A key challenge for understanding life insurance is the range of products that are available, the risks being taken on by the insurance company, and the ways that they generate profit for the insurance company.
The first thing to highlight is that life insurance products help customers to manage a whole spectrum of risks and challenges.
Firstly, insurance products can provide a payout after the death or serious illness of the policyholder.
These can be viewed as traditional life insurance products.
Secondly, there are insurance products that provide some level of protection in the event of death or illness, but which help the policyholder to save and plan for retirement. These can be viewed as hybrid products.
And thirdly, there are investment products, which primarily help the policyholder to invest and save for retirement.
With this in mind, we can think about the level of insurance risk and investment risk for different products.
And we can do this by showing the level of insurance risk on a vertical axis and the allocation of investment risk to the insurance company versus the policyholder on a horizontal axis.
We can then classify insurance products into three broad categories.
Firstly, risk products. These are where the insurance company is taking on significant insurance risk because there is uncertainty over the timing or amount of the claims in the policy.
Therefore, the insurance company seeks to generate most of the profits on these products from underwriting profit, where the premiums exceed the expected claims.
The two most common policies in this category are a term life insurance policy, where the insurance company pays out a fixed amount on the death of the policyholder, or a critical illness policy, where the insurance company pays out a fixed amount if the policyholder suffers from a serious illness.
For both of these policies, there is uncertainty over the timing of any claims, so the insurance company is taking on high levels of insurance risk.
It's important to note that the insurance company still takes on some investment risk, as the insurance company needs to generate investment returns on the premiums to ensure profitability, but the main source of risk is insurance risk.
Secondly, there are spread products.
These are products which have a built-in savings component for the policyholder.
The insurance company takes on significant investment risk by guaranteeing the interest rate for the policyholder in some way, and therefore, the insurance company needs to generate an investment return which exceeds this rate, and this is referred to as a spread.
So spread products have some elements which are similar to banking products, and the main source of profit here is the investment spread.
This category includes fixed annuities, where the policyholder pays an upfront lump sum, and the insurance company pays a fixed guaranteed payment each year until the policyholder dies, with a fixed interest rate baked into the promised payments. This category also includes US whole life policies and European participating life policies, where the premiums are invested by the insurance company to generate investment returns, and some of these returns are allocated to the policyholder's savings account.
This savings account is used to cover the death payments when the policyholder dies.
It's important to note that the insurance company still takes on insurance risk for these policies, as there is still uncertainty over the timing of the policyholder's death, but the main risk is investment risk.
The third and final category is fee products.
These are products where the insurance company is taking on very little investment risk, as this is mostly borne by the policyholder.
The insurance company does not guarantee the investment returns for the policy, and the insurance company is mostly offering asset management services. So whatever investment returns are generated by the premiums, they go to the policyholder, less asset management fees which are charged by the insurance company.
For these policies, the customer makes payments into a fund, which then generates returns added to the fund.
The customer can then withdraw their funds at any time, or they're used to pay out on the death of the policyholder.
The insurance company might also agree to provide a guaranteed minimum death benefit to the customer, but the insurance risk is generally low.
Examples of policies which fall within this category are US universal life policies and European unit-linked policies.
