Insurance companies invest in many areas, but mostly they invest in bonds. This makes sense because bonds are perhaps the safest of all investment categories. insurance companies, which are in the underwriting business, would naturally find the low risk that bonds represent attractive, but there are other reasons as well.
break down the insurance business
insurance is the redistribution of risk. Simplifying a bit, you can build a hypothetical insurance company with a hundred commercial building clients, each with a single building worth $1 million (this, by the way, would be an unreasonably small company if it were real). Applied mathematicians and statisticians called actuaries use their skills to make reasonable assessments of the probability that each of these companies will have a total loss in a given year (again, in reality, the assessment would cover various levels of loss). they find that each of these companies has a 1 percent chance of a total loss.
how insurance companies make money
Conveniently for present purposes, this means that the probability (but not the certainty_)_ is that, in general, the hypothetical insurance company will have total losses in the given year of $1 million – 1 percent risk per building multiplied by 100 $1 million buildings is equivalent to a $1 million building multiplied by 100 percent.
To make money, the insurance company has to charge each customer in the building enough for their insurance to pay for the $1 million likely loss, plus an additional amount calculated by their actuaries to account for less likely outcomes and finally another amount that represents the desired profit. For illustration purposes, it could be assumed that the company needs to receive total premiums of $3 million.
why do insurance companies invest
It would be possible for the insurance company to take the $3 million premium money received and simply store it in a safe deposit vault. It would also be a bad idea, because there are reasonable ways to invest that money to make more money. Inverting premiums does two good things: it increases the insurance company’s profits, and it makes it possible for the company to lower its premium amounts, which makes its policies more attractive to customers.
what insurance companies invest in
Insurance companies could and do invest in the stock market, but investing only in the stock market would be too risky because it is a cyclical market that oscillates between high bull market returns and significant losses. bear market losses. An insurance company needs to know with a high degree of certainty that, in general, in any given year they are not going to absorb an unsustainable loss; therefore, stocks can only represent a relatively small portion of their investment portfolios. For life insurance companies, stock investments represent about 5 percent of total holdings. property and casualty insurance companies typically invest about 30 percent of the holdings in common stock.
The appeal of bonds is that they provide much more predictable future cash flow, but also investment-grade bonds have an average yield markedly lower than the long-term return of the stock market. in 1928, $100 invested in the stock market would have grown to more than $320,000; the same amount invested in treasury and investment-grade bonds would have grown to $7,000. By investing only a portion of their premiums in the riskier stock market, they still participate to some extent in its higher returns, but without taking the full risk of stock market volatility.
But there’s one more reason for insurance companies to invest in both stocks and bonds rather than just bonds: The two investment classes are weakly correlated. they tend to go up and down a bit together, but not exactly. however, there is some correlation.
An ideal third investment option for insurance companies would be another relatively low risk that is uncorrelated; in other words, an investment whose returns are independent. in fact, investment in the mortgage market, which is relatively uncorrelated, does just that. The life insurance sector of the insurance market spends about 15 percent of its premiums on mortgages and first liens. These three asset classes (bonds, stocks, and mortgages) comprise about 90% of the investments of life insurance companies and more than 80% of the investments of property and casualty insurers.
The fourth largest asset class consists of highly liquid short-term investments and cash, accounting for about 5 percent of investments for life insurers and about 10 percent for insurers in the property business and crashes somewhat more volatile. Beyond this, insurance companies invest in areas including derivatives (contracts with securities that are tied to other assets, often mortgages), contract lending, securities lending, real estate, and preferred stock (which behaves more like bonds). than as ordinary shares). But all of these areas together add up to only about 10 percent of life insurance companies’ investments and slightly more than those of property and casualty insurers. An important function of these other relatively minor investments is to provide additional risk diversification.