This article aims to answer an often asked question – what exactly is insurance? Through the post, we would also look at how insurance companies work, their role and how they make money.
What is covered in this article?
What is Insurance?
Insurance is quite simply, an arrangement where an entity (insurer) promises to provide compensation to the insured upon the happening of a specified event or loss.
This promise (or insurance) can be obtained by paying a small charge upfront (premium).
And the exact terms are decided between the insurer and insured via an insurance contract.
Let’s take a simple example
Insurer [A] promises to pay the insured [B] a compensation of ₹10,00,000 (promise) if B is diagnosed with cancer (event) after 6 months from start of policy (terms) and upfront payment of ₹2,000 (premium).
The Four Prime Elements of an Insurance Contract
In effect, these are the four prime characteristics in a simple insurance contract –
- Promise (what is the compensation)
- Event (why is it being paid)
- Terms (how is it being enforced)
- Premium (what is the contribution towards participating in this process)
Role of an Insurance Company
An insurance company works on building products aimed at providing financial protection from risks. These risks include death of bread earner (life insurance), hospitalization expenses (health insurance), damage to assets (car insurance) etc.
The insurance company’s role includes –
- pricing of the premium
- determining the coverage i.e. compensation
- inking the insurance contract
- collection of premium
- administering the claim/promise
How Do Insurance Companies Make Money
The insurance company earns a profit (or loss) by managing the risk.
On a unit economics basis:
Insurer’s Profit = Premium collected + Investment income* on premium collected – Selling expenses – claims paid & provisioned** – Operating expenses
Let’s understand this with an example –
- Premium collected = ₹10 lacs (say, 100 users on avg paid ₹10,000 each as premium)
- Investment income = ₹80,000 (8% interest p.a. on ₹10 lacs)
- Selling expenses = ₹1,50,000 (15% commission paid on ₹10 lacs)
- Claims paid & provisioned = ₹5,50,000 (say, 9% of users made claims averaging ₹50,000 each & ₹1,00,000 is provisioned)
- Operating expenses = ₹2,00,000 (fixed cost of ₹2,00,000 on account of manpower, office, documentation, claim assessment and related administrative work)
Hence, the profit earned by the insurance company is ₹1.8 lacs (₹10 lacs + ₹0.8 lacs – ₹1.5 lacs – ₹7.5 lacs – ₹2.0 lacs).
Please note, in the above scenario the insurer made a profit. It would have been very different had 19% of the users made a claim instead of only 9%. In this scenario, the insurer would have made a loss of ₹3.2 lacs.
₹3.2 lacs = ₹10 lacs + ₹0.8 lacs – ₹((19*0.5 lacs)+1.0 lacs) – ₹2 lacs
Thus, the insurer too has to carry risk on its books and has to manage the delicate balance between risk forecasting and pricing the policy.
Insurance premiums are paid in advance
* Every insurance contract requires that premiums are paid in advance to the insurance company before it can accept the risk. This means the premium comes before any claims are payable. This advance premium is deployed by insurance companies mostly in fixed income securities like AAA rated corporate bonds, treasury bills and relatively safe instruments. These debt mutual funds & debt based instruments earn insurance companies anywhere from 8 to 10% per annum.
What are provisions in insurance?
** Provisions by definition means to keep aside. Now, we said in the example that 9% of users made claims. The provision is kept for two reasons – 1. It’s possible that 9% is not the long-term average insurance claim number and it can be higher and 2. There might be some cases which happened in this year but might get reported the next year. The provision (while carved from the profits of the insurance company) gives the support for future years.
Now let’s put back what we have learnt here into the three key insurance products around. This will help us understand the difference in the works of the these distinct products
How Car Insurance Works


The four characteristics in a typical car insurance policy are –
- Promise (repair your car)
- Event (accidental damage to your car)
- Terms (you should not be intoxicated while driving the car)
- Premium (pay ₹_____ for the year)
How Car Insurance Companies Make Money
Car Insurance policies are structured to make good the loss of the car owner. The losses can be on account of three events –
- Your car might have got stolen (theft of car)
- Your car might be damaged in an accident
- You might have hit a pedestrian (third party insurance)
From a P&L perspective, a car insurance company’s statement looks like –
Receipts | Payables | ||
Premium | ₹100 | Selling expenses | ₹15 |
Investment Income | ₹8 | Claims Incurred | ₹70 |
Claims Provisioned | ₹3 | ||
Operating Expenses | ₹20 | ||
Profit or (Loss) | ₹0 | ||
Total | ₹108 | Total | ₹108 |
Notice in the table above that the car insurance department of the insurance company is operating at a no-profit no-loss basis.
Now, if the car insurance department is interested in turning a profit, it can use one of these many techniques –
- Increase the premium (it might have a negative effect on sales)
- Reduce selling expenses i.e. commission paid to distributors & motor dealers (not easy to do)
- Stringent claims survey and investigation (by putting strictly enforced rules and reducing frauds, the insurer can save money by paying less claims)
- Focus on quality over quantity and pick only profitable cases (it is known that some segments of car insurance buyers are more likely to claim e.g. consumers driving in Delhi claim more than those in Chennai, bachelors claim more than married folks, Indica drivers claim more than Hyundai i10 etc.)
How Health Insurance Works


The four characteristics in a health insurance policy are –
- Promise (pay hospital bills)
- Event (you are hospitalized due to an illness or injury)
- Terms (you should be admitted for atleast 24 hours)
- Premium (pay ₹_____ for the year)
How Health Insurance Companies Make Money
Health Insurance policies are structured to reimburse the policyholder for the expenses incurred on account of his/her hospitalization. These expenses cover surgeries, room rent, organ transplants etc.
From a P&L perspective, a health insurance company’s statement looks like –
Receipts | Payables | ||
Premium | ₹100 | Selling expenses | ₹15 |
Investment Income | ₹8 | Claims Incurred | ₹60 |
Claims Provisioned | ₹5 | ||
Operating Expenses | ₹15 | ||
Profit or (Loss) | ₹8 | ||
Total | ₹108 | Total | ₹108 |
Notice in the table above that the health insurance claims incurred are lower than the car insurance claims. This is generally the case as the health insurance books of most players are skewed towards the 35-45 year old segment. Over the next 20-25 years, the claim incurred % is likely to increase as more users who have aged and the pre-existing clause of 48 months would have expired.
We also see that health insurance makes a profit for the insurer
Health insurance companies can ensure that they make profits for longer periods by doing the following –
- Pick only young and healthy lives (more unhealthy lives = more claims)
- Increase the premium in line with medical inflation (medical inflation in India is increasing by 12-15% per annum)
- Reduce commission paid to distributors & agents (not easy to do)
- Stringent claims survey and investigation (there are many frauds in health insurance often perpetrated in connivance with hospitals)
How Term Insurance Works


The four characteristics in a term insurance policy are –
- Promise (pay compensation to your nominee)
- Event (you meet your death during the policy period)
- Terms (you did not meet your death while perpetrating a crime)
- Premium (pay ₹_____ for the year)
How Term Insurance Companies Make Money
Term Insurance policies are long term contracts often running into 30, 40 or 50 years. There are many benefits of term insurance and are structured to compensate your nominee or beneficiary for future incomes that they would have lost due to your untimely demise.
From a P&L perspective, a term insurance company’s statement looks like –
Receipts | Payables | ||
Premium | ₹100 | Selling expenses | ₹10 |
Investment Income | ₹8 | Claims Incurred | ₹5 |
Future Claims Provisioned | ₹65 | ||
Operating Expenses | ₹15 | ||
Profit or (Loss) | ₹13 | ||
Total | ₹108 | Total | ₹108 |
Notice in the table above that the claims incurred in quite small. This is because most buyers of term insurance policies are young – in their 30s and 40s. The likelihood of them dying now is much lower than 30 years from now when they are in their 60s or 70s. The P&L statement accounts for this as future claims provisioned.
Term insurance companies can ensure that they make profits by doing the following –
- Price the term insurance contracts well (this is no easy task with the actuaries needing to estimate term insurance premiums using interest rate changes, mortality rates, operating expense and the persistency rates)
- Reduce expenses (use more technology and online issuance)
- Source business from preferred income, education, occupation and locations
Additional Resources You Might Like
- 5 steps on choosing the right term insurance plan
- Why term insurance premiums are likely to increase next month?
- Complete SIP Investment Guide (over 8000 words compedium updated until 2020)
- Six benefits of term insurance plans
- Best SIP for achieving long term goals