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How does a car insurance company make money?

In order to understand how an insurance company makes money, you need to understand the philosophy behind insurance. Insurance is an attempt to allow a group of individuals to pool their risks, thus spreading out the possibilities of loss among a number of different people.

The idea of insurance began back when merchant ships were shipping cargo all over the world, subject to the vagaries of weather, pirates, and rough shoals. Merchants began to realize that they could spread out the possibilities of risks by placing their cargo in different ships. That way each merchant would lose only a portion of his or her goods if a ship did not return from a voyage. One of the first maritime insurance companies, known by the familiar name of Lloyds, was established in around 1688 in the old city of London, England. Start comparing car insurance rates now by using our FREE tool below!

Gradually, this concept spread to more types of business than merchant shipping. Now spreading the risk is done with auto insurance, property insurance, liability insurance, health insurance, and life insurance. The idea of shared risk spread to create the insurance industry, as it now exists.

Societal Benefits of Insurance

Insurance protects you against the possibilities of financial loss, allowing you to rely upon insurance to keep you from disaster. This role of insurance helps society in a number of different ways:

  • Reimbursement of people and companies for covered losses
  • Insurance encourages accident prevention
  • Provides funds for investment-allowing people to borrow money
  • Easing tension about illnesses, accidents, and unforeseen circumstances

How Do Insurance Companies Make Money?

Individuals purchase insurance policies from the company, allowing risks to be pooled into one “pool” and spread out the risk. The policy premiums are the fee individuals pay for admission to that “pool”, and the insurance company uses the premiums in this way:

  • A portion of the premium is paid to the agent that services the policy. This varies from 20 percent to less for generating the lead.
  • Service providers receive a portion of the premium. These individuals, such as inspection services, clerical services, and claims personnel are paid employees of the insurance company.
  • If losses occur, a portion of the premium is reserved to pay losses.

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Where the Money Comes From

Insurance companies receive premiums, which they then lump together in account used to pay expenses, claims, and other expenditures. The amount of money you pay for your car insurance premium is put together with the premiums of all the other individuals purchasing insurance at the same time.

A large insurance company can have premiums of up to 5 billion to invest and use for making profits.

The profits from investments made, using insurance premiums, are the source of revenue for an insurance company. Actuaries and CPAs keep a constant guard on the status of investments versus expenses to monitor the profits of the company. A dip in the stock market can cause the insurance company’s profit margin to reduce. So can a disaster such as Hurricane Sandy or Katrina, which obliges the companies to pay out large amounts of losses.

Facts about Car Insurance Claims

When you have a claim on your car insurance, the insurance company needs to dig money out of its reserve funds to pay for the loss. Here are some examples of general losses for Bodily Injury and Property Damage liability:

Bodily Injury Liability

Year – Claim Severity

2004 – $11,640

2012 – 14,000

2013 – 15,443

Property Damage Liability

Year – Claim Severity

2004 – $ 2,596

2012 – 3,073

2013 – 5,231

As you can see, as claims frequency decreases, the costs of claims go up. Note that these are averaged figures. Often we see that insurance rates are increased across the industry when disasters strike. For example, three years ago, the eastern plains of the Rockies had severe hailstorms. There was a time when entire towns and neighborhoods were having their roofs replaced and cars repaired. Subsequently, the insurance companies filed rate increases to account for their losses in the previous years.

Insurance Regulation

As you can see, it would be extremely easy for insurance companies to become overextended because they cut premiums and were not prepared for claims. For this reason, each state’s insurance department examines rates and financial operations of companies and agents very carefully.¬†Before deciding upon an insurance company, seek the advice of national rating firms to determine the soundness of the company’s finances. Two of these places are:

Be sure to read the rating criteria from these sites to allow you to make informed decisions about insurance companies. A few of the problems that may occur if an insurance company is not making money are:

  • Delay in settling claims – they’re increasing the ‘float’ on their investments
  • Extremely conservative approaches to claim settlement
  • Worst case scenario – collapse of the insurance company

Insurance companies are a foundation of our commerce in the United States. Controls are very tight through state insurance departments and legislatures. If you are in the market for an insurance policy, use a comparison tool to find the company that is the best fit for you and your budget. Start comparing car insurance rates now by entering your zip code in our FREE tool below!

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