insurance company.

When this happens, the insurance company can keep the premiums that the client has paid. Then, they pay the client the interest that they earned on their investments. Beyond this, the insurance company keeps everything else.

Cash value payouts can help insurance companies bring in a large sum of cash fast

Coverage Lapses

A coverage lapse happens when a consumer fails to update their insurance policy. So, the expiration date passed without the consumer realizing it.

Under insurance contracts, a lapse in coverage means that the insurance policy expires. This means that the insurance company doesn't have to pay out any existing claims tied to that client.

This is another way that insurance companies can make money. The insurance company gets to keep all of the premiums that the client paid. And, the insurance company doesn't have to worry about paying any claims on behalf of the client.

Getting Quality Insurance

So, how do insurance companies make money? Well, there are lots of ways. From premiums to investments and more, they have a solid money-making foundation.

Insurance companies can be sneaky, but that's why you have to be a smart consumer. Renew your insurance on time, pay your premiums, and take advantage of the things that your plan covers.

And, in the end, you want to make sure that you have an insurance company that's looking out for you. You can check out our list of Canada's best insurance companies here to find the right company for you.

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