How Do Insurance Companies Make Money on Annuities?

Annuities are a type of investment product intended to provide regular interest payments to investors. To achieve these payments, policy holders must pay insurance companies a premium, either all at once or over time. Since the amount paid out by an annuity usually exceeds the premiums investors put in, it's a reasonable question to ask how insurance companies make money on the product. The answer is that, aside from premiums, annuities often carry a number of fees including insurance charges, surrender charges, investment management fees and rider charges.

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Formally known as "mortality and expense" charges, insurance charges are a way for an insurance company to recoup the costs of providing an annuity, with additional profit built in. The average mortality and expense charge will run about ​1.25 percent​ per year.

In addition to paying for the selling and administrative charges of an annuity contract, these charges also cover the cost of providing the guarantees inherent in most annuity contracts. Typical guarantees offered by annuities include a death benefit to policy holders or the guaranteed safety of an investor's principal, depending on the type of annuity.

Another way companies make money on annuity contracts is through surrender charges. While not all annuities carry these charges, many will charge you a fee if you want to get out of your annuity contract before a specified period of time. Surrender charges typically decline from year to year, but start out high and can last ​10 years​ or longer.

Typically, an insurance company might charge you seven percent if you want to sell or withdraw from your annuity in the first year, with that charge declining to ​six percent​ in year two, ​five percent​ in year three and so forth. In extreme cases, surrender charges on an annuity policy can run up to ​20 percent​ in the first year.

In a variable annuity, an insurance company provides a number of different investment options to a policy holder. Each of those investment options is managed by the insurance company for a fee, similar to a mutual fund. These fees are deducted annually and typically run from ​0.25 to 0.75 percent per year​ or more.

​Read More​: How to Calculate the Expected Return on an Annuity

You can add riders to an insurance contract to take advantage of a specific feature. For example, you might want to buy a guarantee that you'll get a certain annuity payout regardless of the performance of your variable annuity sub-accounts. Other popular riders provide cost-of-living adjustments to annuity payouts, or provide coverage for nursing home expenses.

Typical riders can cost an additional ​one percent or more​ per year. Best annuity companies will have a wide range of riders to help secure every possible emergency that you might encounter.

A fixed annuity promises to pay investors a specific return on their invested principal. An insurance company will invest the money anticipating a certain return, and provides slightly less to the annuity holder. This spread between the money earned and the money paid out is profit for the insurance company.

​Read More:​ Differences Between an Annuity & a Perpetuity