Finance Friday: How Insurance Companies Make Money

Welcome to Finance Friday! Every Friday we will explore one business model that companies use to make money, in 3 minutes or less.

In today's post, we discuss insurance companies and how their business model works.

What value do insurance companies offer?

Have you ever taken out an insurance policy?

Maybe you just bought a car and thought it's a good idea to get it insured. (You know, 'cause you like to drive like Tom Cruise in those Mission Impossible movies). Or maybe you have a friend who just got hospitalised, and thought it's probably wise for you to get a health insurance just in case.

So you contact a health insurance agent, submit some paperwork, and after some time, voila, you are now insured.

Next, you pay a monthly premium to the insurance company, in exchange for the peace of mind of not having to worry about money in case something bad happens.

If you think about it, what do insurance companies really do?

They assume risk on your behalf. That is the risk of you going into financial trouble in case you get sick and need medical treatment. If that ever happens (hopefully not, God forbid), the insurance company will pay for the cost of your treatment such as hospital bills and medications.

So how do insurance companies make money?

Let's break it down step by step, starting with their revenue.

Their main source of revenue is, as you can guess, the premiums paid by policyholders. Let's take Prudential for example. In 2021, they earn premiums of Rp 360 trillion worldwide, which accounts for 85% of their total revenue.

That's a whole lot of money. Government regulation requires insurers to set aside some amount in liquid assets such as cash so that they can pay out claims. But what do they do with the rest? Invest it of course!

And that leads to their second source of revenue: Investment income. Insurance companies invest the premiums collected into various assets. They can be stock markets, bonds, real estate, and even cryptocurrency. In fact, insurance companies are some of the largest institutional investor in the finance world. Returns generated from these investments become additional revenue for the company.

What about their expenses?

The largest expense is paying claims. This is payment made to hospitals or pharmacies to cover the cost of your medical treatment. Going back to Prudential as an example, claims payment was Rp 250 trillion in 2021 globally.

After that, they still have to pay agents' commissions, advertising, employee salaries, and other administrative expenses. These costs are usually called acquisition costs (referring to costs involved to acquire a customer).

Is this profitable?

Now we have a good overview of their revenue and expense. So how do they consistently make profit?

Well firstly, they have to make sure premiums collected are greater than claims paid out. There is a very specific group of people who do this for a living, called actuaries. Before issuing you an insurance policy, an actuary would assess your likelihood of getting sick based on your personal information. They look at your medical history, check if you're a smoker, ask you to do a fitness test, among other things.

Based on these data, an actuary would use math to determine how "risky" you are and calculate the correct amount of premium to compensate them for that risk. A smoker will be charged a higher premium because their likelihood of getting respiratory diseases is higher. You get the idea. So by using math and statistics, they can be confident (within reason) that over time and over a large number of policyholders, they have a high likelihood of making profit.

On the investment side, they have to apply good investment management strategy to ensure their assets are generating healthy return. Invest in very high risk assets and they may permanently lose value. Invest in very low risk assets and the return is minimal. Insurance companies hire smart investment manager who determine the right mix of assets that will likely generate healthy return.

Of course, this is not guaranteed. We can look back to the 2008 financial crisis, when one of the world's largest insurance company at the time, AIG, nearly went bankrupt due to bad investment in the mortgage derivative market. (The US Government had to loan them $150 billion to prevent them from collapsing)

What's next?

Technology is coming to digitalize the insurance market. In Indonesia, startup company PasarPolis have raised Rp 750 billion in their latest funding round in 2020, with Gojek as one of their investors. They are an insurance marketplace connecting traditional insurance providers with end customers through mobile apps and have serviced 35 million customers to date.

Another startup based in Africa, BIMA, enables buying insurance policies and processing claims digitally through mobile apps without the need of paperwork. They have strong backing too, with insurance giant Allianz as their largest investor.

These tech-enabled business models are betting on two factors: more and more people have access to mobile phones and internet connections, yet a small percentage of the population have adequate insurance coverage (Indonesia's insurance penetration rate is 3%, compared to 12% for the US and South Korea). Lots of market share to win!

I hope this explainer helps you understand how the insurance business model works. If you find it useful, make sure to subscribe to my newsletter and share this with your friends.

Have a great weekend!

- Jason