How do life insurance companies make money?

Ratehub.ca
by Ratehub.ca October 28, 2019 / No Comments

As far as business models go, some are simple to understand. A corner store sells gum for more than they bought it for, while a carpenter charges for time and materials. For life insurance however, how money is made is a little less obvious.

Despite it being a little complex, understanding how life insurance companies make money is important to understanding how life insurance works, and which type of life insurance is right for you.

Here at Ratehub we spend a lot of time pouring over life insurance policies, so here’s our explanation – from simple to complex – of how life insurance companies make money.

A quick guide to life insurance

For the uninitiated, here’s how life insurance works. A person takes out a policy for a given term (eg 10 years). That costs them a certain amount per year (the premium). In exchange, the life insurance company promises to pay a death benefit (eg $100,000) if the person were to die within the term. The payment goes to the person’s beneficiary (eg their partner or child).

It’s reasonable to wonder then, how do insurance companies make money if they’re constantly paying out hundreds of thousands in benefits? In short, it’s thanks to lots of cold calculations…

Math over magic

There’s no black magic or trickery involved in how life insurance companies make money, but there is a lot of very complex mathematics.

Instead of Order of the Phoenix, think Order of Operations. While Harry Potter and the Prisoner of Algebra may not sell well, if Harry was an Actuary instead of an Auror, he’d be reading A Guide to Mathematical Methods instead of A Guide to Medieval Sorcery.

Seriously though, insurance companies are very precise when it comes to balancing risk. Every person that buys life insurance is assigned a mortality rate based on a range of factors, including their age, health, smoking habits, job, and family history.

Here’s an example of how age impacts your likelihood of death, based on numbers from Statistics Canada:

Age Probability of death in the next year (Males) Probability of death in the next year (Females)
10 0.01% 0.01%
20 0.06% 0.03%
40 0.12% 0.08%
60 0.72% 0.46%
80 5.08% 3.47%
100 35.46% 31.19%

Based on numbers like these, life insurance companies figure out a premium to charge you. The more likely you are to die within the term of your coverage (eg the next 20 years) the more you’ll be charged.

That also means a longer term will attract higher premiums, as it increases the likelihood that your policy will pay out. For permanent life insurance, which covers you for life, the premiums are significantly higher, as the policy is guaranteed to pay out one day.

If you live long enough, you will probably pay more in premiums than your benefit pays out – this is what happens with most policies. What you’re really paying for in this case is the certainty that at any point in your life, your debts will be repaid and you family will be provided for.

However, if you die early, your death benefit could be much higher than the premiums you’ve paid – don’t think of this as a good investment though, as it comes with a pretty big downside! In this case, the insurance company makes a significant loss.

So how can life insurance be profitable? As before, it’s all a numbers game…

The incredible power of large numbers

Again, it’s math rather than magic that makes life insurance profitable. A slightly morbid way of thinking about life insurance is that the company is making a bet on your life. If you live long enough to pay more premiums than your death benefit, they win! But if you die young, they have to pay out a benefit early, and they lose… as do you.

Over the long term, however, the life insurance company is almost guaranteed to make a profit. That’s because the sheer number of people they ‘make a bet on’ will either live long enough to pay more than their benefit, or live beyond the point that they need life insurance anymore. In these cases, the premiums paid convert into pure profit.

A more cynical comparison would be to a casino. While some gamblers make huge money off a lucky win, the tens of thousands of bets made by punters each night mean that, over time, the house always wins. Unlike casinos however, life insurance companies are selling a product that truly makes people’s lives better, rather than profiting off an addiction.

This is the reason life insurance companies employ hundreds of thousands of actuaries and data scientists – every risk factor is taken into account, and new datasets from both inside and outside the company are used to update their assumptions. It’s incredibly demanding work, but over many decades and many millions of customers, it’s almost guaranteed to average out in the company’s favour.

So, life insurance companies make a profit by making sure they collect enough premiums to cover the cost of the benefits they pay out. But there’s one more way that insurance companies make money, and it’s a big one…

Making money with money

Life insurance companies regularly rank in both the oldest and biggest companies in the world, up there with banks and oil companies. While just selling life insurance is profitable, that’s not the reason why life insurance companies make as much money as they do.

Life insurance companies need a huge amount of working capital to function. They literally have to hold onto most of the premiums they collect so they have enough cash available to cover death benefits.

Like any large sum of money, this can be used to make even more money through investing. With access to literally billions of dollars, life insurance companies can invest in a wide range of markets and financial products to maximize their returns. Having a tonne of data scientists on staff, their financial analysis is as sophisticated as the best and biggest hedge funds.

While some of the returns generated by these investments are used to reduce policy premiums, or are returned to universal life insurance policy holders, they are mostly absorbed into the bottom line of the insurance companies themselves.

The Bottom Line

Life insurance companies make money by selling a product for more than it costs to provide, and by investing the cash they need to hold onto. It’s a robust business model that helps to explain the size and longevity of many life insurance companies.

That doesn’t mean life insurance companies make profits at the expense of customers. The incentives of life insurance companies are closely aligned with those of customers – insurers make more money the longer a customer lives, and most customers want longer lives. It’s also good for customers that life insurance companies are big and hard-to-fail, as they literally need to outlive their customers.

Hopefully this satisfies you with regard to how insurance companies make money. Check out our education centre if you’re keen to learn more about life insurance. If you’re interested in purchasing life insurance, your best bet is to compare quotes between the various companies, which we can also help with.


categories: Insurance Life Insurance
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