Life Insurance Business: Making Money While Paying Out

Life insurance companies make money by assuming the financial risk of a covered event on behalf of an individual or company. They generate revenue by charging premiums in exchange for insurance coverage, and then reinvesting those premiums into interest-generating assets. They also diversify risk by pooling customer risk and redistributing it across a larger portfolio.

Life insurance companies also make money by investing the premiums they collect in stable options like bonds or blue-chip stocks. This money generally grows by a percentage over time, helping the insurance provider remain profitable and stable.

Life insurance companies make money by charging premiums and investing them in interest-bearing assets

The revenue model for insurance companies may vary depending on the type of insurance, such as auto, health, or property insurance. However, the industry operates by assuming the financial risk from customers and transferring it to the insurer. In return for providing insurance coverage, the insurer earns revenue through monthly or annual premiums paid by the customer.

A critical task for insurers is to accurately price the risk of an event occurring and charge a corresponding premium. This process, known as underwriting, involves evaluating the likelihood of a claim being filed and determining the appropriate premium to compensate for the risk assumed. By effectively pricing their risk, insurers aim to generate more revenue from premiums than they spend on claim payouts.

In addition to premium income, insurance companies invest a portion of their premiums to generate interest income. They may invest in interest-bearing assets such as Treasury bonds, high-grade corporate bonds, high-yield savings accounts, and certificates of deposit (CDs). Rising market interest rates can boost earnings by providing higher returns on these investments. Conversely, lower interest rates may lead insurers to invest in riskier assets to meet their earnings forecasts.

By charging premiums and investing in interest-bearing assets, life insurance companies can remain profitable and fulfill their financial obligations to policyholders.

Insurers diversify risk by pooling customer risk and redistributing it across a larger portfolio

The pooling of risk is fundamental to the concept of insurance. Insurers diversify risk by pooling customer risk and redistributing it across a larger portfolio. This mechanism allows insurance companies to predict the “risk” of their enrollees accurately enough to set premiums that cover their costs. Risk is more predictable when enrollee pools are both broad and stable. The larger the risk pool, the more predictable and stable the premiums can be.

In a health insurance risk pool, the medical costs of individuals are combined to calculate premiums. Pooling risks together allows the higher costs of the less healthy to be offset by the relatively lower costs of the healthy, either in a plan overall or within a premium rating category. In general, the larger the risk pool, the more predictable and stable the premiums can be. However, the key factor in determining premiums is the average health care costs of the enrollees included in the pool. A large pool with a large share of unhealthy individuals can have higher-than-average premiums.

In broad risk pools, low-risk individuals subsidize high-risk individuals. This can reduce low-risk individuals’ perceived benefit from purchasing insurance. As a result, low-risk individuals may instead choose to enroll in lower-cost, lower-benefit plans that are less attractive to high-risk individuals. They may even choose not to enroll in health insurance at all. This can lead to a "death spiral", where the risk pools for these plans become so small, unstable, and concentrated with high-risk individuals that insurers decline to offer these plans altogether.

Job-based coverage has generally been an effective way to create broader and more stable risk pools that allow for more affordable and accessible health premiums. For the most part, people do not choose their employer based on their health risk. This means that risk pooling in employer-provided plans happens more naturally and requires insurers to use fewer risk management practices. Most employers subsidize premium costs and give employees a limited set of plans to choose from, resulting in high participation in employer-provided plans and broad pooling of employee risks.

Reinsurance helps insurers avoid bankruptcy due to excessive claim payouts

Reinsurance, often referred to as "'insurance for insurance companies", is a contract between a reinsurer and an insurer. In this contract, the insurance company transfers some of its insured risk to the reinsurance company. The reinsurer then assumes all or part of the insurance policies issued by the insurer.

• By covering the insurer against accumulated liabilities, reinsurance gives the insurer more security for its equity and solvency. This increased security allows the insurer to withstand the financial burden of unusual, major events.
• Insurers are legally required to maintain sufficient reserves to pay all potential claims from issued policies. Through reinsurance, insurers can underwrite policies covering a larger quantity or volume of risk without excessively raising administrative costs to cover their solvency margins.
• Reinsurance makes substantial liquid assets available to insurers in the event of exceptional losses.
• Reinsurance allows insurers to remain solvent by recovering some or all amounts paid out to claimants. It also reduces the net liability on individual risks and provides catastrophe protection from large or multiple losses.
• Reinsurance provides ceding companies (those that seek reinsurance) with the chance to increase their underwriting capabilities in the number and size of risks.

Overall, reinsurance is a valuable tool for insurers to manage their risk and avoid bankruptcy due to excessive claim payouts.

Life insurance is important for small business owners to protect their family's financial stability

Life insurance is a vital consideration for small business owners, offering financial protection for their company and family. It is a key part of business planning, helping to ensure business continuity and protect employees and loved ones.

There are several types of life insurance that small business owners can choose from, including key person life insurance, buy-sell agreements, and individual life insurance.

Key Person Life Insurance

Also known as key man, key woman, or business life insurance, this type of policy provides the business with readily available cash if a critical employee or other person vital to the business's success passes away. The company purchases the policy and is the beneficiary. This type of insurance can help make up for lost revenue and cover the costs of finding and training a replacement.

Buy-Sell Agreements

A buy-sell agreement, or buyout agreement, is a contract between co-owners of a business. In the event of an owner's death, the surviving co-owner can buy the deceased owner's share of the business from their heirs or estate at a predetermined price. Life insurance policies are typically used to fund these agreements.

Individual Life Insurance

Individual life insurance for small business owners can help ensure that, upon their death, their loved ones will have the immediate cash needed to keep the business operating. This money can be used to pay bills or fund the salary of a new key employee.

Other Types of Life Insurance

Small business owners may also benefit from more traditional types of life insurance, such as term, whole, or universal life insurance, depending on their situation, needs, and goals.

Term life insurance provides protection for a set number of years, typically between 10 and 30, and can be beneficial during the years a business is being built. It can help pay off business loans or provide income for family or business partners.

Whole life insurance is a type of permanent life insurance with set premium payments and a guaranteed death benefit. It can accumulate cash value over time at a fixed interest rate, offering an additional savings option.

Universal life insurance is another type of permanent life insurance that provides greater premium and death benefit flexibility. It offers permanent coverage and the ability to accumulate cash value above the set interest rate, depending on market performance.

Why Small Businesses Need Life Insurance

Incorporating life insurance into a business plan is an important step in preserving the company. It can help ensure business continuity, protect employees or loved ones, and provide income replacement for family members. It can also be used to fund buy-sell agreements for business partners and protect the business from financial loss after the death of a key employee.

Life insurance is not a legal requirement for small business owners, but it can provide financial stability for families and ensure the business can continue to operate normally. It may also be necessary to show proof of a business owner's insurance policy when applying for a small business loan through the U.S. Small Business Administration.

When deciding how much coverage is needed, small business owners should consider their personal and business expenses, as well as the size of their business, the number of employees, the company's financial stability, and the amount of debt the company has.

Key person life insurance protects a business from financial loss after a key employee dies

Life insurance is a contract between an insurance company and a policy owner, where the insurer guarantees to pay a sum of money to the beneficiaries when the insured person dies. There are different types of life insurance policies, including term life insurance and permanent life insurance. Term life insurance is designed to last a certain number of years, while permanent life insurance remains active throughout the insured person's lifetime unless the policyholder stops paying premiums or surrenders the policy.

One type of life insurance that helps protect businesses is key person life insurance (also known as key man, key woman, or business life insurance). This type of insurance is meant to provide financial protection for a company in the event of the death or incapacitation of a key employee who is critical to the company's success. The company purchases the insurance policy on the key employee, pays the premiums, and becomes the beneficiary of the policy.

Key person life insurance offers a financial cushion to help the company stay afloat during a difficult time. The death benefit can be used to cover the costs of recruiting, hiring, and training a replacement for the deceased employee. It can also be used to pay off business debts, supplement cash flow, and cover expenses associated with finding a replacement.

The amount of key person insurance needed will depend on the business and the role played by the key employee. It is often recommended to purchase a policy that is eight to ten times the key person's salary or the monetary value of the key person to the company.

When considering whether to obtain key person life insurance, businesses should assess the potential financial impact of losing a key employee. This includes considering the costs of recruitment, hiring, and training a replacement, as well as any operational disruptions or delays in bringing products to market that may occur during this transition period.

Frequently asked questions