How Do Auto Insurance Companies Make Money?

Most everyone who drives has to deal with auto insurance companies. The concept of insurance seems pretty simple on the consumers’ side; we pay our premiums, and if an accident happens they pay for the damages. However, have you ever had a day when you saw half a dozen accidents? Or even just one or two bad ones? You might end up asking yourself: How do insurance companies make any money? In reality, insurance is a very profitable industry (that’s how the insurance companies can spend so much money on all those TV advertisements we’ve all seen). Here’s a summary of the concepts that insurance companies use to make their cash:

Premiums

The whole process starts here. To provide coverage, insurance companies charge a fee called a premium. Premiums are calculated by a complex process that evaluates the risk of a certain type of driver being involved in an accident. This is ensures that the money coming in from each driver is going to be proportional to the money going out based on the frequency and severity of claims for different types of drivers. That’s why people with better driving records get lower premiums.

Shared Risk

The concept that insurance companies operate on is called “shared risk.” This is accomplished by grouping together large numbers of policyholders. The concept is based on the fact that not all drivers will have an accident during a covered period. In fact, the risk most of any driver getting in an accident severe enough to file a claim is relatively low.

As an example, we’ll use an accident that is relatively severe. Assume for a moment that it 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. Every driver that buys a policy beyond that is going to provide cash profit for the insurance company. Using the concept of shared risk allows the insurance companies to recognize predictable trends and adjust premiums accordingly.

Limiting Risk

All insurance policies come with specific limits of liability that the insurance company sets 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 the largest claims.

Re-Insurance

Believe it or not, most insurance companies are also insurance customers. Even using the concept of shared risk and limited coverage, it’s possible that an insurance company could have more claims during a given period then they can handle with their available cash. That’s where re-insurance comes in. 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 that company to limit their liability.

Re-Investment of Premiums

As soon as the check for your premium is cashed, your insurance company puts that money in interest-earning investments. Because of the shared risk that they manage, the company has HUGE amounts of cash available to invest in the short and long term. These interest earnings represent a very large source of the overall profits that insurance companies generate.

These are the basic concepts that help your insurance company operate effectively. By putting these principals into practice, this allows insurers to offer protection for their customers, and put a little cash in their pockets at the same time. That way, in a sense everybody wins.