What the insurance company sells
An auto liability insurance company is engaged in the business of selling responsibility.
To be more clear, an insurer sells responsibility for having to clean up the mess should something scary happen.
Something scary like a cracked windshield. Something scary like a fender-bender.
Something scary like a lawsuit.
Since life can be scary, the insurance company exchanges cash for responsibility.
Or, if you prefer, you could say the insurer is in the business of buying problems.
For the low, low price of $79.99 (a month), the customer can sleep easy, knowing that this month if her Toyota Highlander ends up in a wreck, it will not be her responsibility. Nope, this month—well, assuming she paid on time . . . or, if she didn’t, assuming there was no effective Cancellation—this month, that will be the insurance company’s problem.
How the insurance company makes money
Since auto liability insurance is a business, the insurance company is interested in making money. And insurers obtain money by selling, as noted above, Responsibility.
At first glance, you may think their sales pitch: “You give me a little money now, and, in exchange, I’ll give you big money later” does not seem like much of a business.
You’d be wrong.
But, to be fair, the very nature of the company’s product means that making a profit can be tricky. . . .
The quick and dirty:
Step One: The insurance company must carefully decide what risks to take on, and how much to charge for taking on those risks.
Risks, here, refers to the ways you could get hurt and your car could get damaged.
And, just to be extra clear: One of the ways you can get injured in a car accident is by getting sued.
The insurer determines the risks for which it is willing to assume responsibility. In exchange for doing so, it charges a particular policyholder, a particular price—referred to as a premium. The premium is closely tied to the type and size of the risks the insurer takes on: The bigger the risk, the bigger the premium.
But the premiums alone do not bring the insurance company a profit.
Step Two: The insurer must be fruitful and multiply.
The insurer must then multiply the cash (premiums) it obtained in Step One, by investing it in money-generating stuff. Stocks, bonds, and other fancy financial things.
If it does this well, the insurance company will make enough to have money left over (i.e., profits) after Step Three.
Step Three: The insurer must give back to its policyholders what they purchased, and only what they purchased.
In this step, the insurance company is the 7-11® store manager making sure those darn juvenile delinquents don’t run out with fistfuls of slushies and Funyans.
As briefly mentioned, the insurance company decided how much to charge for its product based on a Formula
Then it charged that much.
Well, that much, or more. Preferably more.
If the insurer does its job right, the money generated in Step One (from all of its policyholders), and the money paid out in Step Three (in all of its claims) will just about balance each other out.
Therefore, in terms of generating profit, an insurance company is only as good as how well it performs Step Two.
Simply put, the insurance company is not getting rich from premiums.
And, despite what you may hear, the insurer cannot get rich by holding on to money and refusing to pay valid claims.
To the contrary, insurance is a highly-regulated industry. That means the government is all up in their business.
So, as you will see later, many laws assist policyholders in recovering all to which they are entitled and penalize insurance companies for purposely dragging their feet, playing games, or even just moving too slowly.
So, ultimately, an insurance company’s profitability really hinges on Step Two: its financial investments. To make money, the insurance company’s investments must make money between the time they leave the customers’ hands (as premiums) and the time they return to the customers’ hands (as paid claims).
Yep, an insurance company is basically your Uncle Alvin borrowing cash to fund his casino habit. When ol’ Al borrows cash, he only ends up ahead if his luck at the casino outpaces the 38% interest you will be tacking on each day. Likewise, an insurer succeeds only if the cash in its hands grows faster than the rate at which it must pay it back.
Except, when a policyholder demands payment, mere excuses won’t cut it—unlike ol’ Uncle Al, the insurance company must ante up. Ok, it’s just like your Uncle Al.
It’s all about control
Since the insurer does not make big money through premiums, to keep its situation running smoothly, the insurer must control what it can.
Starting with Step One, the insurer must carefully agree only to take responsibility for true risks.
This is because insurance company can only predict the odds of true risks.
True risks are a product of pure chance.
By only agreeing in Step One to take on responsibility for events that are the pure product of chance, an insurance company can more closely calculate how much it will later have to pay out overall, in Step Three.
It’s like a coin toss. The outcome of a single coin toss cannot really be predicted. But, the overall outcome of a million coin tosses can be pretty well estimated.
As long as no funny business is going on (ahem, cheating), out of a million coin tosses, you can be pretty sure that will end up with somewhere in the neighborhood of 500,000 heads. And probably around 500,000 tails.
Try it and see.
By only taking on true risks, the insurance company can make sure it charges each policyholder a premium that makes sense.
For Step Two, the only control the insurer has is to hire stellar money pros to hedge its bets and increase the likelihood that its investments will pay dividends.
But, the insurer only has so much control here. Just like any investor, an insurance company is subject to the ebb and flow of the economy and the financial markets.
Finally, when it comes to Step Three the insurer must make sure that it pays only for the risks it agreed to take on in the first place.
Remember, to avoid losing money, but not quite to make money, the insurer exchanged cash for those true risks it took on—it was betting on those risks, and no other.
So, to make money, the insurance company must pay only what those risks are really worth.
This is where the process of claims settlement come in and where understanding how an insurer views and assess those claims helps make the difference when it comes time to negotiate.
But more on that later.