Ben Nguyen 
Life insurance companies rely on a multifaceted business model to generate profits and remain financially stable in the long term. While it may seem straightforward on the surface – collect premiums and pay claims – the reality is more complex. Understanding how insurers make money is essential for consumers looking to purchase policies, as it provides insight into how premium rates are set, why some policies lapse, and what factors influence an insurer’s financial strength.
In this following article of Life Buzz, we’ll examine the various revenue streams life insurance companies in Canada depend on and explore how their profitability impacts policyholders. From the underwriting process to investment strategies, policy lapses to reinsurance, we’ll cover all the key elements of the life insurer’s business model.
KEY TAKEAWAYS
- Charging premiums is the primary revenue source
- Investing premiums to generate additional income
- Profiting from policy lapses and expirations
- Gaining from cash value investments in permanent policies
- Using underwriting to balance risks and set premiums
- Explaining concepts like combined ratios to evaluate profitability
The Business Model of Life Insurance Companies
Life insurance companies operate on a business model that relies on multiple revenue streams to remain profitable in the long term. Unlike more straightforward businesses, life insurers don’t just make money by selling a product for more than it costs to provide. Their profitability depends on expertly balancing their risks and generating income from various sources over many decades.
Understanding how life insurance companies make money is essential for a 4 key reasons:
- It helps consumers choose the right type of policy and coverage
- It provides insights into the financial stability of insurers
- It explains why life insurance is priced the way it is
- It demonstrates how insurers are incentivized to promote policyholder longevity
Revenue Streams – How Life Insurance Companies Make Money
Life insurance companies have four main ways they generate revenue and profits:
| Revenue Stream | Description | Profitability Factor |
| Premiums Revenue | Regular payments from policyholders | Direct revenue generation |
| Investments | Returns from bonds, stocks, real estate | Long-term profitability |
| Policy Lapses | Policies that expire without payout | Direct profit to insurer |
| Reinsurance | Reducing risk by transferring liabilities | Mitigates financial exposure |
Let’s explore each of these profit drivers in more detail.
Premium Revenue – The Core Revenue Source
The core revenue source for life insurers is the premiums paid by policyholders. Insurers employ teams of actuaries to calculate premiums based on complex mathematical models carefully. They aim to charge enough to cover the expected cost of future claims, administrative expenses, and a target profit margin.
Premiums must cover:
- The estimated cost of future claims (death benefits)
- Administrative expenses for servicing policies
- Target profit margins for the insurer
If an insurer collects more in premiums than it pays out in claims and expenses, it will turn an underwriting profit. However, if claims are higher than anticipated or expenses run over, the insurer can suffer an underwriting loss. The combined ratio measures this careful balance between premium revenue and claims paid (more on this later).
Investment Income – Putting Premiums to Work
Life insurers don’t just sit on the premium dollars they collect. They invest a significant portion in interest-generating assets like:
- Government and corporate bonds
- Mortgage loans and real estate
- Stocks and mutual funds
- Policy loans
The returns from these investments allow insurers to:
- Offset claim losses in adverse periods
- Fund policy dividends for some permanent life products
- Boost overall profitability and financial strength
The returns from these investments provide a significant secondary revenue stream. Investment income often exceeds underwriting gains and can help offset years with high claims or other losses. The amount invested and the returns generated are huge with permanent life insurance policies with a cash value component.
Skilled portfolio management and risk analysis are critical to an insurer’s long-term stability and growth. Rising interest rates generally benefit life insurers by increasing their investment yields.
Policy Lapses & Expirations – When Coverage Ends Early
Term life insurance policies only pay a death benefit if the insured dies within the coverage term (usually 10-30 years). If the policy expires before then, the insurer keeps all premiums without paying a claim. Over 90% of term policies never pay out.
For permanent policies like whole life insurance, around 25% lapse within the first 3 policy years – often due to the high premium costs. Insurers may charge surrender fees to recoup some losses when policies are voluntarily terminated.
However, policy lapses aren’t always ideal for insurers. With permanent policies, in particular, a lapse means the loss of expected future premiums that could have been invested. Still, the net effect of most lapses and expirations is increased profitability for the insurance company.
Cash Value Investments – An Added Boost for Permanent Policies
Permanent life insurance policies, like whole life and universal life, contain an investment component known as cash value. A portion of the premiums gets directed into a cash value account that grows over time.
Insurers can invest this cash value into a larger pool of diversified assets to generate additional returns. While some of the investment gains may get passed onto the policyholder, the insurance company still benefits financially from the overall performance of the underlying investments.
The Role of Underwriting – Balancing Risk & Reward
To achieve sustainable profitability, life insurance companies must expertly manage risk. They do this through a process called underwriting. When you apply for coverage, the insurer gathers detailed information about your:
- Gender
- Health status
- Family medical history
- Lifestyle habits (e.g. smoking, dangerous hobbies)
They then use this data, actuarial tables, and statistical models to assign you a risk classification and an associated premium rate. By charging higher premiums to riskier individuals and lower premiums to healthier individuals, the insurer aims to balance out its expected claims over time.
Example: A 30-year old non-smoking female will pay much lower term life premiums than a 50-year old male smoker for the same coverage amount, reflecting their different mortality risks.
Precise underwriting is critical to an insurer’s financial stability. If an insurer underestimates the risk and charges too little for coverage, it may not collect enough premiums to offset future claims, and it may lose business to competitors if it overestimates the risk and charges too much.
This is why life insurers invest heavily in underwriting technology and data analysis. The better they can predict an applicant’s risk of passing away, the more accurately they can price the policy to generate a target level of profitability.
Measuring Life Insurer Profitability – The Combined Ratio
One of the key metrics used to assess a life insurer’s profitability is the combined ratio. This figure compares the premiums collected to the total claims paid and expenses incurred. Here’s the formula:
Combined Ratio = (Claims Paid + Expenses) ÷ Premiums Collected
A combined ratio under 100% means the insurer generates an underwriting profit. It’s collecting more in premiums than it’s paying out in claims and expenses. A ratio over 100% indicates an underwriting loss.
However, even with a combined ratio over 100%, a life insurer can still be profitable overall due to investment returns. This is why insurers strive to price policies to achieve a combined target ratio of 85% to 95%, providing a buffer for potential investment gains to boost the bottom line.
Here’s an example to illustrate:
A life insurer collects $10 million in premiums in a given year. They pay $6 million in claims and incur $3 million in administrative expenses. The combined ratio would be:
($6M + $3M) ÷ $10M = 90%
With a 90% combined ratio, the insurer achieved a $1 million underwriting profit, plus any additional gains from investing the premium dollars.
Other Factors Influencing Life Insurer Profits
While the core profit drivers discussed above apply broadly to the life insurance industry, each company’s exact financials depend on 5 other factors:
Product mix – The blend of term, whole life, universal life, and other policy types an insurer sells impacts profitability.
Reinsurance – Most insurers purchase their insurance (reinsurance) to mitigate the risk of unexpectedly high claims.
Operating efficiency – How well a company controls administrative costs affects the bottom line. Insurers increasingly leverage technology to streamline operations.
Investment portfolio – The exact composition and performance of an insurer’s invested assets plays a major role in profitability, especially during market volatility.
Regulatory environment – State regulations and capital requirements can influence an insurer’s premium rates, underwriting standards, and investment strategies.
Besides, Despite their financial strength and diversification, life insurers face several key risks:
Economic risks – Recessions and market shocks like the COVID-19 pandemic can simultaneously depress investment returns and drive higher policy lapses.
Mortality/morbidity risks – Pandemics, opioid addiction, and other public health crises can lead to higher-than-expected death claims. Insurers also face longevity risk if annuity holders live longer than projected.
Interest rate risks – Prolonged low interest rates strain life insurers’ investment margins, as they still must pay guaranteed rates on certain products. Volatile rate changes also pose risks.
Regulatory risks – Changing capital requirements, reserving rules, and tax laws can materially impact insurer financials. Privacy/cybersecurity rules like GDPR increase compliance costs.
Conclusion
As we’ve seen, life insurance companies generate profits through a multi-faceted business model. By collecting premiums, investing strategically, and managing risk through underwriting, insurers aim to remain financially stable and fulfill their promises to policyholders.
For individuals, understanding these profit mechanisms can help demystify how life insurance works and underscore the importance of choosing a reputable, well-capitalized company for such a long-term product. While paying premiums may feel like an expense, recognize that you’re really buying a piece of mind in knowing your loved ones will be financially protected if the unexpected occurs.
Frequently Asked Questions
Do life insurance companies make a lot of money?
Yes, life insurance can be pretty profitable, but it requires a long-term outlook. Insurers must carefully balance premium rates, claim payouts, and investment returns over decades.
What happens to premiums when a term policy expires?
If a policyholder outlives the term of their life insurance coverage, the insurer generally keeps all the premiums paid as profit. No death benefit gets paid out.
How do insurers make money on cash-value policies?
With permanent life insurance policies with a cash value component, insurers profit from the "spread" between the guaranteed rate credited to the policyholder and the total return achieved on the underlying investments.
Why does underwriting matter for life insurance profits?
Underwriting is how life insurers assess and price risk. If an insurer underestimates the risk of a policy or a book of business, it may not collect enough premiums to pay out promised death benefits.
How do life insurance companies invest in premiums?
Life insurers invest premium dollars into diversified portfolios of stocks, bonds, real estate, mortgages and other interest-generating assets to earn additional income. This helps them cover claims and stay profitable.
