Insurance is about sharing risk. It’s a form of security that’s based on cooperation. By distributing the risk of a catastrophe among a group of people insurance offers a low-cost approach to providing financial security against unforeseen and quite often financially devastating events.
Each insurance policy then is a contract or a promise between you and the insurance company. The contract stipulates that should you suffer a significant loss on say your car or house the insurance company will cover that loss based upon the contract terms. But in order for an insurance company to take on the risk of such a loss policyholders must pay a fee which is known as a premium. These premiums are used to pay for claims.
To earn revenue insurance companies calculate the risk on each policy and set the premium accordingly. The difference between the premiums collected and the money paid out in insurance claims is known as underwriting income. In some years providers will collect large sums of cash but have few claims to pay out; in other years the premiums collected won’t cover the cost of claims paid out.
Quite often however people assume that because claims are made infrequently the entire premium collected by an insurance company is banked as profit. That’s just not the case.
Where do your Insurance Premiums go?
According to the Insurance Bureau of Canada $0.55 of every dollar collected as part of your premium goes to paying for insurance claims. Another $0.21 goes toward operating costs such as 24-hour customer service claims lines the maintenance of records and making sure websites are up-to-date while another $0.16 is paid to various governments in the form of taxes. Insurance companies only earn $0.08 out of every $1 in profit—and this profit margin has been consistent over the last seven years from 2007 to 2013.
Revenue from investments
To generate revenue insurance companies will invest a portion of the small amount of money earned from annual premiums. By taking this money and putting it in low-risk investments insurance companies can earn additional profits which help improve their balance sheets and bottom line. However in the last 10 years interest rates have been at historical all-time lows. This means that any revenue earned on investments has been minimal and has not contributed to the revenues of an insurance company in any significant way.
Keep in mind that insurance companies are heavily regulated by the Canadian government. There are strict requirements on how much money an insurer needs to keep in their bank accounts to cover losses and there are strict rules on how much investment risk they are allowed to take on. These legal requirements allow insurers to risk some of their earnings in an attempt to earn more profit through investing and yet still ensure that their policyholders are covered should claims be filed.
How profits are determined
To sum up insurance companies make money from two sources: Premiums collected from their customers and earnings from investing a small portion of those premiums.
One major reason why insurance providers don’t earn more in profit is because claim costs have risen dramatically in the last few decades. According to the Insurance Bureau of Canada the worst year in Canada’s history for weather-related damage was in 2013 when severe flooding in southern Alberta created more than $1.72 billion in insured losses while an ice storm in Toronto left 300 000 households without power and cost an estimated $109 million in claim damages and a severe rainstorm in the Greater Toronto Area caused $65.2 million in water damage. In fact since 1998 extreme weather alone has cost insurance providers almost $10 billion in claims. This has only been increasing as the impact of climate change increases. To put this in perspective the Royal Bank of Canada earned$10 billion in profitin 2015 alone.
Once all claims are paid all administrative costs are paid and a small portion is allocated for investment an insurance provider is said to earn a very good profit if they’re able to earn $0.05 on every premium dollar collected.