May 4, 2022
Here’s a mystery—how in the world do insurance companies stay in business?
After all, their business model seems… odd. Their main product is cold, hard cash. In some cases, those payouts are substantial—for life insurance, it’s recommended that people buy 10X their annual income. That can mean payouts of well over $500,000. That’s a huge chunk of cash! The premiums you pay over your lifetime likely don’t even scratch the surface of that amount.
So what’s the secret? The answer is minimizing risk. Here’s how it works…
Let’s say you run a mom-and-pop life insurance company. You find 20 clients, and charge them each a $100 monthly premium for $500,000 of protection.
Your business earns $24,000 per year, and for the first five years it’s smooth sailing.
But what would happen if just one of your clients died? Suddenly, you would have to pay out $500,000. And unless you had some other income, that would mean the end of your business.
Here’s an even scarier proposition—what if you decided to exclusively market towards the elderly? And what if two of them died in quick succession? Suddenly, you’re on the hook for a million dollars, and your business is toast.
This is why insurance companies are so risk-averse. They have to be, or they’ll go bankrupt.
Their solution? They evaluate every person they insure. Actuaries plug the amount of coverage, age, history, health, and even the zip code of prospective customers into complex algorithms to determine their risk level. It’s why life insurance is often vastly more expensive for smokers than non-smokers—their risk of death is simply higher.
Then, the actuaries hand the results to underwriters who determine the premium amount.
Let’s consider your hypothetical business again—this time with proper risk protection.
You still have 20 customers, each with $500,000 of protection. But now, you’ve evaluated each customer for risk, and adjusted their premiums.
You charge 5 clients $100 per month, 5 clients $250 per month, and 10 clients $400 per month. Plus, you’ve had to decline serving the highest risk customers. Now, you’re earning $69,000 annually. And because of your new qualification process, you don’t have to make your first payout for 10 years. Now, you can easily cover the cost, with some to spare!
And as you expand your client base, you’ll have a larger and larger pool of low-risk customers to help offset the cost of payouts for the high-risk ones.
This is the secret to how insurance companies stay in business. By carefully evaluating and managing risk, they can keep their costs low, and ensure they have the cash on hand to make payouts when needed.