How Do Insurance Companies Invest Money?

How Do Insurance Companies Invest Money?

Insurance companies invest in a variety of things, but their primary focus is usually on bonds, which stands to reason since securities are among the safest investment options available. And because insurance providers are in the business of assessing risk, the low risk that bonds symbolize resonates to them, along with other motives as well.

Bonds are the most common investment for insurance companies, but they also invest in stocks, mortgages, and liquid short-term investments.

Taking a Closer Look at the Insurance Industry

To simplify things a little, imagine an insurance firm with a hundred commercial building clients, each with a single $1 million structure (this, by the way, would be unreasonable). Actuaries are applied mathematicians and statisticians who utilize their talents to make realistic estimates of the likelihood of each of these organizations experiencing a total loss in a given year. Again, in reality, the assessment would cover various levels of loss. They discover that each of these businesses has a 1% risk of going bankrupt.

The Business Model of Insurance Companies

For layman purposes, this means that there is a chance that the make-do insurance firm will have total losses of $1 million in the given year in each percent of risk per building time.

To make money, the insurance company must charge each building client enough for their insurance to cover the likely $1 million loss, plus an additional amount computed by its actuaries to account for less likely outcomes, and ultimately a profit amount.

The Essence of Investment Ventures for Insurance Company

It would be possible for the insurance firm to simply store premium payments received in a safe deposit vault and on the other hand, it could also turn out to be a bad idea because there are other methods to invest that money to make more money.

Investing premiums accomplishes two goals: it raises the insurance company’s earnings and allows it to cut premium levels, making its policies more appealing to customers.

Financial Instruments Employed by Insurance Companies

Insurance firms could and do, invest in the stock market, but doing so alone would be extremely dangerous because the stock market is a continuum, swinging from huge bull market returns to significant bear market losses.

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An insurance firm must know with a great deal of confidence that it will not incur an untenable loss in any given year; as a result, equities can only make up a small fraction of their investment portfolios.

On the other hand, stock market investments account for about 5% of total holdings for life insurance firms, while property and casualty insurers typically invest roughly 30% of their assets in common stocks.

Furthermore, bonds are appealing because they guarantee a much more consistent prospective cash inflow, but investment-grade bonds yield significantly less on average than the stock market in the long run. $100 invested in the stock market in the 1900s would have risen to over $320,000; while the same amount placed in investment-grade and Treasury bonds would have increased to over $7,000, given the same time frame.

By investing only a fraction of their premiums in the riskier stock market, they can benefit from greater profits while avoiding the extensive liability of stock market instability.

Risk Diversification

Another reason why insurance companies trade in both stocks and bonds rather than just bonds is that the two types of investments are relatively faintly associated. They tend to fluctuate simultaneously, but not identically.

An appropriate 3rd investment product for insurance firms will be another low-risk, random investment, in other words, the mortgage market demonstrates this.

Mortgages and first liens account for around 15% of the premiums paid by the life insurance sector of the insurance market. For instance, in the life insurance sector, bonds, equities, and mortgage instruments make up the three asset groups, accounting for around 90% of investments, while property and casualty insurers account for over 80%.

Highly liquid short-term investments and cash make up the fourth-largest asset type, accounting for around 5% of life insurers’ investments and about 10% of property and liability insurers’ investments.

Aside from that, insurance companies invest in derivatives (contracts whose values are based on the values of other assets, such as mortgages), contract loans, securities lending, real estate, and preferred stock, which perform more like bonds than common stock.

The Author

Oladotun Olayemi

Dotun is a content enthusiast who specializes in first-in-class content, including finance, travel, crypto, blockchain, market, and business to educate and inform readers.