How do Insurance Companies Make Money

How do Insurance Companies Make Money – Unicorn Economy Analysis

How do Insurance Companies Make Money
How do Insurance Companies Make Money

Insurance is one girl, that every one misses the most when it is needed and not there! ¬†I meant in case you need expenses covered by Insurance policy and you don’t have one, this is when it hurts you the most! ¬†Well Insurance is subject matter of one’s personal understanding of the risks that he is prone to (like Death! ūüôā ). ¬†People normally avoid taking insurance in light of over estimating one’s health and underestimating the hazards they are exposed to. ¬†Here we analyse¬†How do Insurance Companies Make Money.

Type of Insurance Policies

Before moving to How do Insurance Companies Make Money Let’s first understand the type of policies that exist.

Following are the various types of Insurance Policies Available (in India):

  1. Health Insurance (Covers Health Risks, Some Treatments) – Also called accident policy, critical illness treatment policy, medical insurance etc
  2. Life Insurance (Covers Dealth Only) РLinked to death of individual
  3. Business Insurance (Covers risks involved in Business) РTrade Risk, Transportation Risk etc.
  4. Risk Return Insurance (Covers Death Only) РLinked to death of individual with selective investment portfolio choice

Classification is also based on Number of Insured Individuals:

  1. Single Person – Individual / Retail
  2. More than One – Group Insurance

Business Model of Insurance Companies

Before we move on to the whats and buts of How do Insurance Companies Make Money via all their modes, we need to understand how insurance works:

Let’s say Joe here wants to buy a PURE COVER based insurance policy (not that investment with returns types). ¬†Joe has boiled down that he needs 15 Lac worth of health coverage [Called Sum Assured] (Type 1 & 3 are appx the same in money making strategies), 2 crore worth of Life Coverage (Type 3) and 1 Crore worth of Investment Coverage (Type 4). ¬†P.S. Types refer to type of Insurance Policies given above.

Premium is the amount of money that Joe needs to pay every month / year for the cover to continue till the end of his life / health deterioration etc.  We will consider premia to be paid yearly.

Business Model of Insurance Companies via Premium Calculation

The premium here depends on following factors:

  • Age of Insured Person
  • Gender of Insured Person
  • Overall Health of Insured Person
  • Smoking and other activities of Insured Person
  • Previous diseases / family disease, if any

Assuming that Joe is young (appx 28), Male, Fully Healthy, no bad habits and no family history of illness, Joe will pay appx 15,000 INR Premium for Health Insurance (Assumption of the author for example sake).  This premium comprises of:

  1. Risk Premium (12,000)
  2. Agent Commission (1,500)
  3. Government Taxes (assume 10% = 1,500)

How do Insurance Companies Make Money

How do Insurance Companies Make Money by retaining premium paid is explored here.  What Health (Business) Insurance company retains is 15,000 Р1,500 Р1,500 = 12,000 INR Per Individual.  Now assume 1,00,000 same individuals buy same worth insurance from the insurance company at the same date i.e. 1st April of the year, assume no sales made by the company for the rest of the year (for calculation simplicity).

How do Insurance Companies Make Money via Expense Reduction

  • Total Premium Collected by the Company = 15,000 * 1,00,000 = 1,50,00,00,000 (150 Crore)
  • Total Commission Paid Out = 15 Crore
  • Total Taxes Paid Out = 15 Crore
  • Total Premium¬†Retained by the Insurance Co. = 1,20,00,00,000 (120 Crore)
  • Total Salary Expense for the year (assume 10000 employees at avergae salary of 30,000) = 30,00,00,000 = 30 Crore
  • Total Infra Expense = 10 Crore (Rent, etc)
  • Total Money remaining with Insurance Company = 80 Crore
  • Total Claim Risk of 15,00,000 * 1,00,000 = 1,50,00,00,00,000 (i.e. 1.5 Lac Crore worth of Claim Liability i.e. if all people fell ill and claimed their 15,00,000 worth of insurance this company will have to pay 1.5 Lac Crore)

Now this 80 Crore is not the profit of the Insurance Company, it is money available for investment and paying out claims.  Insurance authorities of all countries ask selling companies to ear mark some money for payment of claims.  Assume that money is about 20% of total premium collected.  i.e. 30 Crore (150 Cr * 20%)

Now the company is left with 50 Crore (80 Crore Money Remaining from expense calculation Рear mark money of 30 Crore).  This 50 crore is invested in two parts:

  • One portion will be used to mitigate the claim risk of 1.5 Lac Crore : This is done by transferring some of the risk to an Insurer of Insurers – Called RE-INSURER. ¬†This is the grand daddy that is a global company which shares some risk of insurance companies. ¬†How do Insurance Companies Make Money¬†via transferring the risk is pretty obvious, they don’t want to bear the entire brunt of paying the sum assured to the claimant in case of mishaps. ¬†The insurance company would ideally want to pass on the entire risk but Re-Insurer will evaluate the total risk and then agree for a mutual share number, lets say Re-Insurer here agrees to share 30% of the risk at 20% of the premium i.e. 30% of 1.5 Lac Crore = 45,000 Crore worth of claims at 30 Crore Re-Premium (20% of 150 Crore).

P.S. Reinsurer will pay 30% of all claims arising to the insurance company.

  • Other portion will be an invested into an asset which would yield investment returns to the insurance company so that they will better be able to mitigate the claims risk that they may face in the current or any calamity year (when calamity strikes insurance claims rise and insurance companies lose money) i.e. 20 Crore

The Insurance company is now left with 20 Crore to invest into high risk high return securities so that they can make returns (say 10% ) to reduce their risk of 1.05 Lac Crore (1.5 Lac Crore Р45,000 Crore).  Assuming they made 2 Crore interest on the same (20 Cr * 10%).

The 30 Crore ear marked for claims is also invested into low risk low return securities, for e.g. the 30 crore can be invested in 5% liquid income which does not have any risk i.e. 1.5 Crore Interest.

Related Business Model wrt Discounting : Structured Settlement Annuity Companies

How do Insurance Companies Make Money by Rejecting Claims

How do Insurance Companies Make Money can be understood via their Income and Expense statements.  This is what their Income and Expense Statement for the year looks like:

  1. Total Income Premium = 150 Crore
  2. Total Interest Income Received =  2 Crore + 1.5 Crore = 3 Crore
  3. Total Commission Paid = – 15 Crore
  4. Total Taxes Paid = Р15 Crore
  5. Total Reinsurance Premium Paid = Р30 Crore
  6. Total Salary and Expenses = Р40 Crore (Salary 30 and Rent 10)
  7. Total Claim Asset Created =  Р30 Crore
  8. Total Money Made by the company = ( 1 + 2 Р3 -4 -5- 6 Р7) + 7 = 23 Crore (Invested + Interest) + 30 Crore Claim Asset

Now assume there are claims made by 3% of the insured which looks as follows:

  1. 0.1% full sum assured (15 Lac Claim Value) – Which means cost of treatment for these people is greater than or equal to 15 Lacs
  2. 1% partial sum assured –¬†Which means cost of treatment for these people is less than 15 Lacs (avg claim 1 lacs)
  3. 1 %¬†partial sum assured –¬†Which means cost of treatment for these people is less than 15 Lacs but is rejected by the insurance company on some grounds (called Repudiation of claims o account of mis-representation at the time of coverage or the disease or treatment is not covered in the policy)
  4. 0.9 % full sum assured –¬†Which means cost of treatment for these people is greater¬†than or equal to 15 Lacs but is rejected by the insurance company on some grounds (called Repudiation of claims o account of mis-representation at the time of coverage or the disease or treatment is not covered in the policy)

Total Claim Value:

  1. 0.1% of 15 Lac worth of claims = 100 people * 15 Lacs = 15,00,00,000
  2. 1% of 1 Lac worth of claims = 1000 people * 5 Lacs = 10,00,00,000

Total Claim Pay Out: 25,00,00,000 (25 Crore)

  1. Paid by Insurance Company : 17.5 Crore (25 Crore – 7.5 Crore of Re-Insurer)
  2. Paid by Re-Insurer : 7.5 Crore (30% of 25 Crore)

Thus Total Money Made by Insurance Company at the End of the Year:  53 Crore Р17.5 Crore = 35.5 Crore РHow do Insurance Companies Make Money seems pretty clear from this!

Life Insurance Premium Calculation

The premium here depends on following factors:

  • Age of Insured Person
  • Gender of Insured Person
  • Overall Health of Insured Person
  • Smoking and other activities of Insured Person
  • Previous diseases / family disease, if any

Assuming that Joe is young (appx 28), Male, Fully Healthy, no bad habits and no family history of illness, Joe will pay appx 4,000 INR Premium for Life Insurance Sum Assured of 2 Crore (Assumption of the author for example sake).  This premium comprises of:

  1. Risk Premium (3,000)
  2. Agent Commission (600)
  3. Government Taxes (assume 10% = 400)

How do Insurance Companies Make Money by way of life insurance policies is pretty similar to the way Health insurance has been put up at the top.

Here is a Related Article You Must Read: How do Credit Card Companies Make Money

Investment Linked Insurance Premium Calculation

Apart from the standard risk premium these type of insurance policies, have a component of fund management charge that they charge to the customer for giving returns on their investment.  How do Insurance Companies Make Money from fund management charges over and above risk premium is allowed in some countries, the point to note here is that the risk cover in investment linked policies is not as high as pure risk policies, so the quantum of funds made here contribute to a higher percentage in the top line.

Here is a Related Article You Must Read: How do Banks Make Money

Disclaimer: The understanding of the How do Insurance Companies make money is of the Author’s himself, neither any insurance company (life or health) or qualified consultants have confirmed or explained the same to the author and the descriptions, stats, facts and figures, if used, are either obtained through secondary web research or interrogation of relevant search professionals or other resources on the web.  Please use your own discretion to use this info when required and by continuing to read you agree to indemnify the author & Unicornomy from the entire liability arising out of using this info on your own.

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