How Do Life Insurance Companies Make Money?
Learn how life insurance companies earn money with our guide.
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The life insurance industry is one of the most profitable industries in the world. Every year, insurers report billions in profits on their corporate tax returns.
According to the Insurance Information Institute (III), the U.S. insurance industry totaled $1.28 trillion in money paid for life insurance in 2020.
In this article, we will discuss how life insurance works, how insurance companies make money, and how much money they really make.
What Is Life Insurance?
Life insurance is a type of long-term coverage that insures a person’s life. Life insurance policies are contracts between policyholders and insurance companies.
A policyholder (the person covered by the life insurance policy) pays a monthly or annual premium to the life insurance company (the business offering coverage).
In exchange, the life insurance company promises to pay out a death benefit to the insured person’s beneficiaries when the policyholder dies.
Terms You Should Know:
Death Benefit: The amount of money that will be paid out to a policyholder’s beneficiaries when they die.
Premium: A regular payment made to an insurance company in exchange for insurance coverage.
Policyholder: The person who is insured by a life insurance contract.
Beneficiary: A nominated person who will receive the full or a portion of a life insurance contract’s death benefit.
Cash Value: A cash value account is a type of savings account that policyholders with permanent life insurance can use to build up additional wealth through their policy.
Source: Pexels
How Does Life Insurance Work?
Life insurance is defined as a legal agreement or a contract, where an insurance company agrees to pay a sum of money or cash value to a beneficiary when an event covered by the policy occurs, usually death.
In other words, life insurance takes the place of the income you provide your family and dependents. It replaces the loss of your financial value when you’ve passed away or can't work anymore.
When purchasing a life insurance plan, the insured makes payments in the form of premiums. They are based on the amount of coverage required and the insurance company's perceived risk of covering their life.
This perceived risk will depend on a number of factors such as:
Age
Medical and health conditions
Smoking habits
Hobbies
Occupation
The higher the perceived risk, the more expensive the premium gets.
How Does an Insurance Company Make Money?
The two main ways insurance companies make money are from premium payments and their investments with those premiums. They do this by using actuarial tables.
Profiting from Your Premium
Insurance is all about spreading risk. Before you're insured, the insurance company has to do their research to determine how “risky” you are to insure.
What Are Actuarial Tables?
Actuarial tables are spreadsheets and formulas that can predict the likelihood of your death happening within a given period of time.
For example, if you frequently take part in extreme sports, you will be deemed riskier to insure and therefore pay higher premiums.
The formulas that insurance companies use have become increasingly more accurate. Once an insurance company figures out your life expectancy, they can then determine how they can collect more money from you over your projected lifetime than the amount they’ve agreed to pay out when you pass away.
They make sure they get more money in than the amount they’ve agreed to pay out through underwriting income.
Underwriting IncomeUnderwriting income is the difference between how much money is collected for all policies sold and how much money is paid out in insurance claims for those policies in any given time period.
For example, an insurer might get $1,000,000 in premiums from policies that are sold or renewed in a given year.
If they pay out less than $1,000,000 in claims, they make a profit. If they pay more than $1,000,000 in claims, they’ve lost money.
Fortunately, insurance companies have other unique ways to make a lot of extra money, such as reinvesting.
Insurance companies tend to make a lot of money each year and they may not have to pay out on claims for many years, or even at all.
Reinvesting Your Payments
In order for insurance companies to generate revenue, they invest a small portion of the premiums they receive from policyholders.
Insurance companies invest in the stock market, but it's only a small percentage of their investment funds.
What Are Stock Markets?
Stock markets are institutions where buyers and sellers meet to exchange equity shares of public corporations.
They are vital components of a free market economy because they enable equal access to trading and exchange of capital for investors of all kinds.
This is because they recognize that the stock market is very risky, due to the unpredictability of bull and bear market conditions.
What Are Bull and Bear Markets?
A bull market is the condition of a financial market in which prices are rising or are expected to rise.
The term "bull market" is most often used to refer to the stock market, but can be applied to anything that is traded, such as:
Bonds
Real estate
Currencies
Commodities
Unlike a bull market, where there's no fixed definition, a bear market has a very specific definition: when the market is down 20% for at least a two-month period.
Insurance companies make low-risk investments, such as:
Premium stocks
Common stocks
Real estate
Bonds
Mortgage loans
They are happy with receiving steady predictable investment income, because they can guarantee their policyholders’ return on investment and continue to pay dividends.
What Is a Life Insurance Dividend?
A dividend is a return of a portion of the premiums paid on your policy. The dividends can be distributed as cash, or used to purchase additional insurance or reduce premiums due.
Lapsed and Term Policies
Insurance companies also make a huge amount of money when a policy lapses, which is when you stop paying your premium.
What Is a Lapsed Policy?
When policyholders stop paying premiums and when the account value of the insurance policy has already been exhausted, the policy lapses.
A policy does not lapse each and every time a premium payment is missed. Insurers are legally bound to give a grace period to policyholders before the policy lapses.
When you stop paying your premium, they no longer have to guarantee your death benefit. That money then gets contributed to their investment portfolios so that they can make more money.
However, policies that lapse may also be a lost source of income. The premiums are no longer being paid and in the case of permanent insurance, the cash value can no longer be invested.
In a study by the University of Pennsylvania, about 4.2% of all life insurance policies lapse each year, which is about 5.2% of the face value of all the insured policies.
Cash Value Payouts
In many cases, when people who have whole life insurance policies find out their cash value is quite high, they are tempted to withdraw all the money, even if it means shutting down their account.
The insurance companies are more than happy to help, because they know that when a client takes the cash value and closes their account, the insurer has no more responsibility for the policyholder.
The insurance company keeps all the premiums that the policyholder has already paid, pays them the interest that they have earned on their investment, and keeps the rest of the money.
In that sense, cash value payouts are a good thing for insurance companies.
Source: Pexels
How Much Money Do Life Insurance Companies Make?
Revenue-wise, the life insurance industry generated $881.2 billion in 2020, which was below the 2018 and 2019 figures, due to the COVID-19 pandemic.
In 2019, $759 billion was paid in direct premiums to life insurance companies.
About 80% of the revenue from life insurance premiums came from ordinary, direct policies.
The additional 20% was $242.4 billion’s worth of group life policies.
Where Can I Learn More about Life Insurance?
The life insurance industry has spent a great deal of time and money analyzing mortality rates and the percentage of policies that remain in force until either their terms expire, or a death benefit is paid out.
If you’re unsure about what life insurance is right for you, get in touch with one of our professional consultants for personal and detailed advice. Send us an email at help@policyscout.com or give us a call at 1-888-912-2132.
For more information, insurance quotes, and getting the process started, visit PolicyScout today.