With the steadily increasing cost of accidents, as a result of increasing medical costs, you may wonder how car insurance companies make any money at all, let alone earn a profit.
Most companies make profit by selling something for more than it costs them to make it. In this respect car insurance is not so different, but it does have it’s own little quirks.
How They Generate Revenue
Basically, car insurance companies make money or earn revenue in two ways. Both are vital to the long term health of today’s modern insurers.
The first and most obvious way companies make money is by charging premiums to policyholders. The amount they charge for premiums is based on their risk assessment of the driver and the amount and type of coverage offered. This whole process of assessing and pricing risk is known as underwriting.
Underwriting is the life blood of any good insurance company. Without knowing the future for sure, they have to make a best guess based on past performance. Underwriting typical makes up the bulk of an insurance company’s revenues, but often not the bulk of it’s profit.
The second less well known way insurers make money is through investments. A normal property and casualty insurance company should have greater premium revenue than immediate costs (discussed below). This excess is known as the ‘float.’ The float is then invested in a variety of short and long-term investments.
This investment income can be a significant contributor to a company’s bottom line. Of course companies only make money with their investments when they yield a positive return. However, given that insurance companies are fairly sophisticated investors, they generally make money in most years. Finally, the float can also be used if a major unforeseen disaster strikes and there is a huge surge in claims.
Car Insurance Company Expenses
Now all insurance companies would love to be able to be able to collect premiums and earn high investment returns without having to pay anything out. Unfortunately for them, this does not happen. There are three major types of expenses that a typical insurance carrier has to deal with.
By far the largest expense among auto insurers is the amount paid out in claims. The whole reason for having insurance in the first place, is that it is a hedge against unfortunate events in the future. How much money is paid out in claims, is thus one of the most important things that needs to be manged by an insurance company if it wants to remain profitable.
This is why claims adjusters play such a crucial role for insurance companies
In terms of costs, the day to day running of an insurance company or standard operating expenses make up the next largest outflow of money. This would include typical business costs such as office, furniture, phones, computers and most important of all staff. Larger insurance companies employ tens of thousands of people to write, manage, invest and adjust insurance policies.
Nevertheless, business expenses actually only make up a relatively small amount of the costs associated with a typical insurance company. Claims payouts far eclipse these.
The third and final expense most insurance companies have to pay for is marketing. There is a reason why you see so many car insurance ads on TV and why there are still so many insurance agents around. Insurance companies need new customers, if they want to expand (not unlike any other business). However, the internet has truly democratized the process of buying insurance.
In the past, most people only had time to compare a handful of insurance companies. However, now with the internet you compare dozens of companies very quickly and possibly find a company that offers you better rates. Thus, the internet has made the whole industry a little more transparent and has helped to push down rates and keep them lower than they would be otherwise.
To see how an online auto issuance quote works just have a look at the top or bottom of this page where you can get one or several today for free.
Therefore, car insurance companies make money from premiums and investments, but have to spend money on claims, business expenses and marketing. The final profit formula looks like this:
Profit = premiums + investment returns (usually positive but not always) – claims – operating expenses – marketing costs
Now in theory a company could still earn a profit even if the premiums paid were lower than all combined expenses, if the investment portion of the business did exceptionally well. Thus, a company with large profits today may not, necessarily be viable long term. To strip this out, many state’s and other insurance governing bodies publish what are known as loss ratios.
The loss ratio is a simple calculation that looks all combined expenses in relation to only the amount of premiums collected. For example, if the total expenses of a company were $700,000 but the company collected $1 million in premiums the loss ratio would be 70%. However, if the same company all of sudden had expenses jump to $1.1 million (a major car accident), but still had the same $1 million in premiums it’s loss ratio would be 110%.
The loss ratio is arguably the most important factor when looking at the long term financial health of an insurer. So long as the company has a loss ratio below 100% it can be said to be operating an underwriting profit. Most property and casualty insurance companies (e.g. car insurance companies) have loss ratios below 80%, a company that consistently has a ratio much higher than this, may be in trouble.
Excessive Profits And Public Auto Insurance
Property and casualty insurance is generally extremely profitable, except when major disasters occur and claims and settlements spike to cover them. Unlike the property side of the business, auto insurance is less prone to major swings. For example, you can’t exactly move your house from the path of an oncoming hurricane, but you can drive your car away.
As you may or may not be aware car insurance regulation is a state responsibility. At the present time all operate on a more less free market approach and there are no state run auto insurance companies. However, 4 Canadian provinces do operate public (government run) auto insurance schemes. The logic being that private auto insurance companies generate excessive profits.
The Consumer’s Association Canada claims that these provinces generally enjoy lower auto insurance rates than those with private auto insurers. However, some caveats need to mentioned. The first is that government run auto insurance means that consumers have no choice in the market. Younger, higher risk drivers, usually enjoy lower rates under such a system, but older, safer and more experienced drivers do not.
Moreover, there is an incentive for the government to cap payouts on accidents to control costs. Fine if you’re the at fault driver, but perhaps problematic if you’re the victim. Also, without the discipline of the market there are the risks of auto insurance fraud, and the risks of increased bureaucracy as there is no pressure to turn a profit. Finally, if the public auto insurance company ever loses money it has to be subsidized by all taxpayers, not just the ones who drive.
Therefore, while many people complain about the large profits enjoyed by property and casualty companies such as auto insurers, the alternative system does have issues too. Lower average auto insurance rates, does not mean you’ll save money, especially if you’re a good driver. Plus, the internet is making it easier to compare rates and harder for companies to charge more than each other for coverage.
To see how the internet can help you compare and buy auto insurance, why not get some instant car insurance quotes right now: