When you are young and healthy and life insurance is so cheap, it's hard to see how the insurance company actually makes any money. And, before you buy a life insurance policy, it’s important to have a firm grasp of how the company's policies work and an understanding of the financial incentives of the company.
How Do Life Insurance Companies Profit?
Life insurance companies generate revenue in a handful of ways, namely premiums, investing, and forfeited premiums. Let’s break down how each of these leads to profit for insurance companies.
Premiums
The primary way that life insurance companies make money is through policyholder premium payments. This is the money you pay to keep your policy active, and your unique factors determine how much your life insurance premiums will be.
Your age, health status, policy type, and coverage amount all play a role in how high your premium is. At the end of the day, the higher your risk of dying in the foreseeable future (this is where age and health status come in), the more you can expect to pay.
Investing
To make the most of customers’ premium payments, life insurance companies invest that money. Providers typically do this by investing in a diversified portfolio of assets to help spread out their risk. They can afford to do this because they don’t have to pay out anything on life insurance policies until the policyholders die, so in many cases, they have decades of premium payments to play with. These investment earnings can help offset the cost of expensive death benefits and operating expenses.
Lapses and expirations
One significant way that life insurance companies profit is when an insured person either allows their policy to lapse or their term policy expires before their death. In either case, the insurance companies don’t have to pay out a death benefit but keep any premium payments you make.
How Does Life Insurance Work?
The way that life insurance works primarily depends on what type of policy you choose. There are two main types of life insurance policies: term life insurance and permanent life insurance.
Term life insurance
When you buy a term policy, you only receive coverage for a set amount of time. Usually, these terms range from 10 to 30 years. You only make premium payments during that period and your beneficiaries only receive a death benefit (aka an insurance payout) if you die during that term. Term life insurance is usually the more affordable option and can be a good fit for young families on a budget who want to ensure their kids will have financial protection until they come of age.
Permanent life insurance
With a permanent life insurance policy, your policy will remain in effect your entire life as long as you continue to make payments. This option is more expensive, but you gain a cash value that grows over time in addition to the death benefit.
You can borrow against this cash value or spend it before your death, but when you do, it lowers the amount of money your beneficiaries receive on your death. The cash value also grows tax-deferred over time. If you have a spouse or child who will need financial support for the rest of their lives, this is the better option.
Two different types of permanent life insurance are whole life and universal life. These types of policies include the option to invest the cash value of the policy. Investing this money can pay off, but it also comes with risk, just like any other investment.
Related: Term Vs Permanent Life Insurance: Key Differences
Managing your life insurance
The most important thing to remember about any of these policy types is to always make payments on time (this may be monthly, quarterly, or annually, depending on the policy terms) to keep the policy active. A lapse in payments could mean your beneficiaries won’t receive the full death benefit in the event of your death.
Related: How Much Does Life Insurance Cost?
Designating beneficiaries
Speaking of beneficiaries, you don’t have to leave your entire death benefit or cash value to just one individual. You can choose to split these payments up among multiple different people, such as a spouse and your children. If your beneficiaries do ever receive a payout, a major benefit of life insurance is that they won’t have to pay income tax on that money.
It can be a good idea to prepare your beneficiaries on what steps they need to take upon your death to cash in on the policy. Usually, the beneficiaries have to file a claim after the policyholder dies and provide a death certificate and other key documentation.
Related: How Much Life Insurance Do I Need for My Family?
FAQs
How much is life insurance?
Generally, you can expect to spend anywhere between $15 and $200 per month on life insurance premiums. However, the best way to understand how much life insurance will cost you is to request quotes from a handful of different life insurance providers. The type of policy, desired benefit amount, your age, and many other factors can all influence how much you spend for coverage.
How do I know my life insurance company is stable?
When you choose a life insurance company, you want to feel confident the company will be around for a long time and be able to pay out claims (ideally, many decades in the future). The good news is that experts do a lot of this research for you. Check out financial stability ratings for any insurance companies you may want to work with, such as those offered by A.M. Best, Standard & Poor's, Moody's, and Fitch Ratings. You may have to create a free account to view these ratings.
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