I worked in the insurance industry for 16 years and saw
first hand how profitable an insurance company can be. I
will not attempt to go into the nitty gritty details but I
will give you a pretty good idea in the form of an
overview, how profitable a venture an insurance company can
Insurance is a form of risk management. It is purchased to
avoid the possibility of a large, potential future loss.
To compensate the insurance company for taking on this
potential future payout, the insured pays the insurance
company a certain sum of money known as the premium. In
return for the payment of the premium the insured receives
a written document, known as the insurance policy, that
lays out what events are being insured and what the payment
to the policyholder would be if that event actually
The insurance company collects the premiums of a large
group of insureds to cover the few losses they would have
to pay out for. They use historical data to figure the
probability of losses and then charge premiums to cover
them while building in a profit for themselves.
For example, let’s say there were 100 houses each worth
$100,000 in a particular area. They would have a total
value of $10,000,000. According to the history of that
neighborhood, two houses are expected to burn down during
any one year. Without insurance all 100 homeowners would
have to keep $100,000 in the bank to cover the possibility
of the house burning and needing to rebuild it. With
insurance, each homeowner would only need to pay $2,000
into an insurance pool to pay for rebuilding the two houses
that are expected to burn down.
2 houses burn x $100,000 = $200,000 for rebuilding the
houses $200,000 divided by the 100 homeowners = $2,000
That $2,000 premium will then have to be increased somewhat
to add a profit margin for the insurance company.
In addition to the built in profit that the insurance
company adds in to each premium it takes in, the company
would also be subject to the actual experience of the
insured group. If it takes in more money in premiums than
it paid out in claims then it receives what is known as an
underwriting profit. And, on the other hand if it pays out
more than it has taken in then it has an underwriting loss.
One way of looking at how well an insurance company is
doing is to look at their loss ratio. The loss ratio is
calculated by taking the losses they had to pay out and add
to that the expenses they incurred to actual pay out the
claims and divide that sum by the premiums taken in. A
ratio of less than 100% shows a profit and a ratio greater
than 100% indicates a loss.
In many cases if an insurance company’s ratio is greater
than 100% they can still be profitable. That is because
there is usually a period of time between taking in
premiums and paying out claims. During that period of time
the company can invest the money taken in and they can earn
a profit from that investment to offset any underwriting
loss and could actually end up with a net profit. For
example, if the insurance company pays out 15% more in
claims and expenses than premiums it took in, but made a
25% profit from its investments, then it would have
received a 10% profit.
So, as can be seen there is more than one way to skin the
profitability cat for an insurance company to make money.
Two key factors in that regard are how well they can
predict their payouts and how well they can invest the
money they take in.