An insurance company sells promises. Just pieces of paper with signatures on it. No manufacturing, no big machinery or assembly lines, just words. How can anything so airy have any value? Well, marriage is just a promise and most people consider that valuable. The American Constitution and Declaration of Independence have value, and they can’t be traded in for anything. Customers enter into contracts with insurance companies when they know they’ll keep their promises, and they usually do.
As an actuary with ten years of experience I’d like to discuss the two types of relationships an insurance company has with its policyholders: insurance relationships and investment management.
Insurance & Pooling Relationships
Insurance is the collective action, taken by people who are risk averse, to transfer their risk to other individuals through an intermediary, usually an insurance company. No single person knows when they will experience an automobile accident, but an insurance company with millions of people paying premiums for automobile coverage knows with great certainty how much they will have to pay out on regular auto claims.
Most people consider it worth it to pay an insurer a set amount of money in exchange for a large payout on damages if they get into an accident. This is the “pooling” concept. People are paying to be in a large pool of individuals with similar risk characteristics in order to receive a payment themselves when they get in trouble. It’s not gambling. In fact it’s the opposite of gambling! Gambling creates a risk where none existed before while insurance removes the financial burden of risk from an insured individual.
Deposit & Spread Management Relationships
Because insurers are entrusted with a lot of money that they have to hold onto in order to pay claims they tend to do a good job of investment management. In fact insurers became so good at managing their customer’s money that new customers started to use them to simply manage their money as if they were a bank.
These types of contracts have no insurance risk, the insurance company simply seeks to do a great job of investing money, credit as much back to their policyholders as they can, and keep a spread between the amount of investment income they earn and the amount of investment income they credit to customers.
For example, for an equity indexed annuity contract the insurance company might guarantee the customer a 3% annual return on their money no matter what the market does, and if the market goes up by more than 3% the customer is allowed to keep 90% of the investment income earned by the insurer. In this case the insurance company takes all the risk, if the market goes up by less than 3% they have to pay the customer to top off the guarantee, while taking 10% of their return in excess of the guarantee.