How Does An Insurance Company Operate?
Have you ever wondered how an insurance company operates? Almost everyone will pay for some sort of insurance in his or her lifetime, but do they have an understanding of where their money goes? Well, in this blog I will take you from the side of the insurance consumer to the insurance supplier (the insurance company).
The insurance industry is a complex one, full of mathematical equations and minute details. My goal is to explain it in a way that you will have a better understanding of how the insurance industry works and how insurance rates are determined year after year.
The first point that I want to make very clear is that Bridge First Insurance is not an insurance company. Bridge First Insurance is an independent insurance agency.
When you purchase an insurance policy, you are purchasing it through an agent such as Bridge First Insurance, but the policy is from an actual insurance company like Erie Insurance. The insurance company holds all of the financial responsibility associated with an insurance policy, whereas the insurance agent or agency can act as a resource or adviser to you. Without getting too deep into it, here are the three typical ways people can purchase insurance:
- Independent insurance agency or agent – represents multiple insurance companies and can shop all of them for you (Bridge First Insurance).
- Direct writer – represent one carrier and can only sell their products (Liberty Mutual, State Farm, Allstate, etc.).
- Online – insurance companies that only sell online (Geico, Esurance).
All three ways are totally acceptable but if you have read any of my previous blogs, you will know, I never recommend making insurance decisions without consulting a licensed insurance agent. Also, as you can imagine, each insurance company will have its own business model and strategy.
While Erie Insurance, State Farm and Geico all operate completely different, at the core there is one thing that drives these companies: Profit. While I know profit is an extremely obvious answer, getting there is much harder for insurance companies. Let’s look at a basic example first. Take a manufacturing company that makes widgets. That manufacturer knows: I need to make X amount of widgets, it will cost me Y to make them and I need to sell them at $50 a widget in order to make a profit. The widget company can forecast its upcoming revenue, expenses and hopefully turn a profit. When it comes to insurance companies, forecasting is near impossible.
An insurance company, when really boiled down, has three main parts to its operation: collect premiums, pay claims, and control operating expenses. We are going to walk through these three parts and hopefully you will be able to gain a better perspective on how an insurance company operates.
Controlling Operating Expenses
The easiest part of the equation to forecast is the operating expenses. Operating expenses for an insurance company can include things like: underwriters, call centers, claims adjusters, area supervisors, taxes, utility bills and other general items. The point about the operating cost is that most insurance companies can predict what their fixed operating cost is going to be for the year. Most insurance companies operate in the 30-40% range, meaning their operating cost is about 30-40 cents for every $1 of premium they collect. These cost are generally controlled, and if an insurance company is being run well, this should never be the reason your premium increases.
While operating costs can be predictable and controlled, paying claims is the exact opposite for insurance companies. Paying claims is such a tough job because you can look at historical data and try to forecast claims, but there are just too many varying factors. There is no way to predict how many hurricanes are going to reach land later this year and how much damage they will do. There is no way to tell that the person that hasn’t had a claim in 10 years will total their car next week.
At the end of the year, each insurance company will add up all collected premium and add that to the total money paid out for claims, arriving at what is called the loss ratio for the company. Loss ratio is the biggest driver of insurance rates, and it all comes back to profit. A typical insurance company will aim to keep their loss ratio in the 55-65% range, meaning that for every $1 of premium they collect, they will pay out 55 – 65 cents in claims. If a loss ratio skyrockets because there were more claims or bigger claims during a given year, you can count on insurance rates going up, and here is the reason. If an insurance company operates at $0.35 per dollar and has a loss ratio of $0.65 per dollar, they made no profit for the fiscal year. They paid out $1 in expenses and claims for every $1 of premium brought in.
If an insurance company doesn’t experience a year of profitability, adjustments must be made in order to turn a profit the following year, and as discussed there are only a few things they can change. The insurance company could try to cut back on operating expenses, but that would usually result in layoffs and consolidation. The next favorable option would be to reduce the amount of money paid out in claims, and there is no easy way to control that. The insurance company might then try to clean up their book of business a little by dropping some clients with bad claims history or the insurance company could raise the rates of its current policyholders to drive more premium into the company.
Now, it is not uncommon for rates to gradually increase in the 1-3% annually in effort to stay with the cost of inflation. Even the price of a loaf of bread could go up a little, but when your premiums are jumping from 10-15% a year, you really need to pay attention. If you are experiencing major increases, it might be a sign that an insurance company is trying to pull out of a high claim area (a place that gets hit with Hurricanes a lot), or you had some serious claims recently, and the insurance company is trying to recover some of the money they have paid out for you.
The point is, that the main controlling factor in your insurance rate is YOU. It is not that you have a red car instead of a blue car or that you are 30 and not 29. More importantly, insurance companies are looking at claims history and moving violations. Insurance companies will look back as far as five years and can potentially surcharge you for accidents until they are off your record. The best thing you can do to control your insurance rate is to maintain a clean driving record.
An insider tip from an underwriter: one of the worst tickets that can show up on your driving record is texting while driving. Almost every insurance company will either increase your rate or opt not to offer you insurance at all.
Want more insurance tips? Check out our blogs below or contact a Bridge First Insurance Agent today! (571) 249-3857
Dave has accumulated extensive knowledge of commercial insurance and the skill set that it takes to succeed. In 2013, he and co-founder Jack Cordes, joined forces to establish Bridge First Insurance. Through Bridge First Insurance, Dave utilizes his knowledge and unique expertise to offer clients the best care in insurance.