This question is allied to the one of: how do insurance companies make money?
Well obviously insurers aren't in the business simply to provide a service and
help everyone sleep better at night - they are businesses like everyone else,
and their efforts are focused on a bottom line. So they don't just lump all
premiums together in a bank account and use it to pay out claims (well, they do
in a way, but not all of it, and not all in one account).
In short they use the premiums to cover their running costs, broker
commissions (if applicable), their administrative and legal costs, and to make
investments - as well as pay out premiums, of course. Amongst other things that
you are effectively doing by giving them your premiums, is funding their payouts
to other policy holders. Before you get all up in arms about this, bear in mind
that the same happens when you claim. You quite possibly will claim for far more
than the cumulative sum of all the premiums you have paid at the date when you
make a claim. So clearly you won't have built up enough "savings" through your
premiums to fund your claim. It's just as well that you don't have to then.
The insurance company guarantees you that it will always have enough money to
pay out any claims you make that are approved. They are able to make this
guarantee because firstly, they carefully calculate that the sum of everyone's
premiums will always be more than the sum of the claims they have to pay out,
for a given period. And secondly, because they use the premium funds to invest
and make more money.
That brings us to the other things that they use premiums for - running costs
and administrative fees. It costs a certain amount of money to run an insurance
company and to pay all the administrative costs involved. Processing claims can
be pretty admin intensive, and there are always costs attached. In the past,
these admin fees were a bit higher than they are today, as computerisation has
made administration more efficient and cheaper.
There are also legal fees that are accrued when insurance companies contest
claims or sue other insurance companies to cover damages to their policy
holders, if the policy holders are not at fault in an accident, or if there is a
dispute as to who is at fault. All of these fees need to be paid out of the
money that the insurer has available - and premiums make up part of this money
(along with returns on investments).
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The other modern development that has had an impact in reducing premiums is
the direct insurance model - where you deal directly with the insurer, without
an intermediary broker. This has had two favourable effects. Firstly,
administrative costs have been reduced, as the insurer doesn't have to maintain
admin for a network of brokers, and secondly, it means that there are no
commissions due to brokers in the direct insurance model. So that portion of
your premiums that went to pay these commissions is now no longer spent on it -
which means that effectively you're getting more bang for buck with your
premiums.
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