I was thinking about this the other day. If i have a $500,000 life insurance policy and i pay $100/month, even if I pay into it for 50 years, that only adds up to $60,000. Then i die and my family gets $500G
So how are these companies making money, do they just bank on people dieing in ways that aren’t covered in their policy?
The basic principle is that of the time value of money. $100/month for 50 years, properly handled, is worth a lot more than $60k. If invested such that it returns 6% annually, it would be worth around $378k.
Now that’s still short of $500k, so we need to look further. Is your monthly payment guaranteed to be $100 forever (unlikely), or does it increase as you get older?
Another way of looking at this is that the insurance company knows that when the time comes to pay, they’ll be doing so with dollars that are worth less than those they received.
With term life insurance they are banking on people making it through the term without dying.
In general you will not be able to get $500,000 of life insurance over 50 years for $100/month. You will be able to get that price while you are relatively young. This price will go up as you age.
https://www.budgetlife.com/expertquotes.htm give me a quote of $655/year for 20 years if I am 40 and $14,000 if I am 69. The length of the term also varies the cost. The previous quotes were for a 20 year term. The price for the 69 year old goes down to $6,480 if the term is 10 years.
Generally speaking, insurance companies are investment firms. They make money by investing capital, and they raise capital by selling insurance. They can lose money on the insurance as long as the investments are covering the losses. In other words, a firm could take in a million dollars in premiums, pay a million dollar insurance policy off at the end of the year and still make a profit on the investment returns they earned on that million dollars during the year.
A lot of people get life insurance when their kids are young and then drop it later because they don’t think they need it anymore. I have a $600,000 portable life insurance policy with guaranteed rates for life but I could screw that up easily if I missed a couple of premiums 20 years from now and it got canceled and then the rates would soar.
They make money the same way other businesses do: assess the costs of producing their products and then add on a profit margin.
Mad magazine observed that Life Insurance is one of the few things where you lose if you win, but win if you lose…
Jeff Foxworthy does this bit where he peels off a few 100’s & says " here - I betcha I die this month". Then he changes voices to an accountant dweeb - “I bet you won’t”. Back to Jeff’s Redneck Voice . “HA!! I bet I do too!!”, etc.
I’ts better live than in a transcript; it really captures the perversity of the situation.
I took a business economics course in college, and that’s the way the Professor explained it: You’re betting you’re going to die, and the insurance company is betting you won’t 
Isn’t this perversity inherent in any insurance policy? When I pay my home insurance, technically I’m betting that my house is going to burn down, and the insurance company is betting that it won’t. Same with my car. I pay into health insurance every month, but I’m not wishing for a major illness just so I can get some use out of my policy.
I’ve often said my life insurance company probably has a statistically better chance than my doctor of predicting when I’m going to die.
By not writing a lot of checks.
ETA: it kills the joke but Googling “By not writing a lot of checks” the one and only result is for an insurance company. So Google agrees with me even if the fake bill gates quote was a paraphrase.
I saw it put this way in a comic strip once:
“So, what’s ‘life insurance’?”
“It’s a like a game where we bet that you’ll live long enough to give us more money than you’ll get in return.”
“What if I die young?”
“Then you WIN!”
Two ways: underwriting and investments.
Let’s simplify it a little. Imagine a life insurance company is going to issue $100,000 policies to 1000 people for a one year period. They collect a pot of premiums from those 1000 people. During that one year, some number of the 1000 insureds will die and collect the $100,000. The rest won’t. Underwriting is choosing who to sell the policies too and figuring out how much premium to charge.
There are different approaches to this. You could take all comers and charge them all the same amount. Of course, going into it you have to have a prediction of how many people are going to die so that you’ll have enough to cover and still make a profit. Say you think 10 people will die. So you’ll have to collect 10 x 100,000 = 1,000,000 to cover plus a little more for profit, administrative expense and a safety margin. Let’s say you decide you need 1,250,000. You charge each of your 1000 insureds $1250.
Of course you could also charge the 25 year old healthy male non-smoker less than the 75 year old diabetic overweight heart patient who smokes like a chimney because the first guy is far less likely to die during the year. After centuries, the life insurance industry is very sophisticated about predicting how many and when people will die. But the whole idea is that you collect enough from the large pool of insureds to pay the benefits of the small number that die during the year. That’s the underwriting side of it.
The other way insurance companies make money is through investment. Go back to our example. Say you collect $1,250,000 in premiums on January 1 for that one year insurance policy. During that year you invest the $1,250,000 and make a return – for ease of calculation sake, say 10%. 10% of $1,250,000 is $125,000 – Profit!
In the most simplistic terms, the life insurance company takes 1000 people all of age x, all in similar heath and determines that (10000.03) or 30 of these people will die within the next 30 years (or whatever the length of the term policy is). These 1000 people all get a $1,000,000 policy and split the cost of the $30,000,000 that will eventually be paid out. I think that works out to $84 a month per person. (84 people12 months30 years1000 people = yep, 30 mil). The company builds in some profit margin of course. If it is a mutual company less of a profit margin supposedly.
I am making up these numbers to illustrate life insurance in the most simplistic of term. The 0.03 number is especially made up.
If anybody is really interested in this topic, there’s a really fun series of actuarial exams that will teach you way more than you ever dreamed possible about exactly how insurance companies make and lose money.
When you know you’re going to die, it’s an excellent investment. I know my wife will be well taken care of at least. I think they count on you falling behind at some point and dropping your ass.
Never miss a payment.
The difference is that you’re guaranteed to die in your lifetime (or very shortly after, depending on your definition of “lifetime”). Your house burning or you being in a car crash are much less likely events.
If you keep up your life insurance payments it’s guaranteed to pay off (barring limitations on causes of death), but insurance companies make up for this, as has been mentioned, by investing the money now, and by changing the payments as their expectations of your total payments shrink.
Okay, let’s clear up a few things in this thread:
Yes, that accounts for what appears to be a low payment now (or a large payout later), but it doesn’t tell us how much to charge today to cover the risk of paying a claim at death. The risk can be quantified using Actuarial Science.
But, they are charging much less than whole life insurance. The amount of risk to the insurance company is proportionately the same. (Roughly.)
Insurance companies are not investment firms, even though they invest money. They make their money by collecting more in premiums than they pay out in claims, while keeping their other costs under control.
Yes, this is a pricing consideration based on the “lapse ratio”, i.e. how many policies remain in force over a given period of time. Lapsing too soon is bad for the insurance company because they need the policy to in be force for a few years to recover the initial underwriting and sales costs; not enough lapses can be bad because it means that there will be more death claims because more policies will be in force at the time that the insured dies.
Well, sort of. It’s a bit of a stretch to say that paying a death claim is a cost of “producing” their products. It’s an expense that is incurred after the product is sold.
Maybe. It depends on how thoroughly the insurance company has underwritten you, and on how much your doctor knows about mortality statistics. 
Perhaps. But, more by pricing their products properly, by having good underwriting, by keeping their costs under control, by effectively matching assets and liabilities, and by selling enough insurance to keep the whole thing going.
In a general sense, yes. But, only sort of, if we use the word “underwriting” in the way that it is usually used in the life insurance business.
Who to sell and how much to charge is based on actuarial, underwriting, marketing and sales considerations.
That’s correct.
Again, not in the way that the word “underwriting” is usually used in the life insurance business. The idea of “large pools of insureds” is an actuarial consideration, not an underwriting one. Underwriters evaluate one case at a time. Actuaries look at large numbers.
This means that actuaries know how many people will die, but they don’t who is going to die. (Unless, the actuary is Sicilian … ;))
Hope that helps.