A:

Insurance companies base their business models around assuming and diversifying risk. The essential insurance model involves pooling risk from individual payers and redistributing it across a larger portfolio. Most insurance companies generate revenue in two ways: charging premiums in exchange for insurance policy coverage, then reinvesting those premiums into other interest-generating assets. Like all private business models, insurance companies should try to market effectively and minimize administrative costs.

Pricing and Assuming Risk

Revenue model specifics vary among health insurance companies, property insurance companies and financial guarantors. The first task of any insurer, however, is to price risk and charge a premium for assuming it.

Suppose the insurance company is offering a $100,000 conditional payout. It needs to assess how likely a prospective buyer is to trigger the conditional payment and extend that risk based on the length of the policy. (For related reading, see: How an Insurance Company Determines Your Premiums.)

This is where insurance underwriting is critical. Without good underwriting, the insurance company would charge some customers too much and others too little for assuming risk. This could price out the least risky customers, eventually causing rates to increase even further. If a company prices its risk effectively, it should bring in more revenue in premiums than it spends on conditional payouts.

Interest Earnings and Revenue

Suppose the insurance company receives $1 million in premiums for its policies. It could hold onto the money in cash or place it into a savings account, but that is not as efficient. At the very least, those savings are going to be exposed to inflation risk. The company can find safe, short-term assets to invest its funds. This generates additional interest revenue for the company while it waits for possible payouts. Common instruments include Treasury bonds, high-grade corporate bonds and interest-bearing cash equivalents.

Claims and Loss Handling

The real product of the insurer is insurance claims. When a customer files a claim, the company must process it, check it for accuracy and submit payment. This adjusting process is necessary to filter out fraudulent claims and minimize risk of loss to the company.

(For related reading, see: How to Value an Insurance Company.)

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