What does my term life insurance company do with my premiums?

What does my term life insurance company do with my premiums?

Once in awhile, it hits someone. "Wait a minute," they think, maybe while stuck in traffic. "Over the entire thirty-year course of my term life insurance policy, I’m only paying a lifetime cost of $14,000 or so. How could the life insurance company possible afford to pay my family $500,000 if I died in a car accident because I am distracted right now?"

It’s a pretty good question, especially if you’re worried about the ability of your life insurance company to pay out ten, twenty, or thirty years down the line. You’re going to be with this company for a long time, and you want to make sure that you’re not going to be left in a precarious situation because your life insurance company went bankrupt.

Luckily, that’s not really something you have to worry about. For starters, life insurance companies rarely go out of business. And, as we’ll explain below, if they’re ever in a situation where they can’t pay out a policy, there are backup plans in place.

How your life insurance company makes money

Like every company, your life insurance company makes money by taking in more cash than they spend. But a life insurance company doesn’t just have to worry about the administrative costs of running a company. Every year, they’ll have to spend an amount of money paying out life insurance benefits for policyholders who die.

How do these companies make sure they have enough cash to pay the benefits, plus all the normal costs of running a company?

First, they price out their policies according to how likely it is that you’ll actually die. If you’ve purchased a life insurance policy, you already know this – it’s why you answered all those health and lifestyle questions on your application and probably had to undergo a medical exam. If you’re unhealthy, it’s more likely that you’ll die and, therefore, more likely that the insurance company will have to pay out, and you’ll end up paying more money for your life insurance policy.

Life insurance companies spend a lot of time figuring out how risky different diseases and lifestyle choices are. And when I say "a lot of time," I mean literally thousands of work hours every year. People are poring over research papers and Excel spreadsheets right now, trying to figure out the statistical likelihood of death from hundreds of different causes.

All of this helps the life insurance company decide how much they need to charge to cover the risk that you may die from heart disease, for example, or the risk that your skydiving hobby may have a ground-landing problem.

Secondly, life insurance companies don’t just put all of your money in a vault and call it a day. Instead, your money is invested in bonds, real estate, and other investments designed to generate a return. Life insurance companies rely on safer investments, such as bonds, instead of investing in the stock market, due to the fact that they need to protect their ability to pay out large sums of cash at a moment’s notice.

Together, these two strategies help ensure that the life insurance company will be able to pay its expenses while still taking in a profit. But what happens if a lot of people die and they can’t pay, or the company goes bankrupt? Luckily, there are backup plans.

Backup plans for paying out benefits

But lets say that after all that hard work of investing your premiums (not to mention your hard work in paying them!) a life insurance company goes bankrupt or otherwise ceases operations? While this is pretty rare, it does happen, and in every case, your policy will be covered. This is done through three methods: reinsurance, reserve requirements, and guaranty associations.

Did you know there are huge insurance companies that issue insurance on other insurance companies’ insurance policies? Yes, that’s right – it’s the most boring sequel imaginable to Inception.

This type of insurance – called "reinsurance" – protects your life insurance company in the event that a natural disaster or other event results in a higher than predicted volume of claims in a particular year.

Then there are reserve requirements. This is capital that insurers are required to have on hand to pay claims. Reserve requirements are set at the state level, and typically range from 8-12% of the company’s total revenue.

Finally, there are guaranty associations. As you might have figured out by the name, these groups guarantee insurance policies. If a company becomes insolvent, you (and the other customers of the company) are protected. This is done by either coordinating claims payments to policyholders, or working to transfer policies to other insurers.

As you can imagine, this can become a complicated Russian nesting doll of insurance policies, but you should never have to worry about that. All of that complication is designed to make sure that life insurance benefits are always paid out, no matter the circumstances.

At the end of the day, you can rest assured that no matter what, a life insurance policy will actually cover you for the full length of time that you need it. While it can be hard to imagine buying something that is actually meant to last thirty years, a life insurance policy is more than up to the task.