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In most business practices, a customer exchanges money for goods or services. But when it comes to car insurance, the practice is a little different. Customers pay a fee to the insurance company and the company might provide a service of financial assistance–though the customer would probably be happier if that service was never rendered.
So how do car insurance companies make money? And what do they do with that money if they don’t pay it back to their customers? Let’s investigate.
How do car insurance companies make money?
Car insurance companies make money through investment income and through underwriting. Companies put their policyholders into groups via risk-assessment criteria like driving record and type of car.
These groups are put together by actuaries, who use statistics and mathematical models to evaluate the risks associated with insuring them.
Every person in that group pays in an insurance premium every month, and that premium goes into a pool of money from which car insurance companies can draw from if someone they insure gets in a car accident.
Car insurance companies know it’s likely that a very small percentage of those policyholders will have an accident severe enough to necessitate a claim. But if someone does get in an accident that results in a payout, that payout would be a direct loss to the company–except for the fact that the rest of those insured in that group, the people who have paid in, have ensured the car insurance company won’t lose money.
How do car insurance companies use money?
All of that money in premiums generates a lot of money for car insurance companies, especially since they don’t have to pay out any money until someone files a claim. But that money doesn’t just sit there gathering dust.
Car insurance companies have a lot in common with banks: they take money in from customers and hand out money when needed, just as a bank does. Similar to a bank, your car insurance company invests policyholders’ money in interest-earning investments.
The shared-risk approach car insurance companies employ ensures there will be cash on hand to pay policyholders’ claims, but keeping that money invested ensures the company will have cash on hand for years to come.
This is the biggest reason why the car insurance industry is such a lucrative one. As strategic investing develops and as technology ensures that drivers stay safer on the road, car insurance companies are able to make and hold onto more money than ever before.
How do car insurance companies limit money spent?
Car insurance companies limit the amount of payouts they will sign off on, even in the event of a serious accident. Limits of liability are set to match the premium rate each policyholder pays.
If a driver pays a premium, their liability cap is typically set in accordance with that amount. If a driver does something to raise their liability–like having a point added to their license–that will also affect their premium rate.
This is probably the most directly noticeable element of car insurance to a policyholder. Your car insurance company won’t pay for damages or bills beyond an amount that you agree upon–and that amount is largely up to you when you sign up for car insurance.
Ultimately, your car insurance company has put itself in the position–through strategic investing and underwriting–to always be able to serve you and pay your claims should you need them. But, for your sake and for theirs, fingers crossed you don’t!