Why insurance companies need to make a profit

A competitive insurance market is a pretty remarkable thing. It allows individuals, owners and employers to transfer their risk at a very low cost to a company that will pay to restore what’s been lost. For most people and companies, it allows them to recover from potentially devastating losses. Though the fundamentals are the same for both property/casualty and health insurance, the examples below address property/casualty and the need for profit.

Imagine not having insurance and seeing your home burn while you still owe your mortgage company more than a hundred thousand dollars. Or how about being one of the nation’s largest retailers and having your customer data stolen including credit card information. Think about having an ice storm knock out the power to your store during the largest retail season of the year? Insurance can pay for these losses by spreading the risk over thousands of other policyholders. So how does it all work?

On the cost side, the insurance companies attempt to predict what the actual cost of claims will be in any given year. These estimates are called loss costs. In addition, the insurance companies then calculate what it costs to run their operations: agency commissions, claim management, underwriting, administration, actuarial services, investigations, etc.

Once they have calculated their costs, they then can price their products. If their prices are attractive and their coverage competitive, they can make a profit. The combination of competitive pricing and solid coverage allow them to compete to get you to be their customer. They can’t afford to be the most expensive without providing superior or unusual coverage and service. On the other hand, they can’t lose money either. The insurance company has to make a profit. Profits allow a company to pay their claims, grow and pay dividends to their investors. Those investors include millions of people who have 401(K) retirement plans that may include publicly traded insurance companies. In other words, profit is not a dirty word.

Another aspect of insurance operations are loss reserves – the money an insurance company needs to set aside to pay for claims that have not been fully valued or reported. For example, following an ice storm with wide spread power outages, insurance companies have to assume they will be receiving insurance claims for months following the storm: food spoilage, loss of business, water damage from frozen pipes, building damage from falling trees to name just a few situations. That’s why insurance companies have to have deep pockets, another word for profit.

Workers’ compensation insurance is known as a long-tail line of business. Insurance companies that offer workers’ compensation coverage tend to have very large loss reserves to assure there is money in the bank to pay for lost wages and medical bills associated with workplace injuries. Imagine a 24 year old roofer hitting the ground and being paralyzed for life. Though his employer may have paid a few thousand dollars in premiums, the insurance company will likely pay the young man’s medical bills and lost wages for more than forty years. Gratefully for the young man and for society, the insurance industry is highly regulated and audited to make sure money is available to meet its obligations.

Insurance companies also spread their risk by buying insurance from reinsurers. These are usually global companies with vast amounts of money to pay for catastrophic losses. For example, if an insurance company has a claim that will cost $100 million but they have purchased reinsurance for any loss greater than $20 million, the reinsurer will pay the remaining $80 million. The cost of reinsurance is a small part of your personal or business insurance premiums.

A well-regulated insurance industry is a wonderful and remarkable way in which we can pitch in together to protect one another from the unexpected. It’s also why making a profit is so essential to our individual and economic security.

The insurance premiums are collected over the course of the year

Photo by LendingMemo