How Do Life Insurance Companies Actually Work?

Every form of insurance is a type of equitable exchange of risk. Essentially, this means that the risk of monetary lost is counteracted by purchasing or selling this risk with the promise of compensatory worth should the product fail. Being able to understand how and why other insurance companies make their money, for example auto insurance or home insurance, is quite intuitive once you get the basic facts of how the insurance Indus work, but it's a little harder to come to grips with life insurance - essentially because of the 100% lifetime risk of someone dying.

In the following article, I'll run through the basic premise of insurance companies and how they operate, and then go on to discuss the tactics and strategies that life insurance companies use to make the enormous profits they do.

The insurance firms essentially cover or protect against the risk of something happening which converts into monetary loss for someone. An example is damaging your car in a road traffic accident and then having to fork out for all the replacement parts. Insurance lets you pay a premium in advance to cover against the risk of this happening, and is useful when the cost of the monetary loss is so great that you would not be able to pay it should the event happen. These insurance companies effectively make their money by calculating the risk, hedging the risk of insuring a set of policy holders against each other and then adding their own profit margin (determined by the supply and demand of the industry) to it.

But what about life insurance companies?

In the case of life insurance companies, the risk that someone is going to die is obviously 100%. Yet the amount of monetary loss suffered by family members as a result, or the promised indemnity at the end of the policy might not be do great. They effectively calculate the likely value of the monetary loss. Over the course of the policy, which can usually be upwards of 20 years, they then invest the premiums you pay through several investment types; shares on the stock market, bonds and assets like real estate.

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