Life insurance is a contract between you and the insurance company. The insurance company pays a death benefit to your beneficiaries when you die, as long as the life insurance policy is in force. To keep the policy active, you must make regular premium payments. To a large extent, how an insurer invests these premiums determines the annual profit it makes.
Life insurance policies can be divided into two categories: permanent life insurance and term life insurance.
Term life insurance is the purest form of life insurance because it has only one purpose: to pay the death benefit if you die within the term of the policy. It’s much cheaper than permanent life insurance and can be a good option for people who want coverage for a limited period, such as until they retire, pay off their mortgage, or send their children to college.
Permanent life insurance, by contrast, provides coverage for life and typically includes an investment component called a cash value. Universal and whole life are the two most common types of permanent life insurance policies.
If you have a whole or universal life insurance policy, only part of your premium money covers the cost of the insurance. The insurer invests the other party in interest-bearing securities that grow tax-deferred at either a fixed or variable rate. while the cash value reduces the insurer’s risk, it also provides the policy owner with a tax-free source of money. you can access it by making a withdrawal, taking out a loan or surrendering the policy. premiums for such policies tend to be significantly higher (six to ten times) than comparable term life plans.
How does a life insurance company make money?
Life insurance companies make money in the following three ways:
- benefit from insurance premiums
- investing premium dollars wisely
- through expired policies
- suicide – all life insurance policies have a suicide clause. If you commit suicide within the first two years of purchasing a policy, the insurer will not pay the death benefit.
- misrepresentation: another clause present in all policies is the contestability clause. If she dies within the first two years of the policy and the insurer believes she lied, withheld or withheld key information on her application, she can contest the claim. If a misrepresentation is discovered on her application, the insurance company may deny the claim.
- late payments: your policy may expire due to a late payment. If you die after your policy expires, the insurer is not required to pay the benefit.
profitability of life insurance premiums
At first glance, it can be hard to see how a life insurance company makes money.
Suppose you buy a $1 million 20-year term life insurance plan with an annual premium of $2,000 and die after 18 years. this means that the insurer was only able to collect $36,000, while she must pay $1,000,000.
this just doesn’t add up. So how do life insurance companies make money? Do they try to devise ways to avoid paying claims?
not at all. In most cases, the insurer pays the death benefit. Estimates suggest that 97% of all life insurance claims are paid.
and when a death benefit is denied, it is usually for the reasons listed below and not for malicious intent.
Simply put, life insurance companies generally won’t deny a claim unless there’s a good reason. if so, how do they make a profit?
Don’t worry, the insurance companies know your numbers. One: Only a small percentage of policies ever pay. (More on this later.) Two: Using advanced statistics and probability, life insurers price their policies in a way that gives them the best chance of collecting more in premiums in a year than they pay in claims. That’s why each insurer follows a detailed underwriting process to determine an applicant’s insurability and set her premium rate. the higher your mortality risk, the higher the premium rate.
Some years, an insurance company may make a profit on your underwriting income alone. For example, if the insurer collects $20 million in policy premiums in a given year and pays $15 million in claims, that’s an annual profit of $5 million.
however, even with the most advanced statistics model and the most talented underwriters, sometimes an insurance provider can spend more on claims than it could collect through premiums. To offset this risk and maximize their profits, insurance companies invest premium dollars in stocks, bonds, and other types of investments.
invest life insurance premiums
Life insurers rely more on premium investment income than underwriting income to generate profits. With access to large amounts of money and experienced investment advisors on their team, insurance companies can invest funds in a wide range of investment products and financial markets to generate high returns. in fact, their financial analysis is as advanced as some of the top hedge funds.
While insurers use some of the investment income to lower premium rates and pay dividends to eligible policyholders, most of it is absorbed into their bottom line.
A life insurance policy is considered lapsed when coverage ends without a benefit being paid. For example, a term life policy expires when it reaches the end of its term and the policyholder chooses not to renew the coverage. In this situation, the insurer keeps all the premiums. Many policies also lapse because the policyholder can no longer pay the premiums. Estimates suggest that only 2-3% of term life plans are paid out; the rest expires due to expiration of the term of the policy or due to non-payment of premiums.
Also, when owners of permanent life insurance policies trade in their policies for cash value, the insurer keeps all the premiums paid and a portion of the interest.
So what does all this mean for you as a consumer? it means that life insurance companies are there to make money. they have to be profitable to stay in business and continue to pay claims.
When shopping for a policy, it’s important to keep this in mind and ask yourself if the company is offering a good deal or just trying to take your money. research and compare quotes before buying life insurance; could save you a lot of money in the future.