How Do Life Insurance Companies Make Money?

As everyone dies eventually, you might wonder how life insurance companies can make enough money to be profitable businesses. One reason is that people die at different times and the population keeps growing, so there is a pool of money paid by new entrants that can be used to pay claims. In addition to premiums, companies also make money on policy lapses and claims that they don’t end up paying. And, if a life insurance company invests smartly, it can grow a portion of the premiums to help pay claims. Keep reading to learn more about how life insurance companies make money.

The fundamental business model of all insurance companies is much like any other business model; they want more incoming revenue than outgoing expenses and to turn a profit. Life insurance companies‘ outgoings revolve mainly around paying insurance policy claims. This means that they will do the following:

These all take into account the business thesis that every single policy has a risk of a payout. Charging higher premiums and battling claims helps insurance companies maintain this profit model. However, changing demographics could possibly play a major role in the future of life insurance if population growth slows down. That is to say, a growing number of new people should enter the life insurance pool to help offset the costs of older people that pass away. Demographic changes in the Western world could change this model, as people tend to live longer and birth rates are dropping.

Let’s break down the different ways insurance companies try to turn a profit.

Collecting premiums from as many people as possible is the primary way that insurance companies make money. In order to determine the amount to charge each customer, the insurance company will assess the customer’s risk level with an application and underwriting process. As mentioned above, life insurance companies want to collect as many premium payments as possible. However, from a financial perspective, they don’t necessarily want to pay out all the claims.

Take, for example, a morbid exemption called the “slayer rule,” which states that a person who murders another person cannot benefit from the victim’s life insurance policy. This is one of many reasons, such as failure to disclose an illness or missed payments, that a life insurance company might want to fight paying a claim. Saving on some payouts can help life insurance companies maintain profitability.

If you’re thinking about purchasing a life insurance policy, compare your options so you can find one with an affordable premium.

Life insurance companies will invest a portion of the premiums they charge in different investment vehicles to produce investment income and grow their capital. For example, a life insurance company might have an investment strategy that includes money market funds and a blue-chip benchmark index, such as the S&P 500. If you have a whole life policy that also acts as an investment vehicle, then the life insurance company will make money by charging fees on the portion you invest.

For cash value investors looking at permanent life insurance rather than term life insurance and who want to use their life insurance as an investment vehicle, life insurance companies can add percentages as “management fees.” For instance, if your portfolio under your life insurance wrapper returns 10% a year, a couple of those percentage points might go to fees. Make sure you double-check this, as life insurance companies often add on investment fees.

Some life insurance policies come with excessive fees. These can be fees slapped onto the premiums, percentages taken out of investment growth, or charges when the policy is paid out. Matt Schmidt, a licensed insurance agent and owner of Diabetes Solutions LLC., found one particular policy outrageous. “One type of policy that falls into this category is a variable universal life insurance policy,” he says. “It’s very common for a VUL to charge fees from .75% to 2.25% depending on the life insurance provider. Fees include sub-accounts, mortality, and expense fees that will eat away at the accumulation of cash value over time. If you think you can cancel the policy and cash out all your cash value, you’ll also need to understand that there are surrender fees for up to 15 years.

Another way life insurance companies can make money is by reinsuring other policies. Most of the reinsurance business does not deal directly with the specific policyholders but rather buys packages of financial instruments that help spread the risk.

The fundamental business model of life insurance companies is to pay out less in claims than they collect in premiums. To do this, they do all kinds of risk analysis on applicants while the loan goes through the underwriting process. They also make money by investing a portion of the premiums they collect and charging different types of fees and penalties. Companies also make money with universal and whole life insurance policies that have investment components.

Yes, life insurance companies make a healthy profit. Particularly if they are life insurance companies specializing in cash-value investing, they can charge significant fees.

Life insurance payouts can happen in a number of ways. A lump-sum cash payment is the most common and favored method of life insurance payouts. However, life insurance payouts can also be done via a life insurance annuity or a retained asset account.