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How Auto Insurance Companies Make Money
Dealing with auto insurance companies is part of being a car owner. The consumer’s part of the bargain is pretty simple: you pay your premium, and if you get in an accident they foot the bill. However with the high cost of accidents and settlements nowadays, it may seem like a miracle that insurance companies make any money. Most of us see a collision or two every day, or a bad one that makes you wonder exactly what our insurance providers do to stay afloat. However, insurance in general is actually a very profitable industry. The concepts that keep insurance companies profitable have been around for many years, and they work in much the same way today as they did 40 or 50 years ago. Here are the basic principles that keep your insurer in business.
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Minimizing Risk
To make sure they make money, the first thing an insurance company has to do is make sure that their claims don’t exceed their available cash. The concept that insurance companies use to accomplish this is called “shared risk.” Thist relies on the fact that not all drivers will have an accident during a covered period. In fact, the most risk of any driver getting in an accident severe enough to file a claim is relatively low. Even when a collision does happen, shared risk makes sure that the company stays ahead of its claims. Assume for a moment that a policyholder is involved in an accident that takes $25,000 to settle. If the driver involved in the accident paid $500 for their insurance coverage for that period, it seems like the insurance company got a bad deal. That’s where shared risk comes in. If the insurance company has 50 people paying the same $500 for their coverage, that will cover the expense of paying out the claim for the one driver that got in an accident during that period. So by grouping together large numbers of policyholders, the insurance company virtually guarantees that they will make money. Every driver that buys a policy beyond the cost of settling the claims that come in represents cash profit for the insurance company.
In addition to using shared risk to ensure their stability, insurance companies make sure to define their exact possible payout for each insured driver. Insurance policies come with specific limits of liability set by the insurance company to match a specific premium. This limits the amount of money that an insurance company pays out for each policy. For example; if a policyholder gets in an accident that costs $75,000 to settle but only holds a policy that provides $50,000 in coverage, the customer is then liable for the additional $25,000 worth of damages. This protects the insurance company against being liable for very large claims.
Premiums
Everyone knows that when you buy an insurance policy that you are required to pay a fee called a premium. The amount of each premium is calculated by a complex process that evaluates the risk of an individual driver being involved in a collision. Adjusting premiums is another way that insurance companies make sure they will always have enough money to take care of their claims. That’s why someone with a good driving record will pay a lower premium for a policy than someone who has a history of accidents or traffic violations.
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All the money that an insurance company generates by charging premiums is immediately placed in interest-earning investments. Because they group large numbers of policies together as part of the concept of shared risk, each insurance company has very large amounts of cash available at any point in time. They use this cash to invest in the short and long term. Interest earnings represent a very large source of the overall profits that insurance companies generate.
Re-Insurance
Additionally, insurance companies also buy policies for themselves. Even utilizing the concept of shared risk and limits of liability, it’s possible for an insurance company to have more claims during a given period then they would be able to handle with their available cash. Because of that fact, insurance companies purchase policies from companies like Swiss Re; if they end up with more claims than they can handle, they actually make a claim with their re-insurance company to make sure that they stay in business.
