The Life Insurance Industry's Big Secret

10/04/2012 04:03 pm ET | Updated Dec 04, 2012

How do life insurance companies make money? When I ask this question of my friends, I get a variety of interesting answers -- aside from a bunch of odd looks. One mathematically inclined acquaintance said insurance companies use complex actuarial tables which enable them to predict, very accurately, how long people will live and the insurers figure that, over time, they will collect more money than they pay out. To this answer, I nod in slight agreement. The latter part is true but not because of any actuarial brilliance. Insurance companies make money because a massive amount of all life insurance coverage lapses. (Note: In an earlier version of this post, we published a statistic regarding lapse rates. We removed it at the request of the source.)

Most people pay into a term or whole life policy for years, sometimes hundreds of thousands of dollars, and then allow those same policies to lapse -- and the insurance company never pays out a penny. Yes, if the insured passes away, then the company pays a death benefit, but this is a fairly rare occurrence due to the high lapse rates. Some sources suggest that less than two percent of term policies ever result in a death claim. (Hundreds of millions of death benefits also go unclaimed by the beneficiaries, but the insurance industry's culpability in these cases is a whole other topic.)

As you can imagine, the insurance industry likes its profitable business model: Collect a lot of money and pay very little out. Have consumers buy their product, make regular payments, and then let that same product be rendered useless after allowing it to lapse some years later. It adds up to a lot of money for insurers to line their pockets, continue to buy commercials during golf tournaments and expand their general wealth like Warren Buffett.

However, as times have gotten tougher, insurance regulators have taken notice of lapse and surrender rates and the tremendous economic losses that befall consumers. Two years ago, the National Council of Life Insurance Legislators decided to do something about it and passed The Life Insurance Consumer Disclosure Act with the goal of helping consumers understand the alternatives to lapsing a policy.

As a bit of background, the insurance industry is regulated on the state level. There is no "federal department of insurance" to dictate how the industry should be policed -- it falls on the states. On occasion, state regulators get together and tackle tough issues by creating "model acts" which are viewed as guidance for future state regulation. Such acts don't have to be followed by states, but they often are.

In 2010, NCOIL created its consumer disclosure act which requires life insurance companies to provide written notice of alternatives to the lapse or surrender of life insurance policies, specifically to insureds who are 60 or older or who are known by the insurer to be terminally or chronically ill.

The alternatives include: (a) accelerated death benefits available under the policy or as a rider to the policy; (b) the assignment of the policy as a gift; (c) the sale of the policy pursuant to a life settlement contract, including that a life settlement is a regulated transaction in the state (as applicable); (d) the replacement of the policy pursuant to appropriate regulation; (e) the maintenance of the policy pursuant to the terms of the policy or a rider to the policy, or through life settlement contract; (f) the maintenance of the policy through loans issued by an insurer or a third party, using the policy or the cash surrender value of the policy as collateral for the loan; (g) conversion of the policy from a term policy to a permanent policy; and (h) conversion of the policy in order to obtain long-term care health insurance coverage or a long-term care benefit plan.

To date, Kentucky, Maine, New Hampshire, Oregon, Washington and Wisconsin are the only states that have adopted the disclosure act. California has passed similar legislation and disclosure bills have been proposed in Florida and Georgia.

Let's look at a few of the options that anyone older than 60 should consider before allowing their life insurance policy to lapse:

Accelerated death benefits. For terminally ill policyholders, an accelerated death benefit enables them to receive cash advances against the death benefit.

Assignment of the policy as a gift. A policyholder can give away ownership of a life insurance policy by signing an assignment or transfer document and notifying the insurance company of the change. After the policy is transferred, the new owner is responsible for making premium payments.

Life settlement. Individuals older than 70 can sell their policies for more than the surrender value but less than the death benefit. A life settlement provider continues to pay the purchased policy premiums, collecting the full amount when the policy seller passes away. The amount received for a life settlement varies depending on the life expectancy of the policyholder at the time of sale, and the ongoing premiums necessary to keep the policy in force.

Convert life insurance to long-term care coverage. A life insurance conversion program is the sale of a life insurance policy to a third party in exchange for monthly payments made to a long-term care services provider such as an assisted living residence or home care provider.

Convert from term to permanent insurance. Some term life policies can be converted to permanent insurance, without having to undergo a medical exam or provide health information. This enables an insured to keep coverage that would otherwise lapse at the end of the term. Permanent insurance provides coverage until death.

Many options exist which are far better for consumers than letting their insurance policies lapse. So far a few states have taken action to demand disclosure, but in general the insurance industry's big secret remains intact.