How Do Insurance Companies Generate Income?

Have you ever wondered how insurance companies work? People pay in a plan and have their family covered. But, what really happens when, for example, all members of the family get sick and need financial help? How does this stuff work and what do these insurance companies get out of it?

Why do People Avail of Insurance?

People purchase insurance for risk management. Having insurance preempts the possibility of significant financial loss in the future. To preventively compensate for this potential loss, the insured pays the insurance company a certain amount of money in advance, at a given schedule. This is what they call a premium. In return, the insured will receive a document known as the insurance policy that indicates which occurrences are insured and also corresponding payments to the insured policy holder if ever any of the listed events actually occur.

How do Insurance Companies Generate Income?

Insurance companies collect premiums from a large group of policy holders to cover the losses they would have to pay for in case of accidents or the like. They rely on historical data to test the probability of losses, and they then charge premiums to cover them while raking in profits for themselves.

For example: 10 houses in a particular area are each worth RM 300,000. That area would have a total value of RM 3,000,000. But according to the history of that neighborhood, two houses are expected to burn down a year.

How Do Insurance Companies Generate Income?

Without them being insured, all the 10 homeowners would need to have RM 300,000 ready to cover the possibility of their house burning down and needing to rebuild it. But with insurance, each homeowner would only need to pay RM 60,000 (18,000 USD) into an insurance pool to pay for rebuilding the two houses that are expected to burn down.

Let’s do the Math:

2 houses burned x RM 300,000 = RM 600,000 for rebuilding the houses
RM 600,000 divided by the 10 homeowners = RM 60,000 premium

That RM 60,000 premium will then have to be increased to add a profit for the insurance company.

In all kinds of insurance, the companies calculate in advance what percentage of the assets covered are likely to get fall into some sort of unfortunate event. They do the math to calculate how much it will cost them. They also calculate how much they will get from the daily payments of everyone who is insured, most of whom will have to make claims for any accidents or calamities. The money that they get from the daily payments is more than what they will likely spend to cover claims, and that is how they make money.

Also, they have a lot of money saved or invested, so that if there was an unexpected case of everyone experiencing unfortunate disasters at the same time (such as all health insurance policy holders getting sick due to an epidemic), they could pay the claims.

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.

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