How Life Insurance Works
A life insurance policy is created when you complete an application, are approved, and start paying premiums to the life insurance company. When you die, the life insurance company pays the policy’s death benefit to your beneficiaries. How the insurance company handles those premiums in between their receipt and the payment of a death benefit (if there is payment) is what determines how profitable that insurer will be.
Profiting From Your Premium
The insurance company makes money in primarily two ways: from the profit it makes on premium payments and from investing those premiums. To figure out what premiums should be, insurance companies employ thousands of actuaries who specialize in advanced statistics and probability. They perform calculations to determine the financial costs of the risks insurance companies face, such as whether an insured person smokes, is obese, or has one or more serious health conditions like cancer or heart disease. They use this information to create and modify the mortality tables that underwriters use to determine the premiums charged to a specific insured person with their specific health conditions. In this way, the company knows how much it needs to charge its customers in premiums to cover its liabilities and, ideally, make a profit that year.
Reinvesting Your Payments
While insurance companies may profit directly from premiums, the income from investing premium revenues is even more substantial. In fact, investment income represents a significant portion of total revenues and profit-making up $186 billion of revenue for the life/annuity insurance industry in 2020, compared to $143.1 billion from life insurance premiums. To better understand how this works, consider the cash value component in permanent life insurance policies. 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 you age (and insurance costs increase). A portion of each premium goes into the cash-value account, which is then invested via the insurer’s “general account,” primarily in fixed-income securities like bonds, but also in stocks, real estate holdings, and other types of investments. The insurance company keeps some of the proceeds and pays some of it to its customers. In this way, both insurers and policyholders make money. 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.
Lapsed and Term Policies
Although the investment income from cash value policies is a major source of revenue for life insurance companies, lapsed policies and expiring term policies can sometimes be profitable for insurers as well. This is because when an insurance policy lapses, it is no longer a liability for the insurance company—the company doesn’t have to pay out a death benefit on that policy. However, policies that lapse also represent a source of lost revenue. Premiums for the policy are no longer being paid and/or, in the case of permanent insurance, the cash value can no longer be invested. A joint study sponsored by the Society of Actuaries and industry group LIMRA found that the overall annual policy lapse rate was 4.0% between 2009 and 2013, the most recent data available. The lapse rate for term policies was 6.2% annually.
The Bottom Line
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. It knows based on past experience and the current and past work of thousands of actuaries what to charge and how to invest to be one of the most profitable industries worldwide.
