Perhaps you already know how insurance works, but not too many people know how exactly insurers earn their money (and spend it).

For example, did you know that part of your premium pays for the expense involved in getting someone else to take out an insurance policy? Or that, in traditional insurance models, all the premiums you pay in your first year of being insured are paid to a financial broker? Or even that about 50-60% of all your premiums will go towards paying other people’s claims?

How Do Insurance Companies Make a Profit?

Insurance, like all good business models, has to be profitable. Insurers have to cover their costs and make a profit to stay in business. If they didn’t, there’d be no insurance companies to cover people’s risks.

To make a profit, insurance companies need to get a lot of policies at the lowest possible cost (acquisition), and keep those policies active for as long as possible (retention).

Insurance companies make their money from the premiums they charge people in return for cover. They use these premiums to pay out claims, to cover the cost of attracting new clients, to pay for the cost of having people tested as part of the underwriting process, and for their month-to-month expenses like paying their staff’s salaries and office rental. Whatever’s left over, is their profit.

Because insurers rely on the fact that not all of their clients are ever going to claim, they try to sell as many policies as possible. They use the money they collect from the majority of policyholders to pay for the few who’ll actually claim. This is called ‘spreading the risk’. So the more clients an insurer can get, the better their chances are of making a profit.  

How Does Traditional Insurance Work?

Initially, a new insurance company will run at a loss because they have a lot of upfront expenses to pay before they get enough policyholders on their books to cover their costs. One of the biggest expenses in traditionally-structured insurance companies is the cost of paying for those people who help with getting new clients onboard. They’re called brokers and, for each policy they sell, insurers pay them a commission of roughly the first year’s worth of premiums. So, keeping acquisition costs low, is another way to increase the profit margins.

Another way for insurance companies to be profitable is by keeping their policyholders insured for as long as possible. If a policyholder cancels their policy after the first year, the insurer makes a loss, because of those initial costs we mentioned above. But if they keep their policy for a long time, that initial loss is made up over time and can turn into a profit.

Are There Other Approaches to Insurance?

What we’ve discussed so far is what’s called an intermediated approach. ‘Intermediated’ refers to the use of brokers to sell products.

If you remove those middlemen and replace them with other, more direct ways of reaching new clients, the initial acquisition costs drop because you don’t have to pay commission. However, direct insurers’ expenses will additionally include costs to market their products. They may offer convenient ways for people to buy their products, through telesales or simple online buying processes.

Although they may seem to have an advantage over an intermediated approach, direct insurers often have larger drop-off rates (in other words, their clients tend to not stick around for very long), which eats holes into their profits. To address this, some insurers offer wealth-generating incentives for staying onboard. For an example of how this might work, check out Sanlam Indie’s Wealth Bonus, a rewarding investment clients are given for getting insured.

Ultimately, the winning solution for an insurer is to not merely focus on making a profit, but to offer quality, rewarding products that do more than just promise to pay out claims.