Life insurance is a very profitable business, with top Canadian life insurers generating billions in profits year after year.
But how do life insurance companies make money? In addition to annual premiums, insurance carriers make money by smartly investing your money and through lapsed policies.
In this post, we’ll discuss in-depth how life insurance works and how life insurance providers make money. Let’s get started!
How does life insurance work?
Life insurance is a contract between you and the insurance company. The insurance company pays a death benefit to your beneficiaries when you pass away, provided 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 how much annual profit it makes.
Life insurance policies can be broken down 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 goal: to pay the death benefit if you pass on within the policy’s term. It is much cheaper than permanent life insurance and can be a right choice for people who want coverage for a limited period, for example, until they retire, pay off their mortgage, or send their kids to college.
Permanent life insurance, in contrast, provides lifelong coverage and usually includes an investment component called 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 a part of your premium dollars covers the cost of insurance. The insurer invests the other part in interest-bearing securities, which grows tax-deferred, either at a fixed or variable rate. While the cash value lowers the insurer’s risk, it also provides the policy owner with a pot of tax-free money. You can access it by making a withdrawal, taking a loan, or surrendering the policy. Premiums for such policies tend to be significantly higher — up to six to 10 times — than those of comparable term life plans.
How doos a life insurance company make money?
Life insurance carriers make money in the following three ways:
- Profiting from the insurance premiums
- Smartly investing the premium dollars
- Through lapsed policies
Profiting from the life insurance premiums
At a first glance, it may be difficult to figure out how a life insurance company makes money.
Let’s say you purchase a $1 million, 20-year term life insurance plan with an annual premium of $2,000 and pass away after 18 years. This means the insurer was able to collect only $36,000, while it must pay out $1,000,000.
This just doesn’t add up. So, how do life insurance companies make money? Do they try to come up with ways to avoid paying claims?
Not at all. In most instances, the insurer pays out the death benefit. Estimates suggest that 97% of all life insurance claims are paid.
And when a death benefit is denied, it is generally because of the below-mentioned reasons rather than due to a malicious intent.
- Suicide – All life insurance policies have a suicide clause. If you commit suicide during the first two years of taking a policy, the insurer will not pay the death benefit.
- Misrepresentation – Another clause present in all policies is the contestability clause. If you die within the first two policy years and the insurer believes you lied, omitted, or withheld key information on your application, it can contest the claim. If a misrepresentation on your application is discovered, the insurance company can deny the claim.
- Missed payments – Your policy can lapse due to a missed payment. If you pass on after your policy lapses, the insurer is not obliged to pay the benefit.
In short, life insurance companies usually do not deny a claim unless there is a good reason. If so, how do they make a profit?
Don’t worry, insurance companies know their numbers. One:only a small percentage of policies ever pay out. (More on this later.) Two:using advanced statistics and probability, life insurers price their policies in such a way as to give them the best chance to collect more in premiums in a year than what they pay out in claims. That is why each insurer follows a detailed underwriting process to determine an applicant’s insurability and set their premium rate. The greater your mortality risk, the higher the premium rate.
Some years, an insurance company may earn a profit from its underwriting income alone. For example, if the insurer collects $20 million in policy premiums in a given year and pays out $15 million in claims, that is an annual profit of $5 million.
However, even with the most advanced statistics model and the most talented underwriters, sometimes an insurance provider may spend more in claims than what it could collect through premiums. To offset this risk and maximize their profits, insurance carriers invest the premium dollars in stocks, bonds, and other types of investments.
Investing the life insurance premiums
Life insurers depend more on the income generated from investing premiums than the underwriting income to generate profits. With access to huge amounts of money and experienced investment advisors on their team, insurance carriers can invest funds in a wide range of investment products and financial markets to generate high returns. In fact, their financial analysis is every bit as advanced as some 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 the coverage ends without a benefit being paid. For example, a term life policy lapses when it reaches the end of its term and the policy owner opts not to renew coverage. In this situation, the insurer gets to keep all the premiums. Many policies also lapse because the policyholder can no longer afford the premiums. Estimates suggest only 2-3% of term life plans pay out; the rest lapse because of the expiry of the policy term or the non-payment of premiums.
Additionally, when permanent life insurance policy owners surrender their policies in return for the cash value, the insurer gets to pocket all the premiums paid and a part of the interest.
So, what does all of this mean for you as the consumer? It means that life insurance companies are in it to make money. They have to be profitable in order to stay in business and continue paying out claims.
When you’re shopping around for a policy, it’s important to keep this in mind and ask yourself whether the company is offering a good deal or just trying to take your money. Do your research and compare quotes before buying life insurance – it could save you a lot of money down the road.