Real Life Insurance: Making Money By Protecting Lives

Life insurance companies make money in several ways. Firstly, they charge premiums, which are carefully calculated to cover the policy's death benefit, administrative costs, and provide profits. Secondly, they invest a portion of these premium payments, generating income through interest or returns on investments. Thirdly, they benefit from lapsed or expired policies, where premiums have been collected without paying out any claims. Finally, they gain interest from cash value investments, particularly in permanent life insurance policies, where premiums fund both the death benefit and an investment-like cash value feature.

Charging premiums

Insurance companies employ actuaries who use advanced statistics and probability to calculate the financial costs of the risks the company takes on. For example, an actuary might consider whether the insured person is a smoker, is obese, or has a serious health condition. This information is used to determine the customer's unique mortality risk, which forms the basis of their premium.

The premium charged also depends on the length of the policy's coverage and the insured person's estimated life expectancy. For instance, a 50-year-old male smoker seeking a policy worth $50,000 might have to pay a much higher premium than a 25-year-old female non-smoker seeking the same policy. This is because, statistically, the 25-year-old is likely to pay into a whole life policy for a longer period.

Insurance companies also make money by investing the premiums they receive. They put some of the money aside to ensure they can pay out claims and invest the rest. This investment income represents a significant portion of total revenues, with $186 billion made from investing premium revenues in 2020 compared to $143.1 billion from life insurance premiums.

Investing premiums

Life insurance companies make money by investing the premiums they receive from customers. This investment income can be very lucrative, making up a significant portion of total revenues and profits. In 2020, for example, the life/annuity insurance industry made $186 billion from investing premium revenues, compared to $143.1 billion from life insurance premiums.

Insurance companies invest in a variety of interest-generating assets, such as bonds, stocks, real estate, and other types of investments. They put some money aside to pay out claims and invest the rest.

Permanent life insurance policies, such as universal and whole life, contain a cash value account within the policy meant to offset the cost of insurance as the policyholder ages. A portion of each premium goes into this cash-value account, which is then invested via the insurer's "general account". The insurance company keeps some of the proceeds and pays some to its customers.

The money the general account earns, as well as the type of policy and account expenses, determines how much interest is credited to policyholders' cash-value accounts.

How Insurance Companies Invest Premium Payments

Insurance companies invest premium payments in a variety of ways, depending on their risk appetite and the economic climate.

• Bonds: Insurance companies often invest in fixed-income securities like bonds, which are considered a safe, stable option.
• Blue-chip stocks: Insurance companies may also invest in the stock market, choosing stable blue-chip stocks to minimise risk.
• Treasury bonds: Insurance companies can invest in Treasury bonds, which offer a higher return when market interest rates are high.
• High-grade corporate bonds: Similarly, insurance companies can invest in high-grade corporate bonds, which offer a higher yield when market interest rates are favourable.
• High-yield savings accounts: Insurance companies can also invest in high-yield savings accounts, which provide a higher return when market interest rates are high.
• Certificates of deposit (CDs): Another option for insurance companies is to invest in certificates of deposit, particularly when market interest rates are favourable.
• Real estate: Insurance companies may also invest directly in real estate holdings, providing them with an income stream from rent or property value appreciation.

By investing premium payments, insurance companies can significantly boost their profits and ensure their long-term stability.

Gaining interest from cash value investments

When an individual purchases a permanent life insurance policy, a portion of their premium payments is allocated to the cash value account. The insurance company then invests this money through its "general account" into fixed-income securities, such as bonds, stocks, real estate, and other types of investments. The interest earned on these investments contributes to the growth of the cash value account.

The money generated by the general account, along with the type of policy and account expenses, determines the amount of interest credited to the policyholder's cash value account. This interest accrues over time, and the taxes on the accumulated earnings are deferred. As the cash value increases, the insurance company's risk decreases as the accumulated cash value offsets its liability.

The cash value component of permanent life insurance policies offers a living benefit to policyholders, who can access these funds through loans, withdrawals, or by surrendering the policy. This feature provides policyholders with financial flexibility while also ensuring that the insurance company gains interest income from their investments.

By investing the premiums received from policyholders, life insurance companies are able to generate substantial revenue and profit. This investment income is a crucial aspect of their business model and contributes significantly to their overall profitability.

Benefiting from lapsed policies

A life insurance policy lapse occurs when a policyholder fails to pay the required premiums, resulting in the termination of the policy benefits. This situation can have significant consequences for the insured and their beneficiaries. When a policy lapses, the coverage it provides ceases, and the insured loses all the benefits associated with the policy. The life insurance company will no longer be obligated to pay any death benefit or other contractual benefits if the policyholder dies after the policy has lapsed.

The specific conditions and consequences of a lapse can vary based on the terms of the insurance contract and the type of life insurance policy. However, there are some common implications of a lapsed policy:

• Loss of Coverage: The primary consequence is the loss of life insurance coverage. If the insured individual dies after the policy lapses, the insurer will not pay a death claim, and the life insurance beneficiaries will not receive the death benefit.
• Reinstatement Challenges: While many life insurance companies offer an option to reinstate a lapsed policy, it often comes with conditions. The policyholder might have to provide evidence of insurability, pay all overdue premium payments with interest, and possibly undergo a new waiting period.
• Increased Premiums: If a lapsed policy is reinstated or the policyholder purchases a new policy, the premiums might be higher. Insurance premiums generally increase with age, and new health issues can result in higher rates.
• Loss of Policy Benefits: A lapse can lead to the loss of additional benefits, such as an accidental death benefit or a waiver of premium rider.
• Surrender Charges: For policies with a cash value, if the policy lapses or the policyholder surrenders it, surrender charges may be applied, resulting in the policyholder receiving less than the total accumulated cash value.
• Tax Implications: For policies with a cash value, lapsing can have tax consequences, especially if the policyholder has taken loans or withdrawals from the policy.

While a lapsed policy can result in lost revenue for the insurance company, it also removes a liability. The company no longer has to pay out a death benefit on that policy. Additionally, the premiums paid up to the lapse of the policy contribute to the company's profits.

To prevent policy lapses, insurance companies may offer proactive measures such as setting up automatic payments or using dividends to pay premiums. Policyholders can also take steps to avoid lapses, such as maintaining updated contact information, budgeting for premiums, and understanding grace periods.

Diversifying risk

Diversification is a risk control technique that spreads loss exposures over a myriad of projects, products, areas, or markets. Insurance companies diversify risk by pooling the risk from customers and redistributing it across a larger portfolio. This is an important technique because financial returns from various enterprises are not always directly correlated, so when one activity has low returns, other activities are likely to have higher returns.

For example, a farm that produces both soybeans and corn is less at risk of experiencing extreme fluctuations in revenues since the market prices of the two crops do not always move in the same manner. In a year with low soybean yields and revenues, these may be counterbalanced by relatively high corn yields.

Insurance companies also diversify risk by investing premium revenues. This income represents a significant portion of total revenues and profit-making. For example, in 2020, investment income made up $186 billion of revenue for the life/annuity insurance industry, compared to $143.1 billion from life insurance premiums.

Another way insurance companies diversify risk is through reinsurance. Reinsurance is insurance that insurance companies buy to protect themselves from excessive losses due to high exposure. Reinsurance helps insurers maintain solvency and avoid default due to too many claim payouts. For example, if an insurance company has underwritten hurricane policies based on models showing a low probability of a hurricane occurring in a particular region, reinsurance will take some of the risks off the table if a hurricane does hit the region. Regulators mandate reinsurance for insurance companies of a certain size and type.

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