How do insurance companies make money?

Insurance companies collect small, certain amounts of money (premiums) from policyholders who want to avoid the possibility of a large, uncertain financial loss. The insurance allows the dollars of many to pay for the losses of a few. Insurance companies use historical data to figure the probability of losses and charge premiums accordingly, building in profit for themselves.


For example, there are 100 houses, each worth $10,000, in the neighborhood ($1,000,000 total value). Given the history of the neighborhood, 5 houses can be expected to burn during a typical year. If they didn't have insurance, all 100 homeowners would have to keep $10,000 in the bank to "self-insure" their home for the cost of rebuilding.


With insurance, each homeowner must only pay $500 into the insurance pool each year to cover the five houses that will likely burn:


* 5 houses burn x $10,000 = $50,000 needed for rebuilding homes
* $50,000 needed for rebuilding divided by 100 homeowners = $500 premium


The $500 premium covers the property each year. Of course, it will then be adjusted upward somewhat to build in whatever profit the market will bear for the company. It is important to shop around, because premiums are not the same from company to company.