How Life Insurers Make Money: An introduction

In simple term, life insurance premiums are calculated so that over time the premiums the insurer receives are sufficient to cover the claims it has to pay out. 

Let’s for example, consider a single premium 20-year term assurance policy. Let’s say the policy pays an amount of $1m to the dependents of a policyholder if death occurs during the 20 years of the policy. 

How much would you expect to pay today for that benefit? The biggest factor would be your current age. If you are 30, you would be a lot less that if you were 60. This premium is calculated using a mortality curve. I included an example of a mortality table below. 

The table shows the likelihood of a male aged 30 not surviving to age 31 in the first row. The second row shows the likelihood of someone aged 31 not surviving to age 32. A mortality rate of 0.000438 means that 1 in every 2238 men aged 30 are likely to die before reaching age 31. For a $1m sum assured, the insurer expects to pay $1m/2238 in claims for a 30-year-old man. This equates to an expected claim of $438. If the policy was for 1 year, you can expect to pay a premium of approximately that amount. 

Now, let’s consider the full 20 years of the policy. In year 1, we expect the insurer to pay $438 dollars in claims. In year 2, this number goes up slightly, as a 31-year-old is more likely to die than a 30-year-old. The amount comes down to (1-0.000438) * 0.000448 * $1m = $447.80. In words this means, the likelihood of a policyholder surviving to age 31, but not to age 32, multiplied by the $1m sum assured. The amount the life insurer is expected to pay for each of the 20 years the policy is active is shown below: 

The total across the 20 years is $15,978.76. Now, would you expect your premium to be less or more than that? The answer is less. If the insurer earns 5% interest on the premium you pay,  your expected premium is about $9,500. 

By paying the premium up front you are effectively lending money to the insurer – you are providing it with “float”. It can invest this money and earn interest. If you provide the insurer with say $10,000, it can invest it for 20 years and earn say 5% per year on your premium. Let’s say in year 1, the insurer earns 5% investment income on the $10,000 initial premium, and pays out $438 in claims, by the end of the year it will have $10,062. The projection over the 20-year period looks as follows: 

What we can see here, is the insurer didn’t put up any money of its own, received $10,000 in premium, pay $15,978 in claims and earn $9013.57 in investment income and end the policy with $3034. This logic only works if we have multiple policies, because if there is only one policy, the insurer will either pay $0 in claims or a $1m. If however, there were 100,000 policies each paying $10,000 in premiums, the logic will be that: 

•     The insurer receives $1bn in premiums
•     Pay $1.598bn in claims as it expects to pay out 1598 $1m claims
•     Earn $900m in investment income and be left with $303.4m in profit. 

It is worth noting that the profit is considered at the beginning of the period, not at the end of the period. The present value of the claims discounted at 5% is $8,856. This would be the (very simplified) liability of the insurer at the day it receives your premium. It will realize an asset of $10,000 for the premium you paid. The resulting day-1 profit is about $1144 – the asset less the liability. 

This calculation becomes infinitely more complicated in the real world. The premium will likely not be paid up front; it will be paid monthly over the 20-year period. The insurer will not earn a flat 5% over the 20-year period. If you are older, you will pay more. If you are a woman, you will pay less. If you are a smoker, you will pay more.  If you have a bad credit score, you will pay more – those with bad credit scores are more likely to submit fraudulent claims. The products also become infinitely more complicated. The amount insured can grow over time. You can have an option to extend the insurance after the initial period. There may be a return of premium benefit if a claim does not occur during the initial period. 

On the asset side, the premium changes based on the actual interest rates the insurer can earn on the assets it can invest in. If we are in the US, the UK or Europe, the investable universe of assets is heavily restricted by regulation. If, however we are in Bermuda, the investable universe expands. Bermuda has for decades been the main hub for offshore reinsurance. In our example, let’s say the insurer decides to set up a reinsurer in Bermuda. As it can now invest in riskier assets, it can earn more interest. With riskier assets we mean those that pose a greater risk of default and are less liquid. An illiquid asset is riskier than a liquid one as the insurer will have to take a price cut if it wants to sell it for cash when having to make a fire sale.

Let’s say the insurer transferred all its liabilities to a reinsurer in Bermuda. The insurer pays the reinsurer a premium – in this case the $1bn. The reinsurer is now responsible for paying the claims to the insurer. The benefit is that the reinsurer can earn a higher return by investing the initial premium as it is less restricted in terms of regulation in Bermuda. Let’s say the reinsurer now earns 7% instead of 5%. The math looks as follows: 

•     The reinsurer receives an initial premium of $1bn
•     It still pays $1.598bn in claims
•     Instead of earning $900m in investing income, the reinsurer earns $1.68bn leaving a profit of $1.08bn instead of $303.4m. 

Just like that the insurer increased its profits from $303.4 to $1.08bn. That is the power of compound interest.

If you are a policyholder, how would that make you feel? Would you prefer the stricter regulation in Europe or the US, or the more flexible environment in Bermuda? The intuitive answer is the stricter regulation as it suggests a lower risk of the insurer going bust and not paying your claim. The more nuanced answer is that by transferring liabilities to Bermuda, the insurer can transfer the benefit of higher investment income to policyholders through lower premiums. 

Some of Americas largest insurers such as Chubb (CB) and AIG (AIG) have established operations in Bermuda. Large private equity firms such as the Carlyle Group (CG), among others, also have insurance operations in Bermuda as well. The insurance companies serve a dual purpose for the private equity firms. The premium income provide a source of funds to invest for the firm. On top of that, it shares in the profits of the insurance subsidiary it invests in. 

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