Life insurance is a major industry that provides financial protection and security for individuals and families in the event of unexpected death. But how exactly do life insurance companies make money from selling policies? Here is an in-depth look at the business model and profit sources for life insurance companies.
The Premiums
The primary way life insurance companies generate revenue is by collecting premiums from policyholders. Premiums are the amount of money policyholders pay periodically (usually monthly) to maintain their life insurance policy. When you purchase a policy, factors like your age, health status, lifestyle risks, policy face value, and length of the policy will determine how much your premiums will be.
Premiums are designed to cover the insurance company’s costs of providing the death benefit to beneficiaries, plus generate profit. The insurance company invests the premiums they collect so the funds grow over time. This enables them to pay out the guaranteed death benefit when the policyholder passes away.
Part of the premiums collected goes towards covering the insurer’s underwriting costs and administrative expenses. Underwriting is the process of evaluating and assessing the risks of insuring a specific person or group. It involves researching medical history, asking lifestyle questions, and requiring medical exams. Administrative expenses include overhead costs like employee salaries, real estate, and technology systems.
The remaining premiums are invested by the insurer to generate investment returns which make up a significant portion of their profits. Life insurers invest in assets like stocks, bonds, mortgages, and real estate. The combination of premiums plus investment returns allows them to fulfil the promised death benefits down the road.
Underwriting Gains
In addition to premiums, insurers generate profits from favorable underwriting experiences. Underwriting gain occurs when the cost of paying actual death benefits ends up being lower than the expected claims costs calculated during the underwriting process.
For example, if Acme Life Insurance charges premiums based on an assumed life expectancy of 75 years for 50-year-old males, but their pool of 50-year-old male policyholders end up living past age 75 on average, then Acme keeps the extra premiums as underwriting gain.
Essentially, underwriting gain happens when insureds as a group end up being lower risk than originally assessed. This can occur due to insureds living longer than expected or lower incidence of policyholders dying from unexpected events like accidents or illnesses. Underwriting gains directly boost the company’s profitability above and beyond the investment returns.
Fees from Asset Management
Many life insurance companies earn substantial fees from asset management and investment services they provide. Insurance companies have huge amounts of money to invest from the premiums and ongoing cash inflows. As a result, they often create separate investment management divisions.
The investment management divisions earn fees by offering services to the insurance company’s general account, separate accounts, and providing investment options for variable life insurance policies that require the policyholder to choose investment allocations. The fees generated from the asset management divisions provide another profit center for the insurer.
Reinsurance
Insurance also plays a key role in insurer profitability. Reinsurance is when the original insurer transfers or “cedes” some of the risk to a reinsurer. For example, Company A may have issued a $5 million life insurance policy to one individual. They may then transfer $2 million of that risk to a reinsurer to limit their total loss exposure per insured life.
The reinsurer assumes that portion of the risk in exchange for receiving a share of the premiums. This reinsurance or risk-transferring allows the original insurer to underwrite and issue larger policies, take on more overall business, and reduce volatility in potential claims. The insurance company earns back a portion of the reinsurance premium to reinsure their own policies, thus generating income.
Surrenders
Many life insurance policies allow the policyholder to surrender their policy and receive some portion of the accrued cash value if they no longer want or need coverage. When a policy is surrendered, the insurance company gets to keep any remaining cash value the policy has earned to date, minus any payouts to the policyholder. Although surrenders decrease the company’s future earnings from a given policy, they provide a more immediate cash inflow from both the cash value and stopping future liability for coverage. These surrender profits contribute to the insurer’s gains, especially during periods of higher surrenders.
Policy Loans
Policyholders have the option to take out loans against the accrued cash value of permanent life insurance policies like whole life and universal life. They can borrow up to a certain portion of the cash value. And the loan principal plus interest must be repaid or else it will be deducted from the final death benefit.
The interest payments on policy loans generate income for the insurance carrier. Even though policy loans reduce the accessible cash value. They provide another way for insurers to earn interest payments beyond just premiums and investments. The amount of income from policy loan interest varies based on how many insureds utilize this option.
Fees From Riders
Riders are essentially add-on provisions or benefits that can be included for additional premium costs. Some common riders include accidental death, terminal illness, and disability income riders. The fees collected from optional riders that customize a policy provide additional revenue for life insurance companies.
Tax Advantages
Life insurers also benefit from certain tax advantages. The growth of the cash value within permanent life insurance gains benefits from tax-deferred compounding. The death benefit payouts are also not subject to income tax when they are paid to beneficiaries. Both of these features allow policy cash values to grow faster since taxes don’t need to be accounted for.
These tax perks give life insurance an advantage as an investment and wealth vehicle in addition to risk protection. The tax-advantaged status produces more funds for the insurance company to earn investment income on and ultimately pay claims with down the road.
Conclusion
Life insurers employ a range of profit generation strategies beyond just collecting policy premiums. Leveraging underwriting data, managing assets, providing investment services, reinsuring policies, earning interest on policy loans, charging rider fees. And utilizing tax deferral all contribute to a company’s profit margins. The pool of premiums collected is invested to earn substantial investment returns over time as well.
While paying out death benefits makes up the largest outflow for life insurers. They optimize their profitability through prudent underwriting practices and diversified income sources. This enables them to meet their claims obligations to beneficiaries while maintaining healthy profits levels year after year. Though payouts of death benefits are never certain. Life insurance companies use advanced modeling and sound financial management to earn consistent returns from their book of policies.
