Some questions about how insurance companies work

What is the difference between the premiums they take in versus the claims they typically pay out?

I was under the impression that insurance companies made the bulk of their money off of investments. Is this the case?

Is their some reason that for health insurance, the companies don’t spread the risk around all their policy holders, but instead charge individual rates? That seems like cash on the table to me.

Is it true that unlike other forms of insurance, health insurance cannot be sold across state lines? If so, why?


Profit! (Or loss, if they screw it up.)

It depends on the type of insurance – some (like term life policies) work better for long-term investing, while others (like auto policies) work better by trying to make a profit on the premiums. Of course, all companies try to do a mix of both for every policy.

I’m not sure exactly what you mean. All insurance companies will charge higher premiums to more risky clients when they can, and compete by offering low rates to less risky clients.

Group health plans (like from your employer) are required by federal law to charge the same rate for all members of the group, so they have to factor in the average risk of the group as a whole, rather than consider individual cases.

Almost everything about the insurance industry is regulated at the state level, unlike most financial products which tend to be federally regulated and thus more uniform. Since insurance companies are licensed by the state in which they operate, they can only sell policies in that state. But all the big insurers have subsidiaries in multiple states and thus hold multiple licenses. Nobody is licensed to sell policies everywhere, though. This is not unique to health insurance, as far as I know.

The difference between premiums paid in and claims paid out is called float, and as friedo said, there’s profit to be made there. Here is Warren Buffett’s explanation of this concept, from the 2003 letter to the shareholders of Berkshire Hathaway (note that that link goes to an Adobe Acrobat document).

Mutual insurance companies (i.e., those that are owned by their policyholders) will pay back at least some of this difference to policyholders, or apply it to their future premiums.

I work at a commercial insurance company. The comparison between our earned premiums (the part of the policy that has already passed) and what we’ve paid - or set aside - in claims and claim-related expenses can be expressed as Loss Ratio. Depending on the line of business and some other factors, we might shoot for anything between 40% to 90% of EP payable as losses.

The “set aside” part is where it can get tricky. For some kinds of policies, it may be years before we know for sure if we’ll have a claim on a specific policy; we’ll have to set aside money for that “just in case” (this is called IBNR, incurred but not reported).

Excessive government regulation, caused by every interest group (including the policy holders) trying to get government to mandate that they get something at someone else’s expense. The more that goes on, the more daft the regulations get. In the health insurance market, it’s gone on to the point where we have today’s ridiculous situation, so now the government is going to “fix” the problem by adding still more regulation. Ain’t democracy wonderful?

Please cite an example.

I was looking for the GQ answer.


I don’t know the answers to rest of your questions, but I can say that for some types of insurance (the example I am most familiar with is annuities), regulations require the insurer to hold appropriate investments for the policy. For example, if someone buys an annuity for £100,000 for which the insurer will pay the policyholder £5,000 per year for the rest of their life, the insurer cannot just invest the £100k in the stockmarket and pay the policyholder out of other funds - they would have to invest some (perhaps all) of the £100k into appropriate investments, such as long-term treasury bills. The profit in these cases then comes from the difference between what the insurance company calculates their expected payout to be without profit, and what they actually decide to pay out. This profit will be affected by the actual lifespan of the policyholders.

Some terms:

Loss Ratio = claims paid / premiums
Combined Ratio = (claims paid + expenses) / premiums
Operating Ratio = (claims paid + expenses - investment income) / premiums

As long as the operating ratio is less than 1.00, the insurance company can be said to be making a profit. Thus, the combined ratio can be greater than 1.00 and the insurance company can still be profitable. In that case, you could say that “insurance companies made the bulk of their money of investments” but I think that obscures the underlying point – insurance companies choose the premium they charge (subject to regulatory approval in most cases) so that their operating ratio hits a certain target.

And the amount of investment income earned depends on the rate of return insurance companies can get in the market, as well as the lenght of time between collection of premium and payout of losses and claims. For some lines of insurance, this payout period can be pretty short (auto physical damage, for instance) while for other lines (general liability) this time can be significant.

Example of what, precisely?

Friedo, one nitpick: there are many agencies licensed to sell insurance nationwide in the USA. For an insurance company to do business in a state, their products must be approved by that state’s Department of Insurance (or Office of Insurance Regulation, or whatever it’s locally called). For an agent or agency to sell in a certain state, they merely need to obtain the license - a five-minute application once the initial home-state license is already in place. Getting that first “Resident License” takes significantly longer for an agent.

Beowulff, it’s not the example you’re looking for, but many insurance companies are quite worried about the potential changes on the horizon. As a result, underwriting has gotten extremely tight in the health insurance market, making it more difficult for individuals with health problems to obtain coverage. On the life insurance side, insurance giant AIG has greatly relaxed its underwriting standards in an effort to essentially “buy clients” and assuage some of their negative stigma. Just two examples of how the current political and economic climate are trickling down and making it more or less difficult for individuals to purchase insurance coverage. Whether that’s a good thing or a bad thing, a Republican thing or a Democrat thing, isn’t a GQ topic in my opinion.

One commonly cited breakdown of a “health insurance dollar” can be found here. I think it’s a little bit off, myself, but what do I know?

By the way, health insurance companies do spread the risk around amongst all of their policy holders. I’ve been paying my premiums dutifully but haven’t used my insurance in over two and a half years now (knock on wood). My premium dollar is helping keep costs lower for folks who utilize their benefits.

This doesn’t make any sense.

By nature of insurance, risk is spread. But if you’re suggesting that they would do better to charge all individual policyholders the same rate, regardless of risk, you are wrong.

If they charged everyone an average rate, so that they were losing money on the riskiest customers, but making it up with the lowest risk, what would happen is that the low-risk customers would find another company. A company that gave them a break for being low-risk. So then they’d be stuck with nothing but high-risk customers, which they’d be insuring at a medium-risk rate.

Generally, yes. Most of our business is in the surplus lines market, so we operate largely in the non-admitted space. We don’t file rates/get state product/rate approval for our surplus/excess business.

Insurance is the trade-off between waiting for a possible catastrophe - house burns down, car crashes, you get cancer - and paying for it immediately; vs. finding someone who collects from a whole group of people and pays for the catastrophes that do occur from that pot. Howerver, the company holding the pot will adjust money taken in according to risk of payout - per individual.

The people who complain, for example, about “ridiculous” health care insurance rules that give someone else a break are the healthy “won’t happen to me” types. In a pure, unregulated market environment health insurance companies would be free to cap coverage, drop people who start to run up bills, arbitrarily raise co-payments, etc.

The benefits market is a particularly nasty market because the one who pays (employer) is not the one reaping a direct benefit. The beneficiary, the employee, often has no say on how much of his salary goes to health care, other than to quit and start over somewhere else. The net result is employees with NO health care.

So I hope you’re not arguing for complete lack of regulations. If you accept that some regulations are acceptable, then to quote Bernard Shaw, “We’ve established what. The question now is how much?”

As long as America insists on the archaic method of tying health insurance to jobs, the problem will only get worse as health costs increase.

Of course, since anyone could get cancer or get hit by a truck, one question is how far in the future should statistics look to collect today’s premium? That extra you are paying now to support the co-worker’s kid’s leukemia treatments may turn around and be the money for prostate treatment you receive in 10 or 15 years.

Group benefits usually turn out to be a bargain because many of the forced participants are type who may not consider the coverage personally because their risk (right now) is very low.

Good point - I should have phrased my answer more narrowly to reflect that my area of knowledge lies almost exclusively with life and health insurance.

Hear! Hear! My point exactly, stated much less cynically than I would have.

Any of this blather:

For a start, how about an example of “Excessive government regulation” leading to “daft regulations” which result in today’s “ridiculous situation.”

That is opinion, not statement of fact. I do not have to justify my opinions. They just are. Did I make a factual statement that I have to justify? By all means, point it out, and I will.

“Excessive” is an opinion, “daft” is an opinion, “ridiculous situation” is an opinion. I made NO statement of “fact” in that post that I need to justify. Please point out anywhere that I did. I will justify any factual statement that I made, although I can’t find one in that post. One can agree or disagree with my opinion, but I do not have to justify a mere opinion with “factual” cites. You can agree or disagree with my opinions, but they are just that. Opinions. Nothing more, and nothing less.

Except that the thread is in General Questions and the OP said he was looking for factual answers.