All businesses make money in one way or another. For instance, a store will charge more for the products they sell while services such as a pool cleaning service will charge for their time and the materials they use. Some are not as easy to figure out and one of those happens to be life insurance.
Insurance companies make a lot of money, especially the fast life insurance industry. These companies report billions of dollars each year but how do they make so much money? You need to research and look closely at these companies to find the answer. They make money by calculating their premiums and pass the charges on to those they insure. So, we are going to take a closer look and find out just how life insurance works.
How It All Works
Life insurance policies are created when you are approved after filling out an application and start making payments on your policy. These payments are called premiums. When you die, the death benefit that your policy was approved for will be passed on to your beneficiaries. What goes on in between payments for the premium and death benefits will dictate how much of a profit the company will make.
There’s a lot of math involved with life insurance, not trickery or sleight of hand when looking at their profits. There are two basic ways these companies make their money. The first is collecting payments on your premium and the other is the investments the company makes on the premiums.
Insurance companies hire thousands of actuaries who specialize in statistics and probabilities. These are professionals who work with measurements and management of risks and uncertainties. These risks are affected by the calculations made by actuaries. They make calculations to determine the financial costs of the risks and how the insurance companies will deal with them. Some examples include smokers, those with heart disease, obesity, or other health issues. The information gathered by the actuaries is passed on to the underwriters who will decide what an individual will pay for their premium.
This is how the company knows what to charge their customers in premiums. During this time, the underwriters will take your application, history of health, and other information to create charts or tables to decide your mortality risk which will decide your premium cost. The company knows how much they need to charge in premiums in order to cover its risk, liabilities and make a profit over the year.
Even though companies make a profit from premiums, the income from investing premium revenues is even greater. Investment income is a significant portion of the total revenues and profits, making tons of money for these companies. In one year, 2019 to be exact, these insurance companies brought in billions of dollars in revenue.
You need to understand the cash value in permanent life insurance policies. Permanent life insurance policies (including universal and whole life policies) have a cash value account within the policy to offset the cost of insurance as you age and insurance costs rise.
A portion of each premium goes into a cash-value account which is then invested in the insurer’s general account, mostly in fixed-income securities such as bonds as well as stocks, real estate holdings, and other investments.
The insurance company will keep some of the proceeds and pay some to the customer. Therefore, the insurers make money and so does the policyholder. The amount of money the general account makes along with the policy and account expenses will dictate how much interest is credited to the policyholder’s cash value account.
Cash values in life insurance policies are not invested in a general pool of cash reserves that are held by the company but are invested in mutual fund sub accounts offered within each policy.
Lapsed & Term Policies
Even though investment income from cash value policies is significant revenue for life insurance companies, lapsed policies and expiring term policies can also be very profitable for the company. This is no longer a liability for the company and the company does not have to pay out a death benefit on the policy. Policies that lapse are considered lost revenue. Premiums for the policy are not being paid and in the case of permanent insurance, the value cannot be invested.
A study performed by the Society of Actuaries and LIMRA discovered that the annual policy lapse rate had a variation of 4.0% to 4.5% between the years 2005 and 2009. This created a lapse rate for term life policies to over six percent.
In A Nutshell
The life insurance industry has invested a large amount of time and money going over the mortality rates and percentage of insurance policies that remain active until their terms expire or a claim is paid out. In addition, everyone will buy life insurance at some point in their life whether they are younger or older. Based on past experiences, life insurance companies know the current and past efforts of thousands of actuaries will clarify what to charge and how to invest. There is no question, life insurance companies have been very profitable businesses and will more than likely continue to be profitable.
About the Author
Hi, I’m Michael, the cofounder and editor of REMEDIGAP – a website devoted to Medicare education. As a licensed independent insurance broker in 47 states, we help thousands of Americans understand their Medicare options.