Insurance companies invest in many areas, but most of all they invest in bonds. This makes sense because bonds are perhaps the safest of all investment categories. Insurance companies being in the business of risk assessment would logically find the low risk that bonds represent appealing. But there are other reasons as well.
Breaking the Insurance Business Down to the Basics
Insurance is the redistribution of risk. Simplifying a bit, you can construct 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 of each of these companies having 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 an Insurance Company Makes Money
Conveniently for present purposes, this means that the probability (but not the certainty) is that overall the hypothetical insurance company will have total losses in the given year of $1 million – 1 percent risk per building times 100 $1M buildings is equivalent to one $1M building times 100 percent.
To make money the insurance company has to charge each building client enough for their insurance to pay off the probable $1 million loss, plus some additional amount calculated by its actuaries to take into account less probable outcomes and finally another amount that represents the desired profit. For purposes of illustration, you could assume the company needs to take in total premiums of $3 million.
Why Insurance Companies Invest
It would be possible for the insurance company to take the $3 million premium money received and just stick it in a safety deposit vault. It would also be a bad idea, because there are reasonable ways of investing that money to make more money. Investing the premiums does two good things: it increases the insurance company's profits and makes it possible for the company to lower its premium amounts, making its policies more attractive to clients.
What Insurance Companies Invest In and Why
Insurance companies could invest in the stock market, and in fact they do, but investing in the stock market alone would be too risky because it's a cyclical market that swings from high bull market returns to considerable bear market losses. An insurance company has to know with a high degree of certainty that overall in any given year they're 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 market investments represent around 5 percent of total holdings. Property and casualty insurance companies usually invest around 30 percent of holdings in common stocks.
The appeal of bonds is that they provide a much more predictable future cashflow. But also investment grade bonds return markedly less on average 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 investment grade and treasury 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 assuming the full risk of the stock market's volatility.
Diversification of Risk
But there's one more reason for insurance companies to invest in both stocks and bonds rather than bonds alone: the two investment classes are only weakly correlated. They tend to rise and fall somewhat loosely together, but not exactly.
Nevertheless, there is some correlation. An ideal third investment choice for insurance companies would be another relatively low risk that's uncorrelated. In other words, an investment whose returns are independent. In fact, investment in the mortgage market, which is relatively uncorrelated, accomplishes just that. The life insurance sector of the insurance market invests about 15 percent of its premiums in mortgages and first liens.
These three asset classes – bonds, stocks and mortgage instruments – comprise about 90 percent of investments for life insurance companies and over 80 percent of investments for property and casualty insurers.
The fourth largest asset class consists of highly liquid short-term investments and cash, totaling about 5 percent of investments for life insurers and about 10 percent for insurers in the somewhat more volatile property and casualty business.
Beyond this, insurance companies invest in areas that include derivatives (contracts with values dependent upon other assets, often mortgages), contract loans, securities lending, real estate and preferred stock (which perform more like bonds than common stock). But all these areas together total only about 10 percent of life insurance company investments and slightly more than that for property and casualty insurers.
An important function of these other, relatively minor investments is to provide additional diversification of risk.
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