Insurance companies make profit by paying out less in claims than they do in taking money from selling insurance policies. This seems a simple equation but dig deeper and you'll see it's not quite that easy.
The insurance money making formula
Example: For every £100 they get from selling insurance policies, they may pay out £80 of that in claims. This leaves £20 profit. Multiply that by many thousands of policies and you can see how companies can make a decent amount of money.
However, the trick is to ensure they do in fact pay out less in claims than they have taken in selling policies.
If they encounter more claims than they expect, they could end up losing money. In the above example, if they paid out £110 in claims for every £100 in sales, then they would be making a loss.
So how do insurance companies deal with this issue?
They employ underwriters to set rates based on statistical analysis of what are good risks and what are bad risks.
For example, young drivers are statistically more prone to having accidents, hence underwriters apply higher rates to this demographic.
On the other hand, people who have built up maximum No Claims Bonus are considered good risks because they have a history of not making a claim.
Insurance company expenses
There are other factors that affect rates year to year. An unexpected rise in the cost of repairing cars for example means that the insurance company has to pass this cost onto the customer across the board. Which is why you can often get an increase in your renewal price, even though you have been claim free.
On top of this, insurance companies have their own internal costs of running the business such as staff salaries, computer systems and marketing budgets. These expenses often account for around 15% or more of the income from selling insurance. So, if they pay out 80% of the sales income in claims, they also need to add another 15% for expenses, leaving just 5% of profit.
So, you can see that making money in insurance is actually a very fine balancing act. Add to this the competition for customers and making money in insurance is actually quite difficult.