Insurance companies make money in two ways:
- Underwriting profit (paying less in claims than they collect in premium)
- Investment gains.
Here’s how it works.
Insurance companies collect money from premiums to pay for claims. Usually, they break even if they use less than $0.55- $0.60 per premium dollar to pay for claims. Anything more than that, and they are a losing company.
In the meantime, the law requires insurance companies to put money aside to pay for claims. Their savings need to correspond with the amount of premium they collect. If they insure $1 billion in written premiums, they might need $1.5 billion in reserve funds to pay for claims. Insurance companies must also grow that reserve to grow their business book.
So these reserve funds don’t sit in bank accounts. They’re invested in bonds. They’re invested in the stock market. They’re put into all kinds of alternative investments with managers worldwide. Blackstone manages this money for various insurance companies. Warren Buffet loves owning insurance companies because it provides him with plenty of investment capital.
As long as this capital grows, the insurance company can continue to grow. Theoretically, if an insurance company can grow its investments faster than it loses money in underwriting, it can take on more written premiums.
If investments stagnate, the company must contain the written premium growth.
If investments perform poorly, they must reduce the written premium they insure.
Here are situations that will cause an insurance company’s bankroll to get smaller:
- They lose money paying expensive claims and have to use reserve funds to pay for them.
- Investments lose money. I.e., the stock market goes down. Real estate investments go down. The bond portfolio loses value.
In a nutshell, when the economy is doing well, and investments are performing well, insurance companies will grow the accounts they are insuring. When the opposite happens, they trim back because they have less money to pay for claims.
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