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Exclusive Article on Insurance

Copyright BusinessEconomics.com 2012

Insurance companies are financial intermediaries that in return for payments, generally referred to as premiums, will make a payment to a policy-holder should an insured-against event occur whilst insured. The premiums paid to the insurance company reflect two key variables:

(i) the likelihood of the insured-against event occurring, that is, the risk of a claim being made, and
 
(ii) the payments to be made to the policy-holder in the event of a valid claim.

Insurance companies make their profits by charging for assuming risks on behalf of their policy-holders, and also through the investments they make with the assets under their control. The premiums paid provide a pool of funds from which payments can be drawn to meet valid claims. By their nature, insurance companies therefore exist by assuming risks; an unexpectedly large number of claims or a poor performance of funds under management can call into question  the solvency of an insurance company.
             
There are two main types of insurance business – life insurance (often referred to as long-term insurance) and general insurance. Life insurance deals with death, illness/disablement and retirement policies. General insurance deals with theft, property, house, car and general accident insurance. Property insurance is normally divided into two lines; personal and commercial; with
respect to commercial insurance there are policies available for dealing with  product liability, malpractice, negligence and commercial property.
             
The distinction between life insurance and general insurance is of significance because the differing nature of their businesses leads to different  investment strategies with respect to the premium income and assets under their control. Life assurance business is based upon the fact that death is certain but the age at which it occurs is not. This uncertainty means that people wish to insure themselves to provide benefits for their family should they die prematurely. Life insurance companies provide a wide variety of products which include:
 
•  Term insurance policies – which make a payment if the insured dies within a specified period of time, but which pay nothing if the insured lives beyond the contract. Term insurance  therefore has no element of savings and is a pure insurance product.

•  Whole of life insurance policies – which make a payment whenever the insured dies; such policies can generally be surrendered prior to maturity but usually at a significant discount to the premiums paid.

•  Endowment policies – which pay a fixed sum at a specified future date or upon death should the insured die prior to that date. Endowment policies are often taken out in conjunction with  mortgage business. Upo advancement of a loan, a customer may take out an endowment policy with the same date to maturity as the loan. The customer then  repays the lender (for example, a bank) only the interest on the loan and makes separate payments for the endowment policy. At the end of the loan the principal  becomes due and hopefully the endowment policy has made sufficient growth in profits to pay off the principal due. An endowment policy also generally provides life cover enabling full repayment of the mortgage if the policy-holder dies.

•  Annuities– which provide the policy-holder with regular income payments usually for the remainder of their life, and typically provide some minimum period of payments if the annuitant dies before the policy is due to commence payments. Premium payments for annuities are made either by regular premium contributions over a number of years or by one large capital payment.
            
General insurance companies need to hold fairly substantial amounts of short-term assets to enable them to speedily meet policy claims which can fluctuate considerably from one year to the next. For instance, unusually bad weather can lead to large claims for property damage. Reasonable levels of reserves are therefore needed to meet unexpectedly high losses that occur from  time to time. Most insurance premiums paid are invested either in equities, property investments or government stock, and the success of investments made is crucial in enabling a company to keep its premiums competitive.
          
Insurance companies have very significant amounts of assets under their control and they have been significant investors in stockmarkets, government and corporate bonds. Were an insurance company unable to meet its obligations there is no guarantee that a government would step in. In deciding on the appropriate premium to insure a risk, actuaries are employed to calculate the probabilities of an event occurring. Life insurance companies tend to invest a higher proportion of their assets in long-term investments such as government and corporate bonds than do general insurance companies which have a far greater need for liquidity to meet claims.

Copyright BusinessEconomics.com 2012