How Do Insurance Companies Invest Money?
Insurance companies, being in the business risk assessment, invest in numerous areas, but mainly they invest in bonds. In bond, they find it logically low risk, but there are other reasons as well as to why they find bonds as low risk. Although insurance companies are most likely to invest most of their money in bonds, they also invest in stocks, mortgages, and short-term liquid investments.
Statisticians and applied mathematicians called actuaries employ their abilities in making rational assessments of the probability of the companies who have covered various levels of loss in just a given year. It is mainly because insurance is the redistribution of risk. In other words, you can create a hypothetical insurance company with a hundred commercial building clients, having every single building worth $1 million.
HOW INSURANCE COMPANIES MAKE MONEY.
Overall, the probability of the total losses of the hypothetical insurance company in a given year is $1 million. This means 1 percent risk per building times 100 $1M building is parallel to one $1M building times 100 percent. To make money, insurance companies need to impose each building client to pay off the probable $1 million loss enough for their insurance to pay. Also, some amount calculated by its actuaries are to take into account, but less probable outcomes, and finally, the other amount represents the desired profit. For illustration purposes, assumingly, the company needs to lay hold of total premiums of $3 million.
WHY INSURANCE COMPANIES INVEST.
There are two good things in investing the premiums: the insurance company’s profits increase, and it’s attainable for the company to lower its premium amounts to attract clients by creating its policies more attractive. Although it would be possible for the insurance company to get hold of the $3 million premium money received and just stick it in a safety deposit vault, it is still a bad idea. For a reason, there are rational means for money management to make more money.
WHAT INSURANCE COMPANIES INVEST IN.
An insurance company needs to perceive a degree of high certainty that they are not going to immerse itself in an unsustainable loss. They could invest in the stock market, but investing in the stock market is risky due to a cyclical demand that swings from a high bull market and returns to a considerable bear market loss. Therefore, stocks can mean a relatively small portion of their investment portfolios. Stock market investment for life insurance companies constitutes 5 percent of the total holdings, while for property and casualty insurance companies usually invest holdings in common stocks around 30 percent. Providing a predictable future cash flow is the appeal of bonds.
DIVERSIFICATION OF RISK.
Another reason for insurance companies for not investing in bonds alone but investing in both stocks and bonds is because these two investment classes are weakly correlated. Another relatively low risk that is uncorrelated is the third ideal investment choice for insurance companies, which means the returns of the investments are independent. The life insurance sector of the insurance market invests its premiums in mortgages and first liens for about 15 percent. Bonds, stocks, and mortgage instruments are the three asset classes that comprise 90 percent of investments for life insurance companies, while for property and casualty insurers, they invest over 80 percent. Highly liquid short-term investments and cash is the fourth largest asset class.
There is about 5 percent of investment for life insurers, and there are about 10 percent insurers in the more volatile property and casualty business. Above all, areas that insurance companies invest in include derivatives, cash loans, securities lending, preferred stock, and real estate. Relatively, providing additional diversification of risk is an essential function of these, especially for minor investments.
Based on Materials from Zacks