how does term policy compaines get profit. explaining with example
how does , term insurence companies manage amount to give sum assured amount if any death or disability? how do they profit on this scheme?
ChatGPT said:
Term insurance companies manage to provide the sum assured to beneficiaries and still remain profitable through a combination of risk management, investment strategies, and actuarial science. Here's how they do it:
1. Risk Pooling (The Law of Large Numbers):
- How it works: Term insurance policies are based on the principle of risk pooling. Many people pay premiums, but only a small fraction of them will make claims.
- Actuarial analysis: Insurers use actuarial tables to estimate the probability of death or disability for individuals based on age, gender, health, lifestyle, and other factors. This allows them to set premiums that are statistically sufficient to cover claims and costs.
2. Underwriting and Risk Assessment:
- Screening applicants: Insurers assess the risk of each applicant by evaluating their medical history, lifestyle (e.g., smoking, drinking), occupation, and other risk factors. High-risk individuals may be charged higher premiums or denied coverage.
- Reducing claims probability: Policies may have exclusions or waiting periods for specific causes of death (e.g., suicide clauses).
3. Investment of Premiums:
- Premiums as investments: The premiums collected from policyholders are invested in low-risk, long-term financial instruments, such as government bonds, corporate bonds, or diversified portfolios. These investments generate returns, adding to the insurer's revenue.
- Time value of money: For term insurance, the premiums paid are often much lower than the sum assured. Insurers benefit from earning returns on these funds over time.
4. Policy Lapses and Non-Claims:
- Policy lapses: A significant percentage of policyholders stop paying premiums (policy lapses) before the policy term ends. These lapsed premiums are retained by the insurer without the obligation to pay a claim.
- Non-claims: Since most policyholders do not face death or disability during the term, the insurer collects premiums without needing to pay out.
5. Pricing Strategies and Reserve Funds:
- Premium setting: Premiums are calculated to cover the expected claims, administrative expenses, and provide a margin for profit.
- Reserve funds: Insurers are required by regulation to maintain reserves to cover future claims. These reserves are carefully managed and invested.
6. Economies of Scale and Efficiency:
- Cost control: Large insurance companies operate efficiently due to economies of scale, reducing administrative and operational costs.
- Automation: Technology helps streamline processes like underwriting, policy issuance, and claim settlements.
7. Reinsurance:
- Risk transfer: Insurance companies use reinsurance to spread their risk. They pay a portion of their premium income to reinsurers in exchange for sharing the burden of large claims.
- Financial stability: Reinsurance allows insurers to manage unexpected spikes in claims (e.g., due to natural disasters or pandemics).
Profitability in Term Insurance:
- Lower claims ratio: Term insurance policies typically have lower claims ratios compared to health or vehicle insurance. This makes them relatively more profitable.
- Long-term sustainability: The combination of investment income, lapses, and effective risk management ensures that insurers make a profit even while fulfilling their commitments to claimants.
Challenges for Insurers:
- Adverse selection: If only high-risk individuals buy insurance, it can lead to higher claims than anticipated.
- Economic conditions: Low-interest rates can reduce investment returns, affecting profitability.
- Regulatory requirements: Insurers must adhere to solvency and reserve regulations, which can limit investment options.
In summary, term insurance companies rely on detailed risk assessments, pooling of risks, investment strategies, and efficient operations to ensure they can pay out claims while remaining profitable.
You said:
ChatGPT said:
Let’s break down how a term insurance company makes a profit with an example to show the inflow (premiums) and outflow (claims) while maintaining profitability.
Example Scenario
Assume an insurance company offers a Term Insurance Plan with these parameters:
- Sum Assured: ₹1 crore
- Annual Premium: ₹10,000 per person
- Policy Term: 20 years
- Number of Policyholders: 1,00,000
- Probability of Claim: 0.5% (Based on actuarial data, only 0.5% of policyholders are expected to die in a year.)
- Investment Return: 5% annually on premiums collected.
- Operational Costs: 15% of total premiums collected.
Income (Premiums):
Total Premium Collected Annually:
₹10,000 × 1,00,000 = ₹100 crore per year.Premium Collected Over 20 Years:
₹100 crore × 20 = ₹2,000 crore.
Outflow (Claims):
Expected Claims Per Year:
0.5% of 1,00,000 = 500 claims per year.Total Claims Paid Per Year:
500 × ₹1 crore = ₹500 crore annually.Total Claims Over 20 Years:
₹500 crore × 20 = ₹1,000 crore.
Operational Costs:
Operational Costs Per Year:
15% of ₹100 crore = ₹15 crore annually.Operational Costs Over 20 Years:
₹15 crore × 20 = ₹300 crore.
Investment Returns:
Insurance companies invest the premiums collected each year. Assuming a 5% annual return:
At the end of Year 1:
₹100 crore × 5% = ₹5 crore return.At the end of 20 Years:
Investment returns compound, so the total will be significantly higher. Using a compound interest formula:Total Investment Return ≈ ₹1,650 crore (over 20 years).
Profit Calculation:
- Total Premium Income: ₹2,000 crore
- Total Claims Paid: ₹1,000 crore
- Total Operational Costs: ₹300 crore
- Total Investment Returns: ₹1,650 crore
Net Profit:
₹2,000 crore (Premium) + ₹1,650 crore (Investment Return) - ₹1,000 crore (Claims) - ₹300 crore (Costs)
= ₹1,350 crore profit over 20 years.
Key Points to Note:
Risk Pooling: Out of 1,00,000 policyholders, only 0.5% (500 people per year) claim the sum assured. The premiums from the other 99.5% of policyholders are retained.
Investment Returns: Premiums collected early are invested, compounding over time to generate significant returns.
Operational Efficiency: The company ensures operational costs remain a small percentage of the premiums collected.
Real-Life Simplification:
For every ₹1,000 collected as premium:
- ₹500 goes towards claims.
- ₹150 goes towards operational costs.
- ₹350 is retained as investment capital and profit.
This ensures the insurance company can manage claims while remaining profitable.