Life Insurance Carriers: Making Money Off Policyholders

Life insurance companies make money in several ways. Firstly, they charge premiums, which are regular payments made by the policyholder to keep their policy active. Secondly, they invest those premiums in stocks, bonds, real estate, and other financial instruments to generate income. Thirdly, they profit from lapsed or expired policies, where the policyholder stops paying premiums or outlives the policy term, allowing the insurer to keep the premiums without paying out any claims. Finally, they gain interest from cash value investments, particularly in permanent life insurance policies, where a portion of the premiums is invested and earns interest over time.

Charging premiums

Life insurance companies employ actuaries who use advanced statistics and probability calculations to determine the financial costs of the risks they take on, such as whether the insured person has health conditions like obesity, cancer, or heart disease, or lifestyle choices such as smoking. Actuaries use this information to create and modify mortality tables that underwriters then use to set premiums for each insured person based on their specific health conditions and risk factors.

The premiums are carefully calculated to cover the death benefit, the cost of administering the policy, and to provide profits for the company. The company knows how much it needs to charge in premiums to cover its liabilities and make a profit. If too many customers die sooner than expected, and the insurer has to pay out more claims than planned, the insurer loses money. This is why the life insurance application process is so thorough, and penalties are imposed for concealing information to lower rates.

Premiums for permanent life insurance policies are much higher than for term life insurance. This is because permanent life insurance premiums fund both the death benefit and an investment-like cash value feature. The cash value funds are invested by the insurer, and some of the earnings stay with the company.

Investing premiums

Life insurance companies make money in several ways, one of which is by investing the premiums they collect. When a policyholder pays their premiums, the insurer invests a portion of that money. The insurer sets aside enough cash to pay out claims in the event of a market downturn and keeps any interest accrued. The investment income helps supplement the revenue generated from premiums.

The investment of premium payments is managed by professional investment teams within the insurance company. These teams aim to maximise returns while maintaining an acceptable level of risk. Common investment vehicles include stocks, bonds, real estate, and other financial instruments.

The income generated from investing premiums is substantial and represents a significant portion of total revenues and profits for life insurance companies. In 2020, investment income accounted for $186 billion of revenue for the life/annuity insurance industry, compared to $143.1 billion from life insurance premiums.

For permanent life insurance policies, a portion of each premium goes into a cash-value account, which is then invested via the insurer's "general account". The money earned in this account, along with the type of policy and account expenses, determines the interest credited to policyholders' cash-value accounts.

The investment of premiums is a critical aspect of the life insurance business model, allowing insurers to generate profits and maintain financial stability while providing financial protection to their customers.

Gaining from cash value investing

Life insurance companies make money by investing in permanent life insurance policies, which have a cash value component that grows over time. Permanent life insurance policies, such as whole and universal life insurance, are designed to provide lifelong coverage and are significantly more expensive than term life insurance policies. This is because permanent life insurance premiums fund both the death benefit and an investment-like cash value feature.

The cash value funds from permanent life insurance policies are pooled together and invested by the insurer in a variety of ways, including stocks, bonds, real estate, and other financial instruments. The earnings from these investments are then split between the insurance company and its customers. This allows both the insurer and the policyholders to make money.

The money earned by the insurer from these investments, along with the type of policy and account expenses, determines the interest credited to the policyholders' cash value accounts. This interest provides policyholders with a pot of tax-free money that they can access through withdrawals, loans, or by surrendering the policy.

By investing the cash value funds from permanent life insurance policies, life insurance companies gain an additional stream of revenue that contributes to their overall profitability. This investment income is substantial and plays a significant role in the success and stability of the life insurance industry.

Benefiting from policy lapses and expirations

Life insurance companies make money in several ways, and one of the most significant methods is by benefiting from policy lapses and expirations. This occurs when a policy lapses or expires without the need for the insurance company to pay out a death benefit. In such cases, the insurance company retains all the premiums paid by the policyholder without incurring any liability for claims.

Term life insurance policies are the most common type of life insurance, and they are designed to cover a limited time period, typically until the policyholder's dependents are grown up or financial obligations, such as a mortgage, are met. Most people who buy term life insurance only need it for a set number of years, and they will outlive the policy. In these cases, the insurance company profits from decades of premium payments without having to pay any claims.

Permanent life insurance policies, on the other hand, offer lifelong coverage and often include an investment component called cash value. These policies are more expensive than term life insurance, and they can be surrendered or lapse when owners can no longer afford the high premiums. When a permanent policy is surrendered, the insurance company may pay out the cash value, but they still profit by keeping all the premiums paid and a portion of the interest.

According to a joint study by the Society of Actuaries and industry group LIMRA, the overall annual policy lapse rate was 4.0% between 2009 and 2013, with a lapse rate of 6.2% for term policies. This means that only a small percentage of policies ever pay out, and insurance companies profit from the difference between premiums collected and claims paid.

By understanding the likelihood of policy lapses and expirations, insurance companies can set premiums at a level that ensures profitability. They use advanced statistics, probability, and mortality rates to determine the financial costs of the risks they underwrite, such as health conditions, lifestyle choices, and other factors. This allows them to price their policies to maximize profits and minimize payouts.

Underwriting

Actuaries create and modify mortality tables, which underwriters then use to assess an individual's unique mortality risk. This risk assessment is fundamental in setting premium rates. The higher the mortality risk, the higher the premium rate. For example, a 30-year-old male smoker will likely pay a higher premium than a non-smoking counterpart, as there is an increased mortality risk associated with smoking.

The underwriting process ensures that insurance companies can cover their liabilities and make a profit. By pricing policies based on risk, insurers aim to collect more in premiums than they pay out in claims. This careful calculation of premiums allows insurance companies to manage their risk and maintain profitability.

In summary, underwriting is the process by which life insurance companies assess and manage risk, set premium rates, and ultimately, ensure their profitability. It is a critical function that allows insurers to balance their financial obligations while providing financial protection to their customers.

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