Insurance firms invest in a variety of different sectors, but their primary focus is on bonds. This makes sense, since bonds are perhaps the safest kind of investment. Insurance firms, as risk assessors, would naturally find the minimal risk associated with bonds attractive, but there are other considerations. Insurance firms spend the majority of their funds in bonds, but also in equities, mortgages, and liquid short-term assets. In Summary this answers the question as to where do insurance companies invest?
Understanding Insurance Business
Risk redistribution is achieved via down insurance. Simplifying somewhat, you may imagine an insurance business having a hundred commercial building customers, each of which owns a single building valued at $1 million (this, by the way, would be an unreasonably small company if it were real).
Actuaries, who are applied mathematicians and statisticians, utilize their expertise to create credible estimates of the chance that each of these businesses would suffer a complete 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% probability of going bankrupt.
How Do Insurance Companies Earn Money?
For our purposes, this implies that the likelihood (but not the certainty) is that the hypothetical insurance firm would suffer total losses of $1 million – 1% risk per building times the number of buildings in the given year. One million dollars’ worth of buildings is equal to one million dollars’ worth of buildings multiplied by 100.
To earn money, the insurance firm must charge each building owner enough for insurance to cover the expected $1 million loss, plus an extra amount determined by its actuaries to account for less likely outcomes, and lastly another sum representing the intended profit. As an example, suppose the business has to collect a total of $3 million in premiums.
Why Do Insurance Companies Invest?
The insurance firm may simply put the $3 million premium money in a safety deposit vault. Additionally, it would be a poor decision, since there are acceptable methods to invest that money in order to earn more money. Investing premiums benefits the insurance business in two ways: it raises earnings and enables the company to reduce premiums, making its products more appealing to customers.
What Type of Investments Insurance Companies Make?
Insurance firms might participate in the stock market, and they do, but doing so alone would be extremely hazardous due to the cyclical nature of the market, which swings between huge bull market gains and significant bear market losses.
An insurance firm must be certain that they will not incur an unsustainable loss in any given year; therefore, stocks may only account for a limited part of their investment portfolios. Stock market investments account for about 5% of total assets for life insurance firms. Typically, property and casualty insurance firms invest about 30% of their assets in common stocks.
The attraction of bonds is that they offer a considerably more predictable future cashflow, but they also return much less on average than the stock market over the long run. In 1928, $100 invested in the stock market would have risen to almost $320,000; $100 invested in investment grade and government bonds would have grown to $7,000.
By investing just a portion of their premiums in the riskier stock market, individuals may partake in some of the riskier stock market’s greater profits without taking on all of the risk associated with the stock market’s volatility.
However, there is one additional incentive for insurance firms to invest in both stocks and bonds rather than just bonds: the two asset classes have a low correlation. They generally rise and fall in lockstep, although not precisely. Nonetheless, some connection exists.
A third investment option that would be excellent for insurance firms would be another low-risk investment that is uncorrelated — in other words, an investment whose returns are unrelated. Indeed, investing in the largely uncorrelated mortgage market achieves just that.
The insurance market’s life insurance industry invests about 15% of its premiums in mortgages and first liens. These three asset types – bonds, equities, and mortgage instruments – account for about 90% of life insurance company assets and more than 80% of property and liability insurer investments.
The fourth biggest asset type consists of highly liquid short-term investments and cash, which account for about 5% of life insurers’ assets and approximately 10% of insurers in the slightly more volatile property and casualty sector.
Apart from this, insurance firms engage in a variety of other sectors, including derivatives (contracts whose values are contingent on the performance of other assets, most often mortgages), contract loans, securities lending, real estate, and preferred stock (which perform more like bonds than common stock).
However, all of these sectors account for less than 10% of life insurers’ investments and somewhat more than that for property and liability insurers. A critical purpose of these extra, very small investments is to offer further risk diversification. Above are the most common investment assets answering the question as to where do insurance companies invest?