When you’re making business decisions, one of your most powerful tools is to understand business models. A business model is, simply, how a company makes money. If you want an in-depth definition with examples, check out my article on business models that was written during the first internet bubble, back when PayPal was a startup, Amazon only sold books, and cameras still used film. Almost every example in the article has since captured its market or gone out of business. (Challenge goal: read the article and consider how the companies’ business models did or didn’t change, and how that led to success or doom. Hindsight is a powerful learning tool!)

Become a compulsive business model collector

Often, a company’s business model constrains what it can and can not do. That, in turn, gives it strengths and weaknesses. Learning to spot business models, and do quick back-of-the-envelope calculations on them, will help you become a ninja at spotting opportunity.

When you see a hot pretzel vendor at a ballgame, ask yourself: what’s that person’s business model? How do they make money? How much product or service do they need to sell to make that money? How much does it cost them to make it? Is it a good business? Hot pretzels being one of my favorite foods as a college student, I was astonished to learn that the hot pretzel vendor cleared a six-figure income.

When you pass the neighborhood bookstore, ask how they stay in business? What’s their business model? Why does it work for them, and not for the bookstore down the block that went out of business five years ago?

When you use Facebook, ask and consider: what’s their business model, and what does that imply about the actions they’ll take? Or eBay? Or Uber?

Business models give policy insights

In a recent Facebook flame war, we were discussing different kinds of health insurance systems. Understanding the business model of an insurance company might give you some insight into their incentives and potential actions:

Health insurance companies make money through underwriting profits (premiums minus payouts and expenses) and investment income on the premiums they collect.

Insurance must ALWAYS be priced higher than needed to pay out because all that administrative overhead, salaries and buildings, needs to be covered.

Furthermore, a for-profit insurance company wants to grow profits. That means raising revenues and/or cutting costs.

How can they cut costs? By streamlining operations and finding ways to avoid paying out on existing policies.

How can they raise revenues? By increasing premiums above what’s necessary to pay out on their pool of premiums.

(They can also find ways to increase their investment income, but that’s longer-term and much less under their control. They can even play in the the $1.2 quadrillion derivatives market, which no one really understands, and Warren Buffett considers a ‘Weapon of Mass Destruction’.)

Now, when we formulate our own opinions about healthcare policy (which we all do, rather than simply parroting our favorite pundit, right?), we can at least understand that the business model of insurance companies constrains their actions.

Your assignment:

Every time you interact with a business today, ask yourself:

1. How do they make money? Where does their cash come from?
2. In order to make that money, how much do they have to spend, and from where?
3. What are the levers that their business models allows? What are the risks and benefits of their model?

Pretty soon, you’ll discover you can spot opportunities to bring business models to places they’ve never been used. Often, you’ll discover there’s a reason they weren’t used there. But other times, you’ll find that a shift in business model just might make you the next PayPal.

If you want to read more about [my thoughts on the insurance example implications, keep reading…

Health Insurance Business Models Drive Policy

IMPORTANT DISCLAIMER: This is intended as an example of how understanding a business model leads to confidence in predicting the behaviors of people who use that model. This post reflects my layman’s understanding of insurance business models. If anyone knows better, please please correct me.

For you gentle readers who also don’t know the inner workings of the industry, read this to understand how a business model leads to predictions of behavior. Do not read this for accurate information about the insurance industry.

For-profit health insurance companies must overcharge

I’m guessing that competition will not produce efficient health insurance. Health insurance companies make money only two ways: through underwriting profits (premiums minus payouts and expenses) and investment income on the generated float.

Insurance will always be priced higher than needed to pay out because all that administrative overhead, salaries and buildings, needs to be covered.

Furthermore, as long as we have a market that defines “healthy” profits as profits that grow yearly, there will be ever-increasing pressure to raise profits. That means raising revenues and cutting costs.

You can only cut costs so far on the admin side. But you can reduce your payouts by writing ever more complicated policies that in fact cover less and less. You can also challenge payouts, make the reimbursement process deliberately more cumbersome, lower the ceilings of what you will cover, etc.

And of course, regulation caps permitting, you can always raise revenue by raising premium prices.

Every year, due to the market expectation of continually growing profits, all these forces will come into play. (Premium prices will rise, and people will blame Obamacare or the lack of Obamacare or greed or whatever. It’s just the way growth-oriented markets work.)

Any for-profit insurance company will feel all those forces as a simple matter of doing business. So any for-profit insurance company in a competitive market will be pressured over time to do these things.

Even if their investment income is reliably positive, they can’t control that nearly as quickly, easily, and reliably as all these other forces. And if the company is heavily invested in derivatives (which Warren Buffett calls “Weapons of Mass Destruction”), well, at some point there may be a “correction.”

There are competitive pressures at play, as well. Price wars. When a competitor lowers premium prices below the actual rational value for a given policy, a company is pressured to match that pride and write unprofitable policies in order to compete … resulting in pressure to make up profits from one of the other sources¹.

That’s why private mutual insurance companies are a good thing. They still have these pressures, but at least the policyholders own the company so the company’s goals are more aligned with the goals of its members.