How Do Life Insurance Companies Make Money?
If you are shopping for life insurance, it might have crossed your mind how do insurance companies make their money? After all, you are paying premiums every month for coverage, so where does that money go?
Although life insurance companies provide a valuable service, they are still businesses. And like any business, their ultimate goal is to make a profit.
In this article, we will discuss how life insurance works and answer the question of how life insurance companies earn their money.
How Life Insurance Works
Before we get into how insurance companies make their money, you should first understand how life insurance works.
When you purchase a life insurance policy, you essentially enter into a contract with the insurance company. You pay premiums typically on a monthly basis, and the insurer agrees to pay a death benefit to your designated beneficiaries if you die while the policy is in force.
The payout your beneficiaries receive can be used for any purpose, including final expenses like outstanding debts and funeral costs, but also to help with other financial needs, like replacing your lost income.
There are two main types of life insurance policy – term life insurance and whole life insurance. Term life insurance provides protection for a predetermined length of time. In contrast, whole life insurance covers you for the entirety of your life. The benefit is paid out whenever you die, regardless of when.
Another option is over 50’s life insurance, which doesn’t require a medical examination and is geared towards people in, you guessed it, their fifties or older.
Now that you know how life insurance works, let’s look at how insurance companies make their money.
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The Business Models of Life Insurance Companies
The life insurance business model is based on risk assessment. Insurance companies use actuarial science to calculate the likelihood that an insured event will occur and determine the premium that should be charged to make a profit while still providing coverage. They then make strategic investments to maximise profits.
The key components of the life insurance business model are underwriting, policyholder behaviour, and investment income:
- Underwriting – is the process of determining whether or not to offer coverage and, if so, at what price.
- The actions of the insurance policyholder – refer to how often people file claims and how long they stay with the company.
- Investment income – is the return the company earns on its investments. Together, these are the primary factors determining how profitable the life insurance business model can be.
Life insurance underwriting is the process of assessing an individual’s risk to determine the coverage rate. The underwriter will consider factors such as age, health, lifestyle, and occupation to make a decision.
From Statistica’s 2021 UK mortality rates (per 1,000 people), this is how age affects your probability of dying.
How life insurance companies calculate your premium is based on the figures below and other factors
|Age||Male Mortality Rate||Female Mortality Rate|
|20 to 24 years old||0.4||0.2|
|25 to 29 years old||0.6||0.3|
|30 to 34 years old||0.8||0.5|
|35 to 39 years old||1.2||0.8|
|40 to 44 years old||1.9||1.1|
|45 to 49 years old||2.9||1.8|
|50 to 54 years old||4.4||2.7|
|55 to 59 years old||6.5||4|
|60 to 64 years old||10.1||6.5|
|65 to 69 years old||16||10|
|70 to 74 years old||24.8||16.2|
|75 to 79 years old||43.2||29.1|
|80 to 84 years old||137.8||104|
In some cases, a medical exam may be required to get an accurate picture of the applicant’s health. The underwriter will also review the applicant’s medical history and any family history of illnesses or conditions that could impact life expectancy.
These factors will determine your mortality risk, which is the risk of dying during the policy’s coverage period. The higher your mortality risk, the higher your premium will be.
For example, a heavy smoker may be charged a higher premium than someone who doesn’t smoke, as they are more likely to develop smoking-related health problems.
Or an obese person may be charged a higher premium than someone of average weight, as they are more likely to develop obesity-related health problems.
This ensures that premiums remain fair for all policyholders and mitigate risk for the insurance company. As a business, the insurance company wants to ensure that it doesn’t lose money by paying out more claims than it takes from premiums.
This is where actuarial science comes in – underwriters will use data and statistics to help them assess risk. It can be a complex process, but ultimately it boils down to ensuring people are paying the right price for their coverage.
Excellent underwriting is the key to a profitable life insurance company. If an insurance provider can accurately assess the risk of insuring an individual, they are more likely to profit from the policy.
Multiply this by thousands or even millions of policies, and it’s easy to see how lucrative the life insurance business can be.
The Actions of The Insurance Policyholder
Another important factor in the life insurance business model is policyholder behaviour. This refers to how often people file claims and how long they stay with the company.
Life insurance companies make money when policyholders pay their premiums and don’t file claims. Frequent claims will increase the company’s operating costs and can cut into profits. The companies model their premiums based on the expectation that most policyholders will not file a claim.
Insurance holders who allow their policies to lapse can also generate profits for insurance companies. They might have been paying premiums for years without ever making a claim, but as soon as they stop paying, the policy is no longer active.
While a high number of customers paying premiums is ideal, lapsed life insurance policies mean that money has been paid into the pot that will never be used to pay out claims. Essentially free money for the life insurance company.
Similarly, term policies usually end without any claims being made. This is because people often outlive the terms of their policies. A couple might take out a term policy for 10-20 years when their children are young.
But by the time the policy expires, the kids are grown and gone, and the couple is no longer in need of life insurance. The money they’ve paid into the policy over the years is pure profit for the life insurance company.
However, unless the customer takes out another policy, this is still lost future revenue for the insurance provider and can no longer be invested to generate returns.
Although insurance providers might generate revenues directly from premiums, the income they make by investing the money they receive in premiums is typically far greater. While a certain amount is set aside to cover claims and operational costs, most premiums are invested.
Life insurance companies often have extensive diversified portfolios across many different asset classes, which helps mitigate risk and protect against losses in any area. Investment income can come from a variety of sources, including stocks, bonds, real estate, and even private equity or hedge funds.
They will also earn dividends and interest from their investments, which can add to a significant amount of money over time.
Life insurance providers are conservative with their investments since they need to maintain a high level of safety and security for policyholders.
For this reason, life insurance companies typically invest in relatively safe and stable instruments. They have excellent in-house investment teams or work with external money managers to get the best returns possible without taking on too much risk.
The bottom line is that life insurance companies follow the route of many other successful businesses; they sell a service for more than it costs to provide that service. They make their money by investing in the premiums they collect and carefully underwriting the risks they take.
Life insurance companies play an important role in society by providing a safety net for families in the event of an unexpected death. And while they do make a profit, they also provide a vital service.
If you are looking for affordable life insurance, get a free, no-obligation quote from Insurance Hero today. We work with the top providers in the UK to get you the coverage you need at the best price.
Do life insurance companies make money avoiding payouts?
No, insurance companies are not in the business of avoiding payouts. On the contrary, the ABI (Association of British Insurers) published statistics that show that 98% of all claims were settled in 2020. The reasons for the other 2% are usually due to non-disclosure, missed payments or terms and conditions not being met.
What happens if my life insurance provider goes bankrupt?
A life insurance company filing for bankruptcy is very uncommon. In fact, the last case was during the financial crisis of 2008. Usually, if a life insurance company becomes insolvent, there are two outcomes. Another life insurance company takes them over. This way, the policyholders don’t have to worry about their coverage.
The other is that the policyholders are refunded. In the UK, the Financial Services Compensation Scheme (FSCS) protects consumers if a life insurance company goes bust. This includes compensation of up to £85,000 per person.
So while it’s never good news when a life insurance company goes bust, there are some safety nets in place to protect consumers. And if you’re worried about your own policy, you can check to see if your insurer is registered with the FSCS.
How much do life insurance companies make?
The life insurance industry is very profitable. According to Statistica, in 2019, the UK life insurance sector had written over 175 billion pounds in gross life insurance premiums. The biggest provider in the UK is Aviva, which in 2021 had an adjusted operating profit of around £2.3 billion.