How insurance companies make money

While the premiums policyholders pay are primarily how insurance companies make money, this is just the starting point of the business model. After all, insurance companies have to make enough money to offset claim payments.

So, there are a few other strategies insurance companies utilize to potentially grow their revenue or at the very least, protect it.

The insurance business model

An insurance policy protects a person from financial liability in the case of any peril or event outlined in their policy in exchange for a monthly or annual fee, or premium. The idea is that the premiums collected are a fair financial tradeoff for the likelihood of an event actually happening. This is largely based on the practice of pooling insured clients with similar risk profiles together.

“Insurers may talk about a high-risk pool,” says Mary Kelly, professor in finance and chair in insurance at Wilfred Laurier University. “These insureds all have characteristics that would make them more likely to have a loss, for example, location for property insurance or a car that is likely to be stolen for comprehensive coverage.”

The underwriting process ensures the amount of risk the company is willing to take on is proportionate to the premium being charged to an individual. Ultimately, the premiums paid by customers within a risk pool go toward potential claim payouts within the risk pool. The premiums of the masses therefore go towards the claims’ payouts of the few. And generally, the higher the risk profiles of these groups, the more they are likely to pay for insurance coverage.

How are insurance premiums determined?

While it can be stated that in general, higher risk = higher premiums, the process of setting those premiums varies across insurance verticals. Auto insurance premiums will undergo different risk classification variables then say, home insurance.

“For example, in many jurisdictions credit ratings can't be used to price auto insurance, but they can be used to price personal property,” says Kelly.

Although all property and casualty insurance in Ontario is regulated by the Financial Services Regulatory Authority of Ontario (FSRA), only auto insurers have to get rate changes approved by FSRA. So while auto insurers can increase rates to ensure they’re still making a profit, the process is highly regulated.

Potential risks are different when insuring a car compared to a home.  Your car insurance rate will depend on things like your vehicle make, model, and year, age, and car insurance history, while a home insurance rate will depend on things like how much it costs to replace your home (or replacement value), how well maintained it is, and your proximity to a fire hydrant.

But while only a few risk classification variables may overlap across insurance categories, “the statistical modelling would be very similar,” says Kelly.  

Insurers can charge more the more risk you pose as a customer.

Related: How do home insurance claims affect your rates?

Where are your premiums going?

Underwriting, which is the process of accepting financial risk in exchange for payment, is the main way that insurance providers make money. But fulfilling claims is not the only way they put those premiums to work. They also invest part of their revenue, with the expectation that the investment will later compound or otherwise provide further returns.

“Most insurers invest heavily in fixed income, typically government,” says Kelly. “Overall, in 2022, the industry held 73% of its invested assets in fixed income, 13% in cash and short duration securities, and 9% in common and preferred shares.”

If the company is smaller, it may outsource its investment management, while larger providers are more likely to have in-house investment managers. And depending on how much risk the company is willing to take on, portfolios can vary.

“Typically, property and casualty insurers are fairly risk-averse, so they'll hold a well-diversified portfolio of both Canadian and international equities,” Kelly says.

While it’s possible for insurance companies to make money from investments, they may only make small returns — and some years, none at all.

What happens when customers can’t afford or access coverage?

The business of insurance is complicated, and it evolves with our changing times.

According to the Insurance Bureau of Canada, insured damages from severe weather events across the country exceeded $3 billion for the second year in a row.

As these major climate disasters continue to rise, fewer people may find themselves able to access and afford adequate insurance.

While mandatory auto insurance coverage is likely to remain affordable for those who choose vehicles within their price and risk range, property insurance is a different ballgame.

When it comes to personal property insurance, weather related perils that are included in a home insurance policy like wind, snow, hail, and fire are more common and can’t be controlled by the customer.

 “There could be parts of the country where premiums might become prohibitively expensive,” says Kelly.

And that’s if you can even get insured.

Flood coverage, for example, is often very limited or even not available for particularly high-risk customers.

“Unlike Facility Association for high-risk auto and FAIR plans in the U.S., there is no residual market for high-risk property in Canada,” says Kelly. “That's one of the reasons for the government's proposed National Flood Insurance Program.

If an insurance company were to ever suffer by taking on too much risk or lose business from a substantial number of customers falling out of their price or risk range, they can turn to reinsurance, where insurance companies purchase additional security from other insurers. Reinsurance is often known as “insurance for insurance companies”.

But reinsurance is far from a magic bullet solution – reinsurers can only be so risk-tolerant, so often a company will spread their risk over several reinsurers, which can drive up premiums for both the company and their customers, jeopardizing the fine balance of affordability.

“Insurers do rely heavily on reinsurance,” says Kelly. “And there's been considerable push back from the global reinsurance market to make the domestic market retain more risk.”

Overall, if premiums become too high or other high risk coverage limitations develop for certain perils, customers may choose not to purchase property that is subjected to such risk. For the events that insureds can’t control, more people will likely be calling for governments to intervene.

Read next: One third of homeowners worried about extreme weather damage