Life insurance companies make money through the premiums paid by policyholders. They also invest a portion of those funds in stocks, bonds, and other interest-bearing securities to generate additional income.
Given that the average life insurance policy payout in the US is $160,000 and, in some cases, may amount to millions, the question arises as to whether life insurance companies rely on other entities to cover these costs.
So, how do life insurance companies make money and manage to remain profitable despite offering coverage for potential tragedy? Read on for the details!
Life Insurance Business Model
Life insurance companies operate on a solid business model that allows them to make a profit mainly by assuming and diversifying risk. In general, the financial stability of insurance companies rests on the monthly or annual premium payments made by policyholders, but that’s not all. They must also:
Assume and price risk
Once the premiums are collected, the insurance company calculates the risk level posed by each policyholder, based on factors such as age, health, and lifestyle habits.
They use this information to determine the policy’s cost and the amount of coverage the policyholder will receive. With the help of underwriters, the company is able to assess the likelihood of the policyholder filing a claim and calculate the appropriate premium to charge.
Invest in premiums
Insurance companies also invest a portion of the premiums they receive to generate additional revenue. These investments are made mainly in the financial market or real estate, with the objective of earning a higher return than the cost of the policyholder’s payout.
Increase the number of policyholders
Life insurers benefit from a unique phenomenon – the law of large numbers. This law states that the more policyholders an insurer serves, the easier it is to predict the potential financial losses caused by policyholder claims.
Consequently, with an increased number of similar policyholders, insurers are able to spread their financial risks across a larger pool of individuals, reducing the company’s overall risk exposure.
Note that it’s not unusual for some life insurance policies to have a large payout, making policyholders wonder if the insurance companies have enough funds to cover every potential payout.
However, a large payout is not a major concern to life insurers, or to the income of insurance agents as they use careful calculations and predictions of the likelihood that a claim will be filed.
How Do Life Insurance Companies Make Money?
Life insurance companies make profits by setting premiums at strategic prices and investing wisely. They depend on multiple sources of revenue, with premiums being the main one, but they also rely on the profits they make from investing premiums in financial instruments as well as cash value investments and lapsed policies.
To operate successfully and produce a steady stream of income, life insurance companies rely on:
Underwriting
This type of income refers to the difference between the amount collected by life insurance companies through selling insurance policies (premiums) and the amount paid out for claims or final settlement.
Investment income
Insurance companies invest part of the premiums they receive in order to generate additional income. They typically invest in a variety of assets to diversify their portfolios and mitigate risk. Some of the most common investment vehicles include stocks, bonds, real estate, and mutual funds.
Fees from ancillary services
Typically, both permanent and term life insurance companies make money by charging fees for administrative services, such as processing claims and managing policies. In addition, some insurance companies offer additional services, such as financial planning or investment management, which generate additional revenue.
Cancellations of cash value
Customers who have whole life insurance policies often request the cash values or dividends earned by the insurance company’s investment plans. Some may even consider surrendering their policy. This allows insurance companies to profit, as they are no longer liable once the cash value is paid to the customer.
Lapse of coverage
When policyholders stop paying their premiums, life insurance companies are not obligated to pay out any death benefits if the policy lapses. Thus by not returning any partial or full amount of the premium, they are able to make a profit from the policyholder’s money.
Loss ratio
Insurance companies calculate a loss ratio for each year by using various statistical methods. This ratio considers reserved losses, paid total losses, and operating expenses.
Do Life Insurance Companies Make Profits?
Yes, life insurance companies make profits. As a matter of fact, the revenues of life insurance companies in the US amounted to $159.5 billion in 2021.
The profitability of a life insurance company depends on a number of factors, including the level of competition in the market, the quality of the company’s investment portfolio, and the efficiency of its operations.
How Do Life Insurance Companies Pay Out Claims?
Life insurance companies typically pay out claims in a lump sum to the designated beneficiaries of the policy. In fact, according to life insurance statistics, companies paid a record amount of approximately $100 billion to life insurance policy beneficiaries in 2021.
The process for claiming and receiving the payout varies depending on the specific policies and procedures of the insurance company, but generally follows these steps:
- Notification of the claim – Beneficiaries or policyholders contact the insurance company and provide a death certificate to notify them the insured is deceased.
- Verification of the claim – The insurance company verifies the claim by reviewing the policy and cause of death.
- Beneficiary designation – The company identifies and verifies the designated beneficiaries of the policy.
- Payout calculation – The amount of the payout based on the policy value and any applicable terms and conditions are calculated by the insurance company.
- Payout processing – Once the claim is verified and the payout amount is determined, the insurance company distributes the funds to the beneficiaries.
Note that some policies may have certain exclusions or limitations that could impact the payout, such as suicide within a certain period of time after the policy is purchased. Other policies may offer different payout options, such as periodic payments over time rather than a lump sum.
The Takeaway
To sum up, life insurance companies make money through premiums paid by policyholders and make investments to supplement that revenue. Investing in higher-returning securities and a larger customer base also help to predict potential costs and minimize risks.
That being said, it is clear that careful and diligent management is necessary to guarantee the financial stability of these companies.