To the casual observer, the life insurance industry can seem a bit mysterious. A company, of course, can’t predict when it will have to pay the death benefit associated with your policy. Yet – almost invariably, it seems – the carrier takes in enough income to make good on its promises and earn a nice profit.
As one learns more about how the insurance works, this enigma starts to disappear. The reality is that the industry is more of a science than an art. By using statistics, providers are able to make educated assumptions about how much they should charge you in order to fulfill their obligations to both policyholders and shareholders. Companies also invest proceeds in various securities, which represent an additional source of earnings.
The importance of statistics
The primary way that insurance firms make money is fairly simple – by taking in more money in premiums than they pay out in benefits. But how, exactly, can they do this reliably?
No, an insurance company can’t predict when any particular policyholder will pass away. While it knows how much Customer Y owes in premiums each month, it doesn’t know how long he’ll be paying that amount. And regardless of how long he lives, the insurer is on the hook for face value of the policy.
Insurance firms resolve this problem by analyzing their entire pool of customers. For all they know, Customer Y might only live to age 40, which would probably mean taking a loss on his account. But all the company really needs to worry about is the average longevity among all its clients – and statistically, that’s much easier to approximate.
That’s why actuaries play such a crucial role in the industry. These are the experts who utilize statistical models to calculate the company’s projected liabilities – that is, how much it has to pay out in death benefits and other expenses. Actuaries are also responsible for making sure the company has sufficient capital reserves to cover unexpected events such as an abnormally high number of claims.
Carriers also use statistics to identify the risk profile of certain customers prior to offering them a policy. In some cases, this helps the insurer to avoid individuals who simply aren’t part of their target market. Other times, it enables them to price the policy in a way that correlates to their level of financial risk. It’s the job of the underwriting department to look at specific traits – age, gender, smoking habits, blood pressure and so on – and determine the pricing tier to which the client belongs.
Another key aspect of life insurance arithmetic is determining how many customers will continue paying their policies until death. Surprisingly, most individuals either allow their policy to lapse – in other words, they stop paying the premium – or surrender it to obtain the cash balance in their account. These scenarios are a big component of life insurance profits because the company receives premium revenue for a period of time, but doesn’t have to pay a penny of the death benefit. Thus the “lapse ratio” constitutes a vital element of financial forecasting.
The rise of annuities
In the early days of the industry, virtually all of the premium income that carriers received came from life insurance or other lines of insurance that they sold. But since the 1980s, annuity income has exceeded that of their bread and butter product. Today, annuity considerations account for just over half of all premium revenue.
In a basic annuity, the policyholder makes either a series of payments or a lump-sum installment and, at a pre-determined, starts receiving regular checks from the insurance carrier. As with life insurance, actuaries help determine the appropriate pricing of the product in order to derive a profit. But the risk, from the insurer’s standpoint, is quite different. Here, the underwriter worries about the average contract holder living longer than expected and receiving more payments than anticipated.
From a profit perspective, the growth of annuities over the past few decades has been a boon to insurers for a couple of reasons. For one, they opened up a new revenue stream besides life insurance. In addition, these insurance contracts provide a high profit margin compared to other insurance products. More sophisticated varieties – for example, “indexed annuities” that tie payouts to stock market performance – often charge substantial surrender fees and limit policyholder returns, thus padding the insurer’s bottom line.
Boosting profits by investing
If an insurance carrier is fortunate enough to generate excess premiums after paying benefits and administrative expenses, it doesn’t simply put the money in a vault. Instead, it invests a substantial portion of it to create more value for its shareholders (in the case of a “mutual” insurance company, the policyholders actually own the business and receive dividends).
The challenge is to find the appropriate middle ground between earnings potential and the ability to pay financial obligations. Thus, companies usually direct a portion of their funds to conservative instruments that are less likely to experience major fluctuations in value. Consequently, bonds are the most common source of investment income, followed by stocks and mortgage-related securities.
Sources of income for life insurers (in millions of U.S. dollars).
Source: American Council of Life Insurers
The amount of money that life insurance companies invest is considerable. In 2012, life insurance companies invested a staggering $217 billion in a range of securities. While some carriers outsource money management to a separate firm, larger companies often have internal teams tasked with buying and selling securities at the right time. Some insurance carriers have even created subsidiaries that manage money for other institutional investors, providing the parent company with an additional source of fee income.
The Bottom Line
Life insurance is a highly data-driven industry that relies on complex financial models to predict future expenses and income, from both premiums and investments. By calibrating their prices appropriately, companies try to grow earnings while taking care of their financial commitments.