I’m sure I’m an unforgivable moron for not being able to figure this out, but how exactly do life insurance companies make money? Everybody dies, so presumably they have to pay out to all their policy holders eventually (unless the manner of death amounts to a breach of the contract conditions, but I’d assume those cases are the minority). As an example, I pay $20 a month for a $100,000 policy. By my calculations, I’d have to live to be 416 years old before I put in enough for them to even break even. Even if they’re collecting interest or investing the money in stocks, I can’t imagine they’re getting a big enough return on their investment to cover the payoff. Obviously, nobody’s in the business of giving money away. So how do they afford it?
Life insurance has a high-rate of cancelation. People realize that their spouse/family is in a decent financial situation already and so they cancel their policy and spend the money on a trip to Disneyworld instead.
There are also the rare instances where life insurance policies don’t pay out: Suicides often don’t pay out (especially if committed soon after the policy is signed) and so on.
Then there are those term policies that run out without the person passing on. Lots and lots of them.
Yup. $20 a month for $100K sounds like term to me.
Think of it as a bet… you’re making a 1/5,000 bet that you will die in any given month within the policy term. The insurance company has statistics that tell them this is a good bet–that you *won’t *die in that period. When the policy renews, new “odds” will be used to determine your “monthly wager.”
So one way they profit is by you not dying. Frequently they like to make sure you don’t know something about the bet that they don’t and so they’ll do a physical exam on you–just to make sure that your metaphorical “horse” isn’t doped on Lasex…if you take may point.
And they don’t just throw your money in a cigar box either. It goes to pay for overhead (marketing, underwriting, commissions, etc) and the rest gets invested–usually in a nice safe bond market for about a 3-7% yield.
The insurance industry has billions of policy dollars. The money doesn’t sit idle. Imagine if you had a billion dollars invested in an interest-paying account of only, say, 5%. In one year, simple interest would pay $50,000,000. Even on a million, it would come to $50,000 a year. I can pretty much assure you that they are getting a higher return than simple interest.
Good answers so far, but I think the OP needs a simple explanation of term life insurance. Here’s how it works: let’s say you’ve got a term life insurance policy for 10 years, at $20 a month, with a $100,000 payout. If you die at any time during that 10 years, your grieving widow gets $100,000. If, however, you survive for 10 years, you get nothing, and the insurance company gets to keep the $2400 you’ve paid in premiums ($20 a month x 12 months x 10 years).
Now you want a new policy to cover you for the next 10 years. Of course, you’re older now, and aren’t as good a bet, so that same policy is going to cost you more for the next 10 years. In fact, if you’re very old, the insurance company probably won’t sell you a policy at all, since your chances of making it, say, from 82 to 92, are pretty slim. If they will sell you a policy, the monthly premiums are going to be very, very high!
“Whole life” policies, which stay in force until you die, are another kettle of fish entirely, but essentially, the insurance companies make money on them by charging higher premiums than they do on term life policies.
In New York (and I wouldn’t be surprised if other states have similar regulations) a suicide within the first two years gets a refund of the paid premiums, but the policy does not pay out. After two years, a suicide is treated as any other death and the policy is paid.
Zev Steinhardt
I don’t know how it works exactly, but assuming that you keep this policy until your death, will the monthly payment stay the same, or will it increase over time, allowing them to charge you more when you’ll get older (hence more likely to die)?
If you’re relatively young (say 18-45) , currently, according to a quick calculation I just made, 100 000 times your risk of dying this year is significantly less than the 240 dollars you’re paying each year.
clairobscur: There are two main types of life insurance: term and whole. For term, you pay a fixed amount, based on your age, for a given amount of insurance. For whole, you have someone sit down and explain why you don’t ever want to do that. See “Consumer Reports”, listen to Clark Howard, etc.
So the strategy is: when you’re young and don’t have much savings, get term life. When you get old enough, don’t get any life insurance at all. You should have enough savings to take care of the necessary expenses of an unexpected death plus the surviving spouse isn’t going to live long enough after you to really need a huge pile of money. Note that the money you would be paying for insurance can then go instead into savings.
If you don’t save up money, you’re screwed for more than just life insurance reasons.
I like this explanation. Whole life insurance is a relevant and worth- 
while product, but not for most folks.
I have no idea how that winkey got in there. :rolleyes:
Here’s a figure I run across from time to time…90% of term policies don’t pay off.
This doesn’t mean the insurance company is evil. It means the average person with the term policy has reached a point in life where the kids are out of college, the mortgage is paid off and the price of the term insurance just hit a high mark.
The person doesn’t need that coverage anymore so he/she lets the policy lapse.
They make money in much the same that any race track joint does. Except that you and the insurance company bet on your life instead of the horse and not like a race but just to make it to the end of the term of the policy. You buy because you want to be safe in case of things going wrong and the the insurance company bets that you will keep yourself safe anf fit because no one wants to die. Most often the insurance company wins and pocket the winnings. Simple!
Thanks, guys. I knew I was missing something. It makes more sense now.
Several people here have compared insurance to a race track or betting. This is an incorrect comparsion.
Let’s boil this down to the basics.
Let’s say that you are a member of a group of 1,000 people. From death staticstics we know that on the average 1 of this group will die every year. Everyone in the group wants the family of the person that dies to have $100,000. doing some simple math that will require a premium of $100/ year per person. If at the end of the year, you have not died, that is a good thing, however somebody did die, and the $100,000 was paid out. Unlike betting where the winning may not be paid out, with life insurance someone from the group will die, the actuaries tell us that.
Now, we are going to have to hire someone to administer this fund, pay claims, print policies etc. This costs money, so the $100 levy will have to be increased by a couple of bucks to cover costs. So everyone in the group will be charged say $10 bucks for costs bringing their premium up to $110/ year.
But we have a bunch of money laying around, not doing anything, so we (the group) can invest some of this money and earn interrest. So the administrator invests some of the money and earns interest. So the policy fee of $110 will be reduced by the interest earnings. Let’s say by $3.00 for a net premium of $107.
So how do insurance companies make money? They have Billions of dollars to play with. If when setting rates, the company assumed interrest earnings of 5%, and the company actually earned 5.1% , the company has a pile of profit.
Well, sort of. In a traditional gambling scenario, you and the house are betting on different outcomes. The weird thing about life insurance is that you and the insurance company are hoping for the same outcome. In other words, I would much rather live (than die) for the next 10 years, and so would the insurance company.
Here, and I guess elsewhere, life insurance is increasingly bundled with mutual fund saving schemes - it’s called “investment-linked life insurance” or some such. So you get a guaranteed return (using the word “guaranteed” loosely) regardless of whether you die. The insurance company makes money from this additional component the same way any mutual fund does - management fees etc.
My tip - buy shares in Manulife, and take your share of the profits made from people who buy life insurance.