I was standing inline at burgerking, when all the sudden I was hit with this question…how do insurence(sp??) companys make profit, or even make ends meet?? Say we have bob, at age 20 he takes on a 150,000 plan or what not, and his premium is 150 a month when averaged out over his life, sounds resonable right? Okie, now every year for 60 years until he dies(age 80) he paid that. He only paid in $108000, but took 150000 out, now how do companys cope with that? Any insight would be nice.
a) Bob probably won’t continue his plan till his death in his 80s. That’s profit.
b) When Bob (or other) restarts later in life, the price is higher.
In any case, Insurance companies are as astute in statistics as casinos; they’re great odds players and you can bet (as they do) that they’re on the winning side.
And insurance companies invest the money you pay in as premiums and make a profit on that.
Two things: first, a dollar today is worth more than a dollar tomorrow, even ignoring inflation. Rather than asking how many dollars you put in, ask how much you would have if you had saved 150 a month and allowed it to compound.
Second, insurance works by transferring risk. A person who wishes to be insured is saying that they prefer a smaller, more certain reward to a higher expected reward with a greater expected variablity.
Risk for an individual (getting hit by a bus) can be reduced to near certainty in large pools of people (number hit by bus in US/ year). If people are willing to pay some premium to reduce variability, an company which is willing to pool risks can make money.
picmr
By keeping consumers ignorant of their processes and extreme profits.
This question arises because many people feel if they are insured they get more than they put in. Talk of being naive. Like health insurance. What can you expect? If you have health insurance you can expect to pay more (on average) than if you don’t. You are just paying that much more for the peace of mind that you would be covered in the event of something you could not afford. If you have better than average health and reasonable finances to pay your medical bills, you can save quite a bundle by not being insured. I have explained this to a number of people and they are always skeptical… they still think insurance money is like government money: it grows on trees.
In addition to what everyone else has posted…
Over 80% of term insurance never reaches payout.
Let’s say you hit 60 years old. The term policy you took out to protect your spouse and children years ago is now too pricey. Plus your kids graduated college and have carrers of their own, you own your home, you have other investments that protect your spouse. The policy served its purpose. You cancel it.
That’s the numbers.
Over 80% (in some cases over 90%) of the policy holders have been paying the company for 50 years. And the company never had to return anything.
A more accurate explanation is that insurance companies are just like casinos. They’ll allow you to make a wager, and for the privilege they charge you a percentage.
Insurance companies hire actuaries to try and measure risk. Let’s say you want to insure your house against fire. The insurance company will refer to the estimates of the likelihood of fire in a house of your type, and then charge you enough premium that they make a profit.
In a casino, you can place a wager on roulette on red or black. The house knows that every 38 spins of the wheel, on average black will land 18 times, red will land 18 times and 0 or 00 will land twice and they don’t have to pay either red or black. That’s their profit.
Insurance companies work exactly the same way. If they figure there is a 1 in 1000 chance that your house will burn down in the next year, and that on average they’ll have to pay out 50,000 in damages if it does, their expected cost is $50/yr. So they charge you $75, and pocket the rest. Of course, just like the Casino the insurance company could get unlucky and have far more houses burn down than average and they could lose. That’s why it’s gambling.
Buying insurance is gambling, and the insurance company is the ‘house’. The difference is that insurance is a hedge bet, and therefore decreases your risk, while a conventional wager increases it.
The other point mentioned is also correct - If you buy house insurance for 20 years and then your house burns down, the insurance company got the use of your premiums for those 20 years, during which time the money may have doubled or tripled.
Plus, they only give you the depreciated value…again more profit for them.
People who use the money to put in a house have to pay the new very high property taxes & guess what? They often can’t afford them.
Insurers make money by selling their service to a number of people. They work on the assumption that for every person who actually suffers the loss insured against, many more won’t. They can pay out to the one person from the “pool” of money they’ve collected (and, no doubt, invested) and still keep the rest.
And fire insurance. Thankfully, it’s pretty cheap. I’ve lived in this town for 10 years and although there have been a few small fires (kitchens, garages, etc.), not one occupied dwelling has burned sufficiently to warrant rebuilding.
Figure 5,000 homes, probably 75% of them have fire insurance (I think it’s required if you have a mortgage). Even if they’re only paying $50 a year, that’s a tidy profit for the insurance company.
as handy said, they pay depreciated values. Car insurance is a good example:
Year Car value premium/yr/$
1 20,000 1000
2 15,000 1000
3 11,000 1000
4 8,000 1000
all are hypothetical figures, but you are paying the same price every year and are receiving less coverage
sorry for that mess, i should have previewed first
I am no longer ignorant in that area…thank you all for some wicked pimp ass ansers 
Also, insurance companies work profits and expenditures into their premiums.
Simple example, with numbers, based on term (one-year) insurance. (These numbers are made up by me so that they mutliply easily, these are NOT meant to be reflective of reality.)
Suppose that we know that at age 40, the probability of death before age 41 is .001. We offer an insurance benefit that pays $100,000 if the insured at age 40 dies before reaching age 41.
OK, we have 1,000 customers age 40, so we expect one to die, so the “fair” charge would be $100 for the insurance. Then, if we got exactly the expected results (one death), that beneficiary would receive 1,000 X $100 = $100,000. There would be no money left over.
Well, that’s worrisome. First of all, we the insurance company have expenses in running this insurance, paper work, legal work, selling and marketing costs, administration, checking that the claim is accurate, etc. So, we don’t charge $100, we charge $105 (say) to ensure that our overhead is covered.
Second worry: we “expect” one death, but it’s like flipping a coin or gambling on any other statistical expectation. What happens if we get two deaths in the year? We’d be bankrupt! And it’s not inconceivable we could get three… whoosh! So, we estimate the risk-factor, what is the likelihood of two deaths, or three, or four… and we add a charge (called “risk charge”) to cover that. So now our charge is perhaps $125. ((This cushion for risk may in fact be spread over many years – we hope to sell this same insurance every year, and some years we’ll get no deaths, for instance. The cushion can also be spread among insurance companies, with each insurance company insuring itself against adverse claims, this is often called reinsurance.))
Now… over the long-term, this still doesn’t give us any guaranteed profit. There is a likelihood of profit, of course, because when we estimated our overhead costs and our risk costs, we certainly estimated upwards. We very likely will also add a charge for profit, as well.
Other comments made by others would also come into play. We could take into account the interest rates that we earn, since we charge the premiums at the beginning of the policy year, but any deaths probably occur later in the year, and we might not pay the benefit (the death might not be reported to us) for several months after that. So the time-value of money is usually taken into account, as well… and in the insurance company’s favour. Even if they allow for some interest credit on your premium, it will not be anywhere near the earnings rate that they expect to make by holding your money.
So, the three sources of an insurance company’s profits are:
(a) deliberate (but slight) underestimating of risks and costs
(b) deliberate addition of a profit-margin into the premium structure; and
© manipulation of investment on the premium (time-value of money.)
Having said this, it sounds like the insurance companies are total rip-offs, and I don’t mean to imply that. Two things to bear in mind:
- The addition of profit and the underestimating of risk is a very slight charge on each policy; their profit comes from selling hundreds of thousands of policies, multiplying that small amount of additional charge by hundreds of thousands.
- The competitive market keeps the insurance companies from just loading the premium way the hell up for profit. Competition is very tough, and the company that can cut its premium by an ever so slight amount will have an edge, and more customers. So there is constant tension between the actuaries (who want to be conservative and protect the company against adverse risk) and the marketers (who want to sell as many policies at possible and need to have low costs to do that.)
According to a workshop I attended on this very subject, this is the key. Almost all of the profits insurance companies make comes not from the actual premiums, but rather from investing the premiums.
For many people, NO, NO, NO! Health insurance can begin to pay positive dividends right off the top. Take my example. My two allergy medications cost me about $130/month without insurance. With insurance, $14. Since my premium is only $43/mo, I am already coming out way ahead.
Any additional coverage for doctor’s visits (my cost $5), unexpected sickness, or hospital care is just gravy.
Leaving aside the possibility that divemaster’s insurance company has a good deal on allegy products, the post suggests a major difficulty for insurance companies: adverse selection.
Insurance companies have imperfect information about prospective policy holders, and the market systematically assures that they get the worst risks. Those most likely to insure are those for whom the insurance company has underestimated the actuarally (sp?) fair premium. This means that insurance companies have to build a safety margin into their premium structures.
If consumers are risk averse (willing to pay to reduce spread of outcomes/ have diminishing marginal utilty of income) they will be prepared to pay more than the actuarally fair premium for insurance. However, some people will miss out on insurance because of this.
That many people can expect to gain in money terms from health insurance, year in year out, is a measure of the difficulties and failures in this market.
picmr
Basic economics lesson:
The prices of goods has very little to do with intrinsic value, rather it is mostly determined by what the market will bear (for example: look at Diamonds. They are far and away the most common natural gemstone, and yet still one of the most expensive. Why? People are expecting to pay more, therefore DeBeers can charge more.)
Drug companies only charge what the market will bear. Since insurance companies have big pockets, and they are the real source of the dinero that purchases the drugs, the company will charge extremely high prices. You can be certain of two things:
-
That drug could sell for $14 a month and still not end up a losing venture for the drug company.
-
It didn’t cost the insurance company $130 a month either.
For another example of this sort of price inflation in action, look at college education. People today pay, when you look at money paid upfront, about the same (adjusted for inflation) as they always have for college education. The extra money is in the form of government loans and grants. The extra cost is not seen directly by the consumer, since lack of up-front cash would have been the initial hinderance to college education, colleges can charge whatever the hell they want since the government will make up the difference no matter what it is (or at least it will loan the student the difference). Substitute “drug company” for college and “insurance company” for government, and you have about the same process as goes on in pricing drugs.
I am reasonably sure that was a compliment, folks.