The coverage that life insurance policies offer is a lot of money – often in the hundreds of thousands or millions. However, the premium payments you pay over the course of your policy’s life don’t even come close to matching your face amount, even on the lengthiest plans. That raises the question: How exactly do insurance carriers stay in business if they need to pay claims? Where does all of that money come from? How do your payments turn into thousands of dollars of coverage?
Playing the Odds
Life insurance is a business built on big-picture statistics. Since modern life insurance was introduced 200 years ago, the minds in charge of these companies have gathered exhaustive data on how people live and die. Their intensive mathematical models for predicting how long a person will live are most likely the closest thing we have to seeing the future, and all of that information goes towards providing the right prices for every client.
When you’re approved for a policy, the carrier has priced your plan strategically. If, according to the statistics, you’re going to live past your policy’s term length, it’s probable that your family isn’t going to have to file a claim, so they won’t have to pay out your policy’s face amount. With enough of these safe bets, they are able to generate enough profit to cover the less-likely scenario of someone dying during their term.
Basically, when most people pay for life insurance, they pay only for the peace-of-mind that the plan offers and will never need to file a claim with the carrier. These clients’ premiums add up to the money needed to cover the death benefit of the few clients who end up having need of the financial protection that life insurance offers. If you outlive your coverage, the money you paid will go towards a family that was less fortunate than yours, and needs the financial protection of their policy.
Due to the efficiency of the statistics used by life insurance carriers, and the prices that carriers charge when applicants come to the table with risk factors, the company is able to continue making money and paying out death benefits for the few cases that require it.
For example, let’s say that the average insurance policy is issued to a 35-year-old male – $500,000 for 30 years at the cost of $38.33/month at best class. That’s around $460 per year, totaling $13,978 over the life of a policy. $13,978 is around 2.8%, or 1/36, of $500,000, which means that the premiums paid by 36 applicants will cover a 37th who passes away and needs to claim their death benefit.
Now, anyone can see that a 3% margin of error makes for bad business– it would be difficult for any industry with only a 3% chance to break even. However, the carriers don’t just let the money that comes in sit around.
When your payments reach the carrier, they don’t just leave it in the vault until someone needs it – they put your premium payments to work through investments. As soon as premium payments come in, that money is put into safe investments designed to generate small amounts of profit while keeping the invested premium safe from instabilities in the market.
Insurance companies are actually regulated by the federal government, and are required to set aside reserves (dollars put in very safe and liquid investments that produce little or no interest income), and invest in safe long term investments like bonds and real estate. A very small portion of the income is allowed to be traded on the stock market, but only within very strict guidelines.
If carriers were heavily invested in the stock market and there was a stock market crash, it could jeopardize the carrier’s ability to pay claims. Interestingly, because of the recent low interest rate environment today, insurance companies are beginning to increase premiums on their products because there is little or no margin of difference between what they make on the investments and what they need to pay expenses.
But what happens if something like a natural disaster happens and hundreds of families need their insurance payouts at once? If the carrier doesn’t keep their money on hand and can’t pay for the costs of insuring a huge disaster, do they go into the red? Well, buckle up, buttercup, because this is where things get wild.
To cover large losses due to wide-scale incidents like natural disasters in which the carrier can’t get the money together fast enough to meet all of the claims taken out, carriers buy a special type of insurance called “Reinsurance.” Yes, that’s right, insurance carriers take out insurance on your insurance.
Reinsurers work in almost exactly the same way that insurance carriers do – they collect nominal premium payments from the carrier in exchange for taking on some of their losses. The practice of reinsurance allows insurance carriers to take on more policies than they could otherwise, because it mitigates the risk of larger incidents.
Put simply, a reinsurer pays either a percentage or predetermined portion of the losses that an insurance carrier would suffer during a disaster. This can either be a percentage of the claim, or any amount above a certain threshold the carrier is willing to cover.
For example, if a group of people had life insurance coverage equaling $10 million between them all, and the carrier insuring those people had reinsurance which covered 75% of large-scale disaster costs, the insurance carrier would only have to suffer $2.5 million in losses directly. Alternatively, if a carrier purchases reinsurance for any claims over $250,000 per policy, any policy would only cost the carrier up to $250,000 directly, while the reinsurer would assume the rest of the costs.
The 9/11 attacks on the world trade center highlighted the importance of reinsurance in the industry – without insurance many of the victim’s families wouldn’t have been able to replace the incomes of those who died in the attacks, but the insurance industry was able to pay billions in life insurance claims quickly and without any holdups longer than necessary thanks to the deep pockets of their reinsurers.
Reinsurance works on a much larger scale than personal insurance, and as a result, they’re often some of the most financially stable businesses on earth. If you go looking for the stories behind reinsurance carriers, you’ll often find some extraordinary things. For example, Munich Re – the world’s leading reinsurer – was the only insurance company to remain solvent and active after the San Francisco Earthquake in 1906. Swiss Re, another worldwide reinsurer, got its start when the town of Glarus went up in flames in 1861, and the Helvetia Insurance Company realized that Switzerland was drastically unprepared for disasters of that scale.
Due to the fact that a carrier won’t go out of business if a large-scale disaster hits and they won’t need to empty their vaults to pay out their policies, reinsurance lets them take bigger risks in offering coverage. By exchanging losses for ongoing payments, the practice of reinsurance also stabilizes insurance prices and makes sure that carriers can pay large face amount policies quickly.
All of these systems work together in order to keep people covered and the insurance carriers afloat during financial ups and downs. Your money goes towards claims, expenses, investments and reinsurance payments, all of which allow the carrier to provide coverage to more families.
The end result of all of this is that life insurance ends up being a very simple product for the customer. The risk reduction offered by safe investments and reinsurance result in lower prices, and the guaranteed payout that those practices offer means consistent coverage for those that qualify for coverage and have need of the protection of a policy.
If you’d like to know some more customer-focused information about life insurance, you can check out the rest of our blogs here at Quotacy, or get in touch with us for more information – we’d be happy to tell you what you want you want to know.
Photo Credit to Chris Dlugosz