When you think about how life insurance works, you might wonder exactly how insurance companies are able to make money. After all, the amount you pay in premiums for your term or whole life insurance policy is unlikely to add up to the amount the company will pay out on your policy, even if you lead an exceptionally long life. Suppose you pay $200 a month for a $400,000 whole life policy from the time you’re 20 years old. Even if you live to be 100 years old, you’ll still fall shy of shelling out even $200,000. So your insurance provider will end up paying more than double what they’ve earned from your payments. And most people neither start paying for a policy that early nor do they live that long. So how do life insurance companies stay in business?
There are, in fact, several ways that life insurance providers make money on the policies they sell. First, they tend to include clauses pertaining to certain scenarios occurring within the first two years that you have a policy. For example, if suicide is determined to be the cause of death, a newer policy may not pay out. And if the insured is older at the time the policy is obtained (say, over the age of fifty), beneficiaries may only receive partial benefits if death occurs within the first couple of years. Then, of course, there are term policies to consider. Some people who carry term policies will allow them to lapse before they pay out. The reason for this is that the cost of term policies increases with age. So every time the insured has to renew, they are paying higher premiums. Eventually, they may not opt to renew.
But these circumstances are only the tip of the iceberg. For the most part, insurance providers stand to lose in the long run, all things being equal, since most people eventually come around to procuring a whole life policy and they hang onto it until they pass away. Most insurance providers make some money from underwriting. In exchange for the risk they take on, they charge a fee that comes out of every premium paid. This amount goes up over time as clients age and risk increases. If you read the fine print of your policy, you’ll see that while your payment might not change, the portion allocated to the underwriting fees almost certainly increases. And if a company earns more in underwriting fees each year than they pay out on policies, they’ll turn a profit.
However, the greatest source of income by far is the money they make investing the funds they’re holding for the purposes of paying out claims. Your premiums are invested into stocks, bonds, mutual funds, and other accounts that earn interest. With millions or even billions of dollars invested wisely in a diverse portfolio, insurance companies stand to turn a huge profit, and this is how they earn enough capital to remain in operation, pay out claims, and continue to grow. So if you’re worried about a life insurance provider having the money to pay out your claim down the road, keep in mind that their investment strategy ensures they make plenty of money from the premiums you pay.
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