How Do Insurance Companies Make Money and How Do They Work

Well some of us may think that there’s nothing more boring than attending an insurance conference on a wet Tuesday night in Boston. And we may well be right, but if we look back to see how the industry began, it isn’t as dull as it might first appear. From swashbuckling pirates to a ferocious fire that ravaged the world’s greatest city, insurance has had a colorful past. 

But how do those grey suits who sell insurance make money, and how do the inner workings of one of the most complicated fiscal models work? If these questions whet your curiosity, Why do insurance companies make money and how do they work? 

What is insurance? Well, insurance is a financial vehicle that helps spread risk. By taking a risk from an individual, and spreading that risk around a community, the individual can go about their personal or business life without crumbling from financial ruin. In the simplest terms, let’s look at two people. 

One is named Bob and the other Jim. Bob says to Jim, I’ll give you ten dollars, but if I lose my cell phone, you’ll have to buy me a new one. If Jim agrees, then that’s insurance right there. Insurance companies make money because they evaluate the risk and decide whether it is worth the gamble. Jim believes that Bob probably won’t lose his phone and he’ll therefore be ten dollars richer. 

If Jim finds 100 more people who are willing to give him 10 bucks each to cover their phones, he has 1,000 dollars. If one of those 100 people loses their phone and Jim pays 100 dollars as compensation, he still has 900 bucks. This insurance idea has been floating around since the ancient Chinese and the Babylonians spread their shipping risks. 

But it wasn’t until around the 17th century in London that modern insurance took off. Merchant marine men and traders often hung out in coffee shops in the business district of London, and while drinking copious amounts of coffee, the idea of modern-day insurance was born. Lloyds of London, the heart of worldwide insurance, was developed inside one of these coffee houses, and here’s how it worked. First, you have the client. Say the client has a ship that he is nervous about losing to pirates offshore, or perhaps the vessel will be destroyed in bad weather. The client approaches an insurance broker. 

The broker looks at the ship or pays someone to look at the ship, and they decide how much the total value of that ship is worth. The broker then assesses the risk. He asks the client where he is traveling to and what cargo he will be carrying. With all this information, he draws up an insurance policy which he shows to the third person in the chain – the underwriter. For a cheaper premium, the underwriter may exclude a few risks. And for a few more bucks, he may include some extra risks. Now there are normally lots of underwriters approached, but one will be the lead, and the lead underwriter, like Jim, will normally take the largest proportion of the risk and sign his name first on the policy document. 

He is known as the underwriter, as he writes his name under the risk on the insurance policy. The lead underwriter makes the major decisions when it comes to accepting the policy, and will be the main man to agree to any claims on the policy. Once the terms of the policy are agreed to, it is made legal, the client is happy and the ship sets sail – but not before paying the insurance premium to the broker, who will take about 10%, and pass the rest on to the underwriter. 

But what should happen if pirates board the ship, steal the cargo, and burn it at sea? Well, the client (if he is still alive, if not, a representative of the client) will speak to the insurance broker and the broker will visit with the lead underwriter and tell him the bad news. The rest of the underwriters (there may well be as many as 20 on a big policy) are told the news and then the broker must negotiate the best claim settlement for the client or his or her representatives. 

The underwriters pay the money to the broker, who passes it on to the client, without deducting any cut. The broker makes his money once the premium is paid, and will help negotiate the best claims for his clients through gentlemanly honor and the prospect of future business. Now it may not be all bad news for the Underwriter. If he is wise and not greedy, he may have reinsured the policy. 

Reinsurance puts the underwriter in the position of the client. The underwriter sells the policy to another underwriter or firm of underwriters while retaining a share of the premium. Confused yet? Think back to Jim and his phone insurance. If Jim resold his 10-dollar phone policy for 9 dollars, rather than the 10 he received, then he gets to keep a dollar each for each of his 100 clients, meaning he has 100 dollars completely risk-free. 

Similarly, much of the modern-day insurance that flows through Lloyds of London is reinsured out of the building to smaller insurance companies all across the world. So what starts as a simple agreement between the client and the broker (or Jim and Bob) is spread across a business community that each stand to profit from the premium or take a cut of any losses. This is how insurance works – by the spreading of risk over communities. So that is how maritime insurance was born. It was developed through the need of ship-owners to carry on in business should they lose everything whilst at sea. But what about property insurance? Well around the same time, in 1666, the great fire of London devastated the city where modern-day insurance was born, and famous architect Sir Christopher Wren, in his great London redevelopment project in 1667, made sure to include an insurance office in his new plan. 

Now property insurance is commonplace with most homeowners having a policy in place. Also, medical, life, travel, car, and dental insurance are all commonly held policies. Even pet insurance is a major insurance business nowadays. Over time the business model has evolved. Modern-day insurance companies are fiercely competitive, which is good for you, the client, as policies are priced at their lowest possible point. Companies now look to write as many policies as possible to create a financial pool. They take the premium from thousands of policies and invest that money in another financial product. So the insurance underwriter may pay out more claims than they make in policy premiums. But they have invested all those premiums in a high-interest investment scheme, so they make their money outside of the original insurance product. Insurance in this example is a way of creating cash flow to be used in more lucrative investments.