How Health Insurance Companies Make Money

An insurance company can make money in two different ways; through underwriting, investing, or a combination of both. Financial investments, such as government bonds, corporate bonds, publicly traded stocks, and commercial real estate, make up the bulk of an insurer’s assets. Let’s find out how health insurance companies make money.

Many insurance companies operate with margins as low as 2% or 3%. Small profit margins mean; even small changes in cost structure or pricing can significantly impact a company’s ability to make money and stay afloat.

In 2019, the health insurance market had a slight drop in net earnings to $22 billion and a profit margin of 3 percent, compared to net revenues of $23 billion and a profit margin of 3.2 percent in 2018. From 97 percent to 97.6 percent, the combined ratio increased slightly.

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How Much Do Health Insurers Profit?

How Health Insurance Companies Make Money

Looking at average profit margins by industry, we find that health insurance companies have single-digit profit margins. Health insurers that provide individual or family coverage struggled with profit shortfalls in the early years of the Affordable Care Act’s implementation. Still, by 2018 they had regained profitability and have continued to do so since.

To put things in perspective, profit margins in the banking, private equity, and commercial leasing industries are ten times greater than those in the health insurance market.

There are several particularly profitable industries in health care, such as medical and diagnostic laboratories, biotechnology companies, and the pharmaceutical industry, which account for the most profits in the industry.

However, health insurance does not generate the same level of revenue as those other divisions of the industry because it is much more heavily regulated.

As noted above, the Affordable Care Act essentially limits insurers’ profits by capping administrative overhead costs as a percentage of revenue. In contrast, hospitals, device manufacturers, and drug producers are not regulated.

How Health Insurance Companies Make Money

Insurance comes in a variety of forms:

Health insurance covers some or all of a person’s medical expenses.
Life insurance pays money to one or more selected beneficiaries when the insured person dies.
Property and casualty insurance cover damage to automobiles, homes, and businesses.
Excess and Surplus (E & S) insurance is a kind of specialized insurance that covers risks that other insurers do not cover.

Underwriting Income

Everyone who has health insurance pays a monthly premium. A health insurance company collects premiums from thousands of consumers and puts them into a pool.

When one of those customers requires medical care, the insurance company pays for it using money from this pool in the form of a claim. Health insurers also use premiums to cover operating expenses.

The Affordable Care Act (ACA) requires insurers to spend 80 to 85 percent of their budget on claims and 20 to 15 percent on administrative costs. The amount of revenue is regulated by legislation based on the premium collected.

You must pay other healthcare expenses (such as co-payments and co-insurance) to your healthcare provider (doctors and hospitals), not the insurance company.

Insurance companies may take out reinsurance to cover losses above a certain level. Insurance companies invest money that they do not spend on claims or expenses. The proceeds from these investments (stocks, bonds, real estate, etc.) go to the company’s bottom line.

What is underwriting, and what does it involve?

The act of analyzing the risk of providing coverage and the cost of offering range is known as underwriting. Comprehensive medical underwriting comprised a complete review of an individual’s medical history before the advent of the Affordable Care Act (“Obama care”).

Health insurers spend a great deal of time calculating and anticipating the cost of claims. They controlled guidelines such as eligibility, in-network/out-of-network care, medical necessity, and authorization. Due to the Affordable Care Act, underwriting or limiting coverage for pre-existing conditions is not allowed in individual policies.

Investment income

Insurance companies benefit from premiums. Until and unless an insurance claim is filed, such as a claim for a hospital visit or damage to a home during a tsunami, companies are not required to pay out any money.

What happens to the often colossal amounts of money generated by premium payments?

Companies set aside some money to ensure that they can cover any claims soon, and the rest of the funds, however, are invested.

Reinsurance

Some companies use reinsurance to mitigate risk. Insurance companies purchase reinsurance to protect themselves from excessive losses caused by high exposure.

Reinsurance is an essential part of an insurance company’s efforts to remain solvent and avoid default. They require this by regulators for companies of a specific size and type.

Unless a policy is reinsured, regulators require an insurance company to offer a policy capped at 10% of its value. Because reinsurance allows these companies to transfer risks, they can be more aggressive in gaining market share. In addition, reinsurance softens the natural volatility of insurance companies, which can result in substantial profits and losses.

Investing in insurance companies

There are two main reasons you should think about investing in insurance stocks. First, insurance companies can provide reliable long-term returns. Second, insurers’ business strategies make them resilient to economic downturns.

On both fronts, some insurance companies are superior to others. For example, UnitedHealth Group (NYSE: UNH) has outperformed specialty insurer Markel (NYSE: MKL) by a wide margin over the past ten years.

During the COVID-19 pandemic-induced market decline, Markel was also down substantially more than UnitedHealth Group.

Insurance stocks are generally sound investments for conservative investors. However, some insurance stocks can be attractive to even the most aggressive growth investors. Trupanion (NASDAQ: TRUP) stands out as a potential growth stock for investors. This company offers health insurance for dogs and cats. Its shares have soared in tandem with the growth of the North American pet health insurance market.

Evaluating Insurers

Reinsurance makes the entire insurance industry more attractive to investors by smoothing out business volatility.

Like any other non-financial business, companies in the insurance industry must perform well on profitability, expected growth, payouts, and risk.

Calculating the insurer’s working capital is tricky because there are no standard working capital accounts. Analysts do not employ enterprise or company value indicators; instead, they use equity metrics such as price-to-earnings (P/E) and price-to-book (P/B) ratios.

Insurance companies with expected solid growth, large payouts, and minimal risk tend to have a higher P/E percentage. Insurance companies with high expected earnings growth, low-risk profile, high payout, and high return on equity have higher P/B. Return on equity has the most significant influence on the P/B ratio when all other factors are constant.

Analysts must contend with other considerations that complicate the insurance industry’s comparison of P/E and P/B ratios. Insurance companies set aside money to cover future claims expenses. P/E and P/B ratios can be too high or too low if the insurer estimates those provisions too conservatively or too aggressively.

Frequently Asked Questions

What money from consumers, specifically, do insurance companies carry direct profit?

The amount of money an insurance company uses to profit from premiums directly relates to the amount of money. Premiums are collected and put into a pool. Then they take the money out in the form of claims and expenses.

How Much Do Health Insurers Profit?

Is insurance a good industry to work in?

Working for an insurance company or independent agency provides job security compared to other industries.

Is the health insurance industry growing?

Between 2017 and 2022, the U.S. health and medical insurance industry grew by 2.9% each year on average. The medical and health insurance industry grew faster than the entire economy.

Bottom line

In 2019, the health insurance industry experienced a slight decline in net earnings, to $22 billion, and a decrease in profit margin, to 3%, compared to 2018.

Health insurers offering individual or family coverage faced revenue shortfalls in the early years of ACA implementation. Premiums are an essential source of revenue for insurance companies.

The Affordable Care Act requires them to spend 80% on claims and 20% on administrative costs. Underwriting or limiting coverage for pre-existing conditions is not possible for individual policies under the ACA.

Insurance companies can generate solid long-term profitability. Insurers’ business models tend to make them resilient during economic downturns.

Trupanion (NASDAQ: TRUP) is a viable option for growth investors. UnitedHealth Group has outperformed Markel (NYSE: MKL) over the past ten years. You evaluate companies in the insurance industry, taking profitability, growth, payouts, and risk.

Since insurance companies do not invest in fixed assets, slight depreciation, and very low capital expenditures, the degree of variety also affects comparability across the insurance market.

The ACA effectively limits insurers’ profits by regulating overall administrative costs in revenue.

Working for an insurance company or small independent agency provides more job stability. Between 2017 and 2022, the U.S. health and medical insurance industry grew at an average annual rate of 2.9%.

References

How Health Insurance Companies Make Money | Income Explained

How Much Do Health Insurers Profit?