Question

How can an insurance company make a profit by taking in premiums and making payouts?

The value of the premiums the company takes in is higher than the value of the payouts it makes.
The value of the premiums the company takes in is equal to the value of the payouts it makes.
The company only makes payouts from a pool of funds, not from individual premiums.
The company issues its policies to individuals who are unlikely to require payouts.

Answer 1

Correct answers: 1 and 3.

Short explanations:
- 1 (True): Insurers set premiums so the total they collect exceeds the expected value of claims plus expenses and a profit margin. That difference is their underwriting profit.
- 3 (True): Premiums are pooled into reserves; claims are paid from that pool. Risk pooling and the law of large numbers let the company predict aggregate claims and price accordingly.

Why 2 and 4 are incorrect or misleading:
- 2 (False): If premiums exactly equaled payouts, the insurer would have no money for operating expenses, reserves, investment shortfalls or profit.
- 4 (Misleading): Insurers do try to underwrite and price for risk (and may decline or charge more for very high-risk applicants), but they don’t simply issue policies only to people “unlikely” to have claims. Profit comes from correct pricing, diversification, pooling, and investment income — not just excluding all higher-risk customers.