Premiums and Payouts

• Like any business, insurance companies work by bringing in more money than they pay out. An insurance company brings in money by charging premiums to customers. Their main expenditures consist of payouts to customers. For example, an auto insurance company collects small premiums from each customer, but it might have to pay out a large amount of money to the one customer who gets into an accident. A home insurance company has to pay out money to a customer whose house is flooded, and a life insurance company pays out money to a customer's relatives when the customer dies.
  
  

Shared Risk

• Because of the large numbers of insured customers on any given insurance plan, the principle of "shared risk" can be applied. Shared risk means that the company is able to risk having very few large payouts because so many people are paying small premiums and will get no payouts at all.
  
  If 1,000 people pay $100 a year in premiums, the insurance company collects $100,000. If statistically 2 in every 1,000 people will collect payouts each year, each one collecting $40,000, the insurance company will provide $80,000 in payouts. That means that the insurance company have made $20,000.
  
  

Reserves

• Of course, statistics don't always predict reality. Therefore, there are some years the insurance company will collect the same $100,000 in premiums but will provide only $50,000 in payouts. Instead of viewing the additional $30,000 as profits, however, they will hold it as reserves. The insurance company knows that they will have some years where people collect more than $80,000 in payouts, and they will use the reserves to help provide those payouts. In the meantime, they invest the reserves and view the dividends on those investments as profit.