Life insurance promises to pay your family or other beneficiaries a certain amount of money as long as you pay annual premiums.
People usually buy life insurance to protect their families from financial loss. Imagine the financial stress a family experiences when it loses its top earner. The mortgage that was once well within the family’s means may become impossible to pay.
Other people buy life insurance policies as investments. Permanent life insurance offers a death benefit, but it also pays grows from interest. At the end of the policy, you can cash out the policy for a large sum of money.
Life insurance policies usually have terms between 10 and 30 years. In some cases, though, you can find companies that will sell you policies for even longer amounts of time. Those policies, however, usually cost quite a bit of money.
For the most part, life insurance doesn’t cost very much. Young, healthy people can buy whole life insurance policies with fixed rates. No matter how long they live, they will pay the same premium every year.
If you wonder how life insurance companies manage to earn profits and stay in business, you’re not alone. A lot of people wonder how the companies can give millions of dollars to beneficiaries every year while collecting relatively small fees from policyholders. It turns out that life insurance companies have found some creative ways to generate profits.
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Table of Contents
Life Insurance Companies Do the Math and Measure the Odds
Life insurance companies do a lot of research before they sell policies to their clients.
By asking questions about your age, health history, and lifestyle, they can pick prices that they think will earn them profits. For instance, a healthy, 30-year-old man might get a life insurance policy that costs $250 per year. A 55-year-old man, however, will usually pay a higher premium because he has a higher risk of death.
When choosing prices, life insurance companies determine how much of a risk you are. If they think that you will pass away before the policy expires, then they will charge you a higher price. If they think it’s unlikely that you will die during the policy’s term, then they can charge lower prices.
As long as the insurance company makes the right bet, it will earn money from your premiums. Of course, some people will die, and the insurance company will have to give their families money. Since the companies have thousands or millions of policies, they can use money premiums from living clients to pay the families of deceased policyholders.
Insurance Companies Invest Premiums
Insurance companies know that a few bad decisions could cost them a lot of money. A company that collects $10 million in premiums will lose money if they pay beneficiaries more than $10 million that year.
Since life insurance companies know the risk of losing money, they invest premiums in stocks, bonds, and accounts that pay them interest. When the company invests $10 million of the payments it receives, it will generate $100,000 in profits as long as it gets a 10% return on the investment.
Even if the company pays beneficiaries $10 million, it still makes money from the investments.
Investing comes with its own risks, of course. If the stock market falters, then the company could lose all of the money it invests. Insurance companies know how to manage risk, though, so they protect their investments with diversified portfolios. By diversifying their investments, they lower the risk that they will lose significant amounts of money.
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Life Insurance Companies Count on Lapsed Policies
Some people who purchase life insurance policies don’t make all of their payments. When this happens, the insurance companies get to keep the premiums paid without paying the policyholder anything.
Few people let their life insurance policies lapse. Some experts say that only 2-3% of policyholders let their insurance expire. Even with such a small percentage of lapsed policies, insurance companies can pad their profits nicely.
For example, if you have been paying $250 per year for the last decade, you’ve given the insurance company $2,500 without getting anything in return. When you let your policy lapse, the company keeps the $2,500 and ends your policy.
$2,500 might not sound like a lot of money. When you consider that many life insurance companies have millions of clients, you can see how profitable lapsed policies become. If 2% of a million clients let their policies lapse in one year, then the company makes $50 million.
The Companies Tempt Policyholders With Cash Payouts
Whole life policies accrue interest, so they gain value over time. After 10 years of paying into the policy, you may have access to thousands of dollars. A lot of people make the short-sighted decision to take cash value payouts instead of waiting for their policies to mature.
When you want to buy a new car, several thousand dollars looks tempting. As long as some clients take the cash payout, the insurance company avoids paying the full, future value of the policy.
Even if the company doesn’t earn money from the deal, it lowers the amount of money that it spends. Regardless, it’s a good deal for the insurance company when policyholders cash in their policies early.
Like all businesses, life insurance companies have to earn profits. Their attempts to make more money, though, doesn’t have to affect the benefits you receive. As long as you make financially sound decisions, your policy should meet the needs of you and your beneficiaries.
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