Having insurance for expensive assets such as your car or house as well as emergencies and health care is vital, protecting both yourself and your loved ones. There are a wealth of insurance companies in South Africa offering insurances services for a variety of life aspects.
If you need to claim and meet the necessary requirement, the insurance company will pay out the amount you need, often large sums of money. But if these companies are always handing out money, how do they make money?
Insurance companies make money through two predominant means: investing leftover money, and underwriting.
What is underwriting?
Underwriting is how insurance companies assesses the risk factors of an entity to determine how much to charge the person as an insurance premium.
In exchange for providing insurance, insurance companies charge the price of the insurance, known as a premium. The premium can be paid in many ways and the amount varies depending on your personal preferences as well as the type of insurance.
Premiums vs. Payouts
According to the terms of the insurance, an insurance company will pay out money to the claimant or policy holder if an event happens.
For example, if there is a fire in a home, a homeowner will likely be covered under homeowner’s insurance. The insurance company usually states the maximum payout amount in the insurance policy. A payout represents an expense to the insurance company, whereas a premium represents the company’s income.
To make a profit, insurance companies aim to earn more through premiums than through what they pay out from insurance claims. Actuarial science is a field of science devoted to these complicated calculations, which use statistics, maths, and probability to determine the overall likelihood of a particular entity being destroyed or damaged.
Here is an example to demonstrate the concept of shared risk: if a customer pays R1, 000 per month for auto insurance premiums and does not have an accident or circumstances requiring coverage in that time, the insurance company keeps the R1,000 as income. However, if the same person paying R1, 000 per month has an accident that costs R10, 000, the auto insurance company will still pay out R10, 000 if it is in line with the insurance terms to do so.
To be profitable, the insurance company would need to have more people who do not need to claim to make up for those who do need to claim. This is where statistics and probability comes in – the company needs to work out how much they should charge as a premium to ensure that their income (premiums) exceed their expenses (claims).
In order to make the shared risk model work, insurance companies need to be careful about the insurance they offer and who they offer it to. If an insurance company is unable to measure and estimate a particular risk, they will likely not insure that product.
Additionally, if the company can predict the risk, but discover that they would not be able to make a profit if that risk was covered, they will not offer that particular insurance product. In an area known for hurricanes, for example, insurance companies cannot rely on the shared risk to cover all damages to a particular area, so it may be more difficult to find insurance coverage for high-risk hurricane areas.
How does investing work?
Another method used by insurance companies to make a profit on premiums is by investing the capital from premiums in various accounts and markets.
This is the money that has been paid in the form of premiums but hasn’t been claimed and is known as the “float” money. Float money can be compared to the money a bank gets after people deposit money and before they loan the money out to other clients.
Where do insurance companies invest their money?
Like many stock owners, insurance companies invest float money in a number of areas, including:
- Mutual funds
- The stock market
If any of their investments start to downturn, the insurance companies will often pull their money from these markets. When forced to do so, this means that the profitability ratios will change and the company will need to increase premiums paid by customers to increase their profits.