Finance Quick Answers
How do insurance companies make money?
Insurance companies collect small, certain amounts of money (premiums) from policyholders who want to avoid the possibility of a large, uncertain financial loss. The insurance allows the dollars of many to pay for the losses of a few. Insurance companies use historical data to figure the probability of losses and charge premiums accordingly, building in profit for themselves.
For example, there are 100 houses, each worth
$10,000, in the neighborhood ($1,000,000 total value).
Given the history of the neighborhood, 5 houses can be
expected to burn during a typical year. If they didn't
have insurance, all 100 homeowners would have to keep
$10,000 in the bank to "self-insure" their home for the
cost of rebuilding.
With insurance, each homeowner must only pay $500
into the insurance pool each year to cover the five
houses that will likely burn:
- 5 houses burn x $10,000 = $50,000 needed for rebuilding homes
- $50,000 needed for rebuilding divided by 100 homeowners = $500 premium
The $500 premium covers the property each year. Of
course, it will then be adjusted upward somewhat to
build in whatever profit the market will bear for the
company. It is important to shop around, because
premiums are not the same from company to company.
For informational brochures on a variety of insurance topics, see http://www.insurance.mo.gov/aboutMDI/publications/.
Brenda Procter, M.S., Consumer and Family Economics, College of Human Environmental Sciences, University of Missouri-Columbia
If you'd like to learn more about this and other personal finance topics, the University of Missouri offers 'Personal & Family Finance,' a correspondence course, through the Center for Distance and Independent Study (800-609-3727). Information about this course is available at http://cdis.missouri.edu/CourseInfo/DetailCourseInfo.asp?1985.
Last update: Sunday, July 20, 2008