Understanding how insurance companies make money is important to you for 2 main reasons:
- It affects the premiums you pay for insurance; and
- It affects the payout you receive on an insurance claim if you ever have one.
Insurance companies do not make money by paying out claims. Insurance companies make money in two ways:
Underwriting income. Premiums are the monthly, quarterly, or annual fee that customers like us pay to the insurance company in exchange for an insurance contract. The contract lays out the terms and conditions of when the insurance company will pay on a claim, but they will use every trick, tactic and strategy in the playbook to avoid paying you or to wait as long as possible to pay you and then to pay you as little money as possible on your claim. This is often referred to as the “Deny, Delay and Defend” strategy. Here’s why:
The insurance industry has two major categories of expenses: 1.) payment of claims and 2.) operating expenses. The percentage of money paid out in claims as a percentage of premiums earned is called the “loss ratio.” And the percentage of premium income paid toward expenses is the “expense ratio.” When a greater sum is taken in premiums than is paid out in claims and expenses, an insurance company generates underwriting income. The lower these “combined” ratios are, the greater the net underwriting income. So one reason the insurance company wants to deny or defend against paying you is to decrease its loss ratio and thereby increase its profits. The reason the insurance company wants to delay paying you as long as possible has to do with the main way insurance companies make money – investment income.
Investment Income. Insurance companies have a very different business model from most other types of businesses in that customers pay upfront and they (maybe) deliver a service later. This is called an “inverted production cycle” which means policyholders pay premiums upfront and contractual payments are made only if and when an insured accident has happened. During the length of time between collecting your premiums and paying out on your claim (if and when you have one), the insurance company uses this large pool of cash and invests it in things like money market funds, bonds and real estate.
In fact, insurance companies make the vast majority of their profits through this investment income. So the longer period of time the insurance company has between taking your money in premiums and paying you money on your claim, the longer amount of time is has to invest that money (which is actually your money) for its own profit. This is the main reason the insurance company wants to delay paying you on your claim.
How this Affects your Cost for Insurance
Because insurance companies collect premiums upfront, they do not know how many claims they will have to pay on in any given year (i.e. what their loss ratio will be). Because the actual cost of their product is unknown at the time they charge you for it, they must calculate approximately what their claim payout costs will be through the use of statistics, historical analysis and computer algorithms. This process is called underwriting, which involves calculating the probability of the risk for each insured or category of insureds. So your car insurance rates aren’t an accident. They take into consideration many factors, some of which may surprise you.
Who you are: Age, gender, marital status, ZIP code, number of years you’ve been licensed, homeownership, occupation, education and even grades
Your driving record: Accidents, traffic violations and insurance claims history.
Your credit score: Credit history, type of debt, etc.
What and how you drive: Owned or financed, current value, annual mileage, claims record for all owners of that model, anti-theft devices and safety features, and whether you use the car for business (your rates will be higher if you drive your car to and from work or for business – rates are lowest for people who only drive for pleasure).
How much coverage you want: Liability (from minimum liability limits up to $500,000 or more), whether or not you buy comprehensive and collision (both of which carry a deductible that influences their final cost), medical payments, uninsured motorist, or extras – such as rental reimbursement or towing.
Which of these factors affect car insurance rates the most?
While each car insurance company decides on its own how heavily to weigh a rating factor, for most drivers the following factors tend to influence rates the most:
Your ZIP code. Even if you have never filed a claim, your rate can increase dramatically simply by moving from one ZIP code to another.
Your age. Men under 25 and unmarried women under 21 have the highest rates. Drivers over 50 may get discounts.
Your driving record. Accident claims tend to matter more than speeding tickets do. More than one of either is bad news, and so is a major violation such as a DWI.
Your credit. Insurance companies point to numerous studies that correlate poor credit scores with higher numbers of claims. In Texas, while a company can use your credit score, it can’t refuse to sell you a policy or cancel or non-renew your policy based only on your credit. To find out which companies use credit scores and how they use them, visit the Learning Center on HelpInsure.com, which is a free service of the Texas Department of Insurance.
Your previous insurance coverage. In Texas, companies can charge more if you drove without insurance for more than 30 days in a row in the 12 months before you applied for insurance. If you didn’t, a company can’t charge you more for liability coverage because of your previous lack of coverage.
Are car insurance rates set by law?
Yes and no. Car insurance rates are regulated by the states, but as long as companies observe state laws they are free to charge whatever someone is willing to pay.
State laws ensure that a company charges the same rates to drivers who fit the same risk profile. Another company may charge you much less, or much more, but it too must offer the same rates to all drivers who pose a similar risk.
All states set minimum levels of liability insurance coverage. In Texas, the minimum liability limits are $30,000 per person / $60,000 per accident and $25,000 for property damage per accident. This basic minimum coverage is called 30/60/25 coverage. This means that no single injured person can collect more than $30,000 under the policy and no more than $60,000 can be collected from the policy for a single accident regardless of the number of injured people involved.
Some states require that you buy uninsured motorist coverage. In Texas, you are not required to buy uninsured motorist coverage, but it must be offered to you and your insurance company is required to have you sign that you reject uninsured motorist coverage if you choose to do so. These financial responsibility laws ensure that drivers who inflict injuries on others have a means to pay, and those who are injured have coverage if the other driver does not.
If you finance the purchase of your vehicle, your lender may require that you buy comprehensive and collision coverage to protect your car from physical damage, but states do not require this.
Jason Franklin is founder of The Franklin Law Firm, a Dallas Personal Injury law firm that specializes in providing Real Help for Real Injuries to North Texas accident victims injured in a car accident, truck accident, motorcycle accidents, or other personal injury cases. Because of his years of experience and record of success, Jason Franklin is frequently invited to speak to lawyer groups about Texas personal injury law. Franklin has been repeatedly recognized by Super Lawyers as being one of the best personal injury trial lawyers in the State of Texas.