How Do Insurance Companies Work?

The insurance and reinsurance industry is a trillion-dollar business, with century-old companies all over the world earning billions of profit annually. As a policyholder or a would-be policyholder, you might be curious as to how insurance companies grow and take care of your investments.

To enlighten and educate you, here are things you need to know about how insurance companies work.

Insurance companies invest in many areas and industries, including property and stocks, but most of all, they invest in bonds. Bonds are the safest of all investment categories, compared to equity funds and mutual funds. Given the very nature of insurance companies, it’s understandable that they find the low-risk bonds to be appealing. However, there are other reasons as well.

Breaking the Business Down

Insurance, at the core of it, is the redistribution of risk. The main reason people avail of it is to mitigate risks against their life, health, and properties. It’s a safety net to fall back on when life sends them a curveball or two.

The same concept applies to insurance companies. For example, if you have a hundred commercial building clients with each building worth $10 million. Actuaries and statisticians will use their skills to make reasonable assessments on the probability of each company having a total loss in a given year. Whatever they find will affect the amount of money charged for each one’s insurance and the investment given to it, if any. For example, they find each of these companies to have a 1% chance of a total loss.

How Exactly Do Insurance Companies Make Money

Like any other company in other industries, insurance companies need to make money.

Following the situation given above, the insurance company covering the corporate buildings will have a total loss of $10 million in the given year. Simple math, 1% risk per building times a hundred $10 million buildings equals to a $10-million loss.

To make money, the insurance company has to charge each building client enough for their insurance to pay off the probable loss, plus some additional amount to take into account less probable outcomes (2% loss, 3% loss, and so on) and another additional amount that represents the desired profit.

In this case, we could say that each company needs to pay off total premiums of $13 million.

Why Insurance Companies Invest

Why not just put the premium money received inside a safety deposit account, you ask? Surely that means less risk and less chance for losses. While that’s true, it also means less to no chance of making more money off of it. Given the inflation rate, that also means the $13 million will devolve in value if just stuck in one place.

Also, investing premiums does two things: it increases the company’s profits thus allowing it to lower its premium accounts.

What Insurance Companies Invest In

As mentioned earlier, insurance companies mostly invest in bonds. Sure, they also invest in the stock market but stock market investment alone would be too risky because of its cyclical swings between high bull market returns to devastating bear market losses.

As a company that assesses risks, insurance companies have to know with a high degree of certainty that they’re not going to absorb an unsustainable loss. In life insurance companies’ portfolios, their investments in stocks only amount to 5%, it’s 30% for property and casualty insurance companies.

Bonds provide a more predictable future cash flow but at the same time, its returns are not as high as stock markets. By splitting their investments, insurance companies can enjoy the high returns of the stock market without taking the complete burnt of its possible crash.

Diversification of Risk

Lastly, there’s one more reason why insurance companies invest in both stocks and bonds rather than bonds alone. It’s because the two are only weakly correlated. When one falls, it’s not a given that the other will too. At least not immediately. This gives another layer of security for the investments.

The ideal third choice is investments in the mortgage market. It’s relatively independent of the other two investment classes, making it an ideal addition to the portfolio. Life insurance invests 15% of its premiums in mortgages. The fourth investment class consists of highly liquid short-term investments and cash. Life insurance companies invest 5% in this bucket while property insurance companies invest 10%.

Insurance companies also invest in contract loans, securities lending, derivatives, and real estate. All in the name of diversification of risk.

Now that you know how insurance companies invest your money, you can make more knowledge-driven decisions regarding your finances.

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