The Business of Insurance
To understand how an insurance company is susceptible to fraud, you must first understand what an insurance company is and how it makes money.
An insurance company is a bank. Policyholders “loan” money to the insurance company by way of paying premiums. The bank pays back the policyholders by way of paying claims.
The first profit goal of the insurance company is to benefit from the time value of the money held from when the premiums are received until the claims are paid, also known as the “investment income on reserves”.
The second profit goal of the insurance company is to benefit, if possible, by charging premiums in excess of the claims paid, also known as “underwriting profits.”
Between the two, the investment income is much more important. An insurance company can reasonably expect to average between 8% to 12% or better annually on its investment returns. No insurance company can expect to approach these profit spreads on its typical underwriting activity – except for certain niche areas of particularly lucrative insurance (e.g., credit disability insurance).
Particularly in times where property values are appreciating and the financial markets are doing well, insurance companies may offer insurance at premium rates which are lower than the amount of claims they expect to pay. This is essentially a “loss leader” function designed to obtain cash that can be invested at high rates of return, and is why insurance is cheap during economic good times.
Conversely, when property values are stagnant or depreciating, and the financial markets are doing poorly, the insurance company cannot afford to lose money on its underwriting function. This is why insurance becomes expensive during economic bad times.
So, the core function of an insurance company is investing. The primary fraud threat to insurance companies is investment fraud, and not, as one might expect, fraudulent claims (though certainly fraudulent claims can have a significant impact upon the insurance company’s net profitability).
http://www.cs.trinity.edu/~rjensen/read ... ance01.htm
And here I was thinking that they made all their money by charging high premiums. That's a good lurk they have got going there.
