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How Auto Insurance Companies Work

        Money | Auto Insurance

How Auto Insurance Companies Make Money
Insurance companies stay in business largely by calculating risk.
Insurance companies stay in business largely by calculating risk.
Brian Stablyk/Photographer's Choice/Getty Images

In most consumer activities, the customer exchanges money for a product or quickly performed service. Auto insurance is different: The customer pays a fee to the insurance company, and the insurance company maybe provides a service or financial assistance at some point (although if the service is never rendered, both the consumer and the company would probably be pleased).

Auto insurance companies make money through a combination of managed risk and the strategic use of money. Insurers associate together large swaths of their policyholders into "groups" via the risk-assessment criteria discussed earlier -- type of car, driving record, and so on. Out of each group, it's likely that a very small percentage of these policyholders will endure a car accident severe enough to file a claim during the coverage period.

But say that one policyholder in the group does get into an accident that results in a $50,000 payout by the insurance company. Then, imagine that that policyholder has been a client of the insurance company at that point for five years, and has paid a monthly premium of $100. That person has then brought in $6,000 to the insurance company. That would be a direct loss of $44,000 to the insurance company -- except it wouldn't be. That's because managed risk spreads the short-term financial burden out over the rest of the group, the remaining members of which, in this scenario, haven't received any payouts that cost the insurance company money.

Further, insurance companies are essentially financial institutions: They take in money and dole out money, just like a bank does. (Many insurance companies are even branches of large banking conglomerates.) Also, like a bank, they invest the money of its customers and policyholders in interest-earning investments. While the shared risk approach allows for large sums of cash on hand for claims payouts, investments are a long-term financial strategy, to make sure that the insurance company will have cash on hand for payouts years down the line.

Finally, and most directly noticeable to the policyholder, insurance companies' auto insurance policies limit payouts. Limits of liability are set to match the premium rate paid. For example, if the driver pays a $50 monthly premium, he may have a $10,000 liability cap; if he pays $200 a month, the insurer may enable a $50,000 liability cap. This means that the auto insurance company won't pay for damages or medical bills beyond a specific amount that the driver agrees upon.

Next: how to file a claim with an auto insurance company.