How Your Insurance Company Gambles With Your Money

S&P Insurance RatingsWhile insurance is there to protect you, companies wouldn’t sell it if it wasn’t profitable.  And, in fact, the insurance business is extremely profitable (which is why Warren Buffett loves it so much).  You might wonder how it can be profitable when the premiums are relatively low compared to what the company could potentially pay out?  It’s because the insurance companies perpetually play a game of risk – they essentially gamble with your money everyday.

 

How Insurance Companies Work

The foundation of the insurance business is statistics and shared risk.  Over time, and with a large number of individuals, certain statistics emerge about the likelihood of certain events occurring.  For example, the odds of any individual being involved in a car accident in their life is 1 out of 18,585.  And, the average cost of an injury accident is $126,000.  This does vary quite a bit depending on where you live, but you can break it down even further to figure out exactly how much an accident will cost per insured person – which happens to be about $700 per year in California.

If you’re an insurance company, you can then make sure that no matter what you charge a single individual driver, you need to make sure that the average of all your policies in California exceed $700 per person, so that you can make a statistical profit.

 

How Insurance Companies Boost Their Profits

But that isn’t the only way to make money for insurance companies – in fact, it is their least profitable method of making money.  Instead, insurance companies maintain reserves (which make sense because you never know when you will actually have to pay a claim).  But these reserves just don’t sit there – insurance companies invest this money to make a profit.  And how well they invest this money is what really determines how profitable they will be.

However, this is where the gambling part comes in.  Since this money is invested, how can you be sure that it will be there if you need to make a claim?  For example, what if we hit another financial crisis, and the stock market tanks – will insurance companies have enough reserves available to pay your claim?

 

How To Select a Safe Insurance Company

Since all insurance companies invest their money, it is important to know which are the safest when selecting an insurance provider.  If you are getting  30 year term life insurance policy, will the company be around in 30 years?  That is why companies like A.M. Best and Standard and Poors have rated insurance companies on their abilities to pay claims.

For most individuals, you want to select a company that is rated AA or higher with Standard and Poors.  This rating means that the company has very strong financial security characteristics, and is unlikely to be affected by adverse business conditions.

Once you get down into the BBB or lower range, the companies are vulnerable to adverse business conditions, and likely need favorable business conditions to meet their financial commitments.  This means if another recession does occur, you could be in trouble.

The final safeguard is state regulation – many states require a certain level to be met at all times, and the state may step in to protect policyholders if needed.  However, just like any other government agency stepping in, you may not get everything back.

 

How do you feel about insurance companies gambling with your money?

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  • http://worksavelive.com Jason

    To be fair I think this is slightly misleading. For instance (I’ll mention this one because I know it almost to be 100% certain), the annuity/life insurance companies we work with are required to hold 83% or 87% (one of those two but can’t remember which) of premiums paid in “safe money” and cash reserves.

    The rest (13%) is actually gambled with and invested in things like options.

    So, while they do gamble money, they are required to keep the vast majority of it safe.

    • http://mymoneycounselor.com Kurt @ Money Counselor

      Jason, I’m interested to learn this. After the 2008 meltdown and challenges at AIG and others, I’ve been very reluctant to pay insurance premiums to any company when the benefits are probably far in the future–I’m thinking of long-term care, life, and annuities–for fear the company will vaporize, taking my money with it, and I’ll be left with no coverage or benefits. Do you think my fear is unfounded?

    • http://thecollegeinvestor.com Robert

      Yes, they are required to keep a certain portion safe, but they aren’t always able to. For instance, Arizona just took over an insurance company this year for failing to maintain reserves.

      There are over 6,000 insurance companies in the United States, and at any given time, up to 10% are under-capitalized.

  • http://blog.moneytrail.net/ Pam at MoneyTrail

    Is the investing/gambling model the same for all types of insurance — health, life, auto, home, etc.?

    • http://thecollegeinvestor.com Robert

      Yes, insurance companies float the money from the time the premium is collected to when any claims are paid. They keep a reserve and invest the rest.

  • http://www.onesmartdollar.com sean @ one smart dollar

    It doesn’t surprise me one bit to read this. Banks do it every day so why not our insurance companies as well.

  • http://thirtysixmonths.com Marissa @ Thirty Six Months

    I agree with Sean. If banks can do it, why wouldn’t insurance companies.