Insurance

Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of potential financial loss. Ideally, insurance is defined as the equitable transfer of the risk of a potential loss, from one entity to another, in exchange for a reasonable fee. In practice, however, the business of providing insurance protection often ends up in litigation between the parties involved, while the responsibilities of regulating insurance markets routinely winds up as a political football for government agencies. In general, it is contract in which one party agrees to pay for another party's financial loss resulting from a specified event.

How an insurance company makes money

A customer may pay one or more premium payments over time. The company collects these payments from one or more customers. If something happens which triggers a claim, the company then pays out a certain amount of money. If, during the lifetime of all of the company's insurance contracts, it pays out less than it has taken in, it makes what is known as an underwriting profit. This is rarely achieved in the insurance industry; two companies that are famous for achieving underwriter profit are American International Group and Berkshire Hathaway.

Related Topics:
Underwriting profit - American International Group - Berkshire Hathaway

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In between the time the company collects the money and when it has to pay out the money, it can invest that money. The return from these investments is also a major (or in many companies the only) source of profit. For example, if a company has to pay out 10 percent more than it took in, but made a 20 percent return on its investment, then it made a 10 percent profit. However, since most insurance companies consider it only prudent to invest in risk-free government bonds, or other lower risk and lower return forms of investments, it's important that the extra amount it has to pay out compared to what it has to take in is less than the percent return of these invesments. If it isn't, the company loses money. The extra amount that a company has to pay out can be considered a "cost of funds" and be compared to an interest rate of the same company borrowing money. Because of this, most insurance companies don't have a goal just to have any amount of profit over the cost of funds, but rather to have this cost of funds to be lower than what they would have been able to get by borrowing somewhere else. If this isn't the case, the insurance company does not add any value to their owners, who theoretically could have borrowed money from somewhere else and made the same investments themselves.

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