Insurance companies

Every day we face the possibility of the occurrence of certain catastrophic events that could lead to large financial losses. A spouse’s earnings might disappear due to death or illness; a car accident might result in costly repair bills or payments to an injured party. Because financial losses from crises could be large relative to our financial resources, we protect ourselves against them by purchasing an insurance policy that will pay us a sum of money if catastrophic events occur.

Strictly speaking the term insurance is applied to cover for the risks that apply to goods and property, such as house insurance and car insurance, and the term assurance applies to insurance of the person, e.g. life assurance, endowment assurance and pension schemes. However, the word insurance is commonly used to mean all types of cover and the companies concerned are generally referred to as insurance companies.

Life insurance companies specialize in selling policies that provide income if a person dies, is incapacitated by illness or retires. Property and casualty companies specialize in policies that pay for losses incurred as a result of accidents, fire or theft.

Insurance companies, like banks, are in the financial intermediation business of transforming one type of asset into another for the public. Insurance companies use the premiums paid on policies to invest in assets such as bonds, stocks, and mortgages; the earnings from these assets are used to pay out the claims on the policies. In effect insurance companies transform assets such as bonds and stocks into insurance policies that provide a set of services (for example, claim adjustment, savings plans, friendly insurance agents). If the insurance company’s production process of asset transformation efficiently provides its customers with adequate insurance services at low cost and it can earn high returns on its investments, then it will make profits, if not, it will suffer losses.

Life Insurance Companies

The insurance companies are organized in two forms: as stock companies or as mutuals. Stock companies are owned by stockholders, while mutuals are technically owned by the policyholders. Most of life insurance companies are organized as stock companies but over half the assets in the industry are owned by mutual companies.

Life insurance companies have never experienced widespread failures like commercial banks, so the federal government has not seen the need to regulate the industry; instead, regulation is left to the states in which the company operates. State regulation is directed at sales practices, the provision of adequate liquid assets to cover losses, and restrictions on the amount of risky assets (such as common stock) that the companies can hold. The regulatory authority is typically a state insurance commissioner.

Life insurance companies hold long-term assets that are not particularly liquid - corporate bonds and commercial mortgage as well as some corporate stocks. Life insurance companies are selectively exempt from federal income tax, so in contrast to casualty insurance companies, they do not hold tax-exempt municipal bonds.

There are two principal forms of life insurance policies: permanent life insurance (such as whole or ordinary life) or term insurance. Permanent life insurance policies have a constant premium throughout the life of the policy. In the early years of the policy the size of this premium exceeds the amount needed to insure against death because the probability of death is low. Thus the policy builds up a cash value in its early years, but in later years the cash value declines because the constant premium falls below the amount needed to insure against death, whose probability is now higher. The policyholder can borrow against the cash value of his whole life policy or can claim it by canceling the policy.

Term insurance, on the other hand, has a premium that is exactly matched every year to the amount needed to insure against death during the period of the term (such as one year or five years). As a result, term policies have premiums that rise over time as the probability of death rises. Term policies have no cash value and thus, in contrast to permanent life policies, are pure insurance with no savings aspect.