Alyssa Lane
Healthcare insurers make money in two main ways: underwriting income and investment income. Underwriting income is generated by charging a fee (called a premium) for taking on financial risk. Actuaries are employed to use statistics and mathematical models to predict risks and set premium rates. Investment income is generated by investing the insurance premium payments. While investment income tends to be smaller than underwriting income, it still significantly contributes to the insurer's bottom line.
| Characteristics | Values |
|---|---|
| How they make money | By charging premiums to the insured and investing these payments |
| By weaseling out of payouts | |
| By charging high prices and passing them to patients | |
| Premiums | Charged as a fee for taking on financial risk |
| Charged differently depending on factors like age | |
| Used to pay for medical care and administrative costs | |
| Investments | Relatively conservative, such as bonds or stable blue-chip stocks |
| Can significantly increase profits | |
| Can deliver solid long-term returns | |
| Make the business model resilient during economic downturns | |
| Underwriting | Involves actuaries assessing risks to set premium rates |
| Income is usually smaller than investment income | |
| Accounts for a significant portion of revenue |
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What You'll Learn
Charging premiums for policies
Insurance companies make money by charging premiums to the insured and investing the premium payments. This is known as underwriting, which involves actuaries assessing risks to set premium rates. Actuaries use statistics and mathematical models to evaluate the financial risks involved in insuring different scenarios. For example, actuaries for a property and casualty insurance company will consider the probabilities of natural disasters when determining how much money in premiums that homeowners in different geographical regions should pay.
Insurers also invest a portion of their premiums to generate income. They invest the money in interest-generating assets, such as bonds or stable blue-chip stocks. The revenue model for insurance companies may vary among the different types of insurance, including auto, health, and property insurance.
The amount of liability that remains the responsibility of the individual is called the deductible amount. For example, an auto insurer might require the customer to pay the first $1,000 of any damage costs before the insurance company is willing to pay anything. The insurance company puts some money aside in reserve to ensure that they'll have enough to pay all anticipated claims in the near term.
There are several factors that can affect the profit margins of insurance companies, including the number of claims paid out, the amount of money received in premiums, and the number of policies underwritten. If a company prices its risk effectively, it should generate more revenue in premiums than it spends on claim payouts. However, if the underwriting team miscalculates the level of risk, the insurance company might charge some customers too little and others too much.
In the case of life insurance, the premiums fund both the death benefit and an investment-like cash value feature. The cash value funds are invested by the insurer, and some of the earnings stay with the company. Life insurance companies can also profit from policies lapsing or expiring.
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Underwriting income
> Underwriting Income = Premiums Collected – Claims Paid – Expenses
In other words, underwriting income is the money that isn't spent on claims or expenses. This money is then invested in stocks, bonds, real estate, etc., and the profits from these investments contribute to the company's income.
Underwriting refers to the process of evaluating an application for health insurance coverage by examining the applicant's medical history. The price of coverage is then determined by the risk factors of the applicant. This process is known as medical underwriting. Before the Affordable Care Act (ACA) reformed the individual insurance market, medical underwriting was used to determine applicants' eligibility for individual health insurance in nearly every state. Underwriters would consider factors such as age, height/weight, medical history, and profession to determine whether they were an acceptable risk.
Proponents of medical underwriting argue that it ensures that individual health insurance premiums are kept as low as possible. Critics, however, believe that it unfairly prevents people with relatively minor and treatable pre-existing conditions from obtaining health insurance.
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Investment income
Insurance companies take the money that isn't spent on claims or expenses and invest it. The money earned on these investments (stocks, bonds, real estate, etc.) contributes to the company's income. While underwriting income is the main source of revenue for insurance companies, investment income complements it.
Actuaries, employed by insurance companies, use statistics and mathematical models to predict risk and set premium rates. These predictions help insurance companies avoid losses and make profits. If the insurance company has accurately built high costs into the premium, it can make more money.
The majority of insurance company revenue comes from investing, though it's typically weighted towards the fixed-income market due to reserve requirements set by the state. Insurance companies put some money aside in reserve to pay all anticipated claims over the near term, but they invest the rest. Many insurers invest relatively conservatively, such as by investing in bonds or stable blue-chip stocks. However, insurance companies can significantly increase their profits through these investments.
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Accurate prediction of costs
Healthcare insurers employ actuaries who leverage statistical analysis and mathematical models to assess risks and set premium rates accordingly. Actuaries consider various factors, such as age, sex, and medical history, to calculate estimated life expectancies and determine the premiums for life insurance policies. Similarly, actuaries for property and casualty insurance companies evaluate the probabilities of natural disasters to set appropriate premiums for homeowners in different geographical regions.
The premiums collected from policyholders serve as a significant source of revenue for healthcare insurers. These premiums are pooled together to cover the medical expenses of insured individuals when they require coverage for medical care. The Affordable Care Act (ACA) mandates that insurance companies allocate a substantial portion of premiums, typically 80% to 85%, for medical care, with the remaining 20% to 15% designated for administrative costs. This regulatory framework ensures that a significant proportion of premiums benefit the insured individuals.
In addition to premiums, healthcare insurers also generate income through investments. The money collected from premiums that is not immediately spent on claims or expenses is invested, contributing to the overall profitability of the insurance company. These investments tend to be relatively conservative, focusing on bonds or stable blue-chip stocks. While investment income is generally smaller than underwriting revenue, it can still significantly impact the insurer's financial performance.
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Administration costs
Administrative costs in healthcare are defined as "the nonclinical costs of running a medical system". These costs are incurred by multiple parties within the healthcare system, including hospitals, physicians, clinics, providers, private payers, and public programs. Administrative costs can be divided into two primary categories: billing- and insurance-related expenses, and non-billing and insurance-related expenses.
Billing- and insurance-related expenses include claims management, clinical documentation and coding, and prior authorization. These expenses are necessary for the coordination of care and to ensure patients receive the benefits outlined in their insurance plans. However, the complexity of the US healthcare system, with its multiple insurers and plans, contributes significantly to administrative costs. For example, the process of transferring medical records between providers and sorting out insurance bills can be duplicative and time-consuming. The US system's requirement to translate diagnoses and treatments into special codes for reimbursement is another source of complexity and cost.
Non-billing and insurance-related expenses, also known as general business overhead, include quality assurance, excise taxes, profits, and credentialing costs. These costs are essential for maintaining the operations of healthcare organisations and ensuring compliance with regulations. However, they can also be a significant burden, especially for smaller providers or organisations.
The magnitude of administrative expenses in healthcare can be challenging to estimate as they may not correspond directly to specific line items in cost reports or budgets. Instead, they are often defined as the costs "left over" after accounting for clinical activities. According to various sources and studies, administrative costs in the US healthcare system account for a significant proportion of total healthcare spending. Estimates range from 15% to 30%, with some sources claiming that administrative costs make up at least 25% of medical bills. In 2012, billing and insurance-related (BIR) costs in the US healthcare system totalled approximately $471 billion, with private insurers contributing $198 billion and public insurers contributing $35 billion.
While some administrative costs are necessary, it is widely recognised that there is significant administrative waste in the US healthcare system. This waste is attributed to the complexity and fragmentation of the system, with its multitude of insurers and plans. Reforms such as the Affordable Care Act were designed to curb administrative spending, and proposals for a single-payer system suggest that simplifying the financing structure could result in significant cost savings. For example, a simplified financing system could save over $350 billion annually, nearly 15% of healthcare spending. Additionally, incremental changes, such as improvements in electronic record-keeping and information exchange, could help reduce administrative waste.
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Frequently asked questions
Healthcare insurers make money by charging premiums to the insured and investing the insurance premium payments. Insurers employ actuaries who use statistics and mathematical models to evaluate the financial risks involved in insuring different scenarios.
Underwriting income is one of the two primary sources of revenue for insurance companies. Underwriting involves actuaries assessing risks to set premium rates. It is the money that isn't spent on claims or expenses and is then invested.
Insurance brokers make money mainly through commissions and, sometimes, fees. Commissions are a percentage of the insurance premium paid by the insurer. Fees are charged for specific services, such as helping with complex business insurance policies.
