How Do Life Insurance Companies Make Money?
The way life insurance companies make a living is pretty much like gambling on risk- that you won’t pass away before the policy expires, or your luxury sedan won’t meet an accident, or you won’t fall ill within the policy period.
Like any other viable business model, insurance company revenue structure should profitable in the first place. The idea that drives life insurance companies is the relationship between the insurance revenue model and the customer where the insured pays a fee at regular intervals known as premiums against which the insurance company promises to pay a sum assured in the event of loss of a specific asset. Typically, the ‘loss of specific asset’ refers to illness in case of health insurance, accident/damage in case of motor insurance, and death in case of life insurance.
Most of the customers are unaware of the fact that a portion of their premium is utilized by the insurance company to attract other potential customers to buy insurance. Yes! A significant portion of the total earnings of insurance providers is used in the form of marketing expenses. Not just this, the first year of the premium you pay is paid to a broker as commission for luring a customer.
Revenue Model of Insurance Companies
In order to stay in business, insurance companies have to cover their operational and commercial expenses while generating profits at the same time. Theoretically, insurance companies make their profit by collecting premiums that are used to attract new customers and paying out claims. Apart from managing operational and commercial expenses insurance companies have to use their income to fund the salaries of their employees and whatever is left is their profit.
In real-time, the profits earned by life insurance companies are dependent on the fact that not all of their clients are going to claim so they try to sell as many policies as possible. They utilize the money collected from customers to pay for the few claims submitted out of all the policies sold. This practice is commonly termed as spreading the risk by which insurers manage to get more and more clients and the probability of making a profit rises exponentially.
Understanding how Traditional Insurance Companies Work
At the beginning of any insurance company, there is a very high probability that the company might end up in losses as the operational and commercial expenses of managing the organization are quite high and the returns are quite low.
One of the primary expenses incurred in the case of traditionally organized insurance companies is is the cost of paying people who bring in new customers commonly known as the ‘brokers’. For every new policy sold by the broker the insurance company typically pays the premium equivalent to one year of the policy. So, another approach to making profits is to keep acquisitions as low as possible.
A common approach followed by insurance companies to maximize their profits is by keeping their customers insured for as long as possible. If the policyholder cancels their insurance policy within the first year of issuance the insurer has to bear loss due to the initial expenses. However, if they manage to keep their customer insured for longer periods the initial loss borne by the insured can be converted into profit.
Investment Income of Insurance Companies
The primary source of income of investment companies is their customers. However, another major source of income is investment income. When a policyholder pays their premium for an insurance policy the insurer uses that capital to invest in market-based securities to increase their total revenues.
Insurance companies have an edge when compared to manufacturing product based companies as they do not have to invest cash in product development and manufacturing. Insurance companies have a lot of money from premiums to invest in market-based securities that increase the profits made by these companies.
This strategy of making money is an integral component of a successful insurance revenue model. An insurer receives capital directly from its customers in the form of premiums which is not to be utilized for product manufacturing or development. In most cases, the insurer does not have to pay the claim for every policy sold. The money collected from selling policies is used as capital to yield investment income.
Now the question arises, what if the investments of insurance companies do not work in their favor? A simple solution to this problem is increasing the prices of their product i.e. insurance policies. In case the investment does not provide optimum returns insurance providers manage their expenses by increasing the price of their insurance policies.
Cash Worth Cancellations
When consumers get to know that they have thousands of Dirhams as the cash value that are generated via dividends from investments made by insurance companies they are tempted to cash the value, even if they have to close the account.
When a policyholder takes the cash value followed by closing the account all liability ends for the insurance provider. The insurer keeps all the premiums paid by the customer and provides the policyholder with interest earned on investment vehicles. From this perspective cash, worth cancellations are another source of income for insurance providers.
Very often policyholders are unable to keep current on their insurance plans, which results in a profitable situation for the insurance provider. Based on the insurance plan contract, the lapse of insurance means that the policy expires without being paid out. In such a situation, insurance providers cash in again as all the premiums that are paid by the customer are kept with the insurer with zero possibility of the claim being paid.
In a Nutshell
Undoubtedly, insurance providers have a firm system of generating revenues. According to data based on industry out of 100 customers that purchase insurance plans only 3 to 5 customers make the claim. In the interim, companies use the premiums paid by customers to invest in market-based securities that yield a considerable portion of their returns.
With the system inclined in the favor of insurance providers, it is easy and practically feasible for insurance companies to make profits.