The average consumer believes that most of the money that insurance companies collect in the form of premium ends up in their bank accounts as profits. The reality is that this is not really the case. The reality is that most of the money, collected from premiums has to be paid back either in the form of claims, operating expenses or taxes. Hence, if insurance were simply about taking in and giving out money, it would not be a very profitable business.

The key point to understand is that there is a time lag between when the money is collected as premium and when it is paid out. Since there is a time lag involved, insurance companies invest the money they receive from other people and receive investment income on the same. This investment income forms a significant chunk of income earned by insurance companies. Since a lot of this money is invested in the stock market, the increasing market volatility has a major impact on the income generated by insurance companies.

In this article, we will try to understand how important investment income is, for insurance companies. We will also try to analyze the impact that stock markets tend to have on these incomes and therefore on the solvency of insurance companies.

Profits Are Not Earned From Premiums

Insurance markets across the world have become very competitive. This means that market pressures have reduced the insurance premiums to the bare minimum. As a result, insurance companies only retain about 8 cents as profit for every dollar that they take in as premium.

According to the Insurance Bureau of Canada, about 55% of the money is spent back to service the claims which are generated by policyholders.

A humungous 21% is the administrative cost which is required to service the policy. This includes the cost of paperwork which is sent across to the policyholders as well as the costs required to maintain customer service helplines.

Also, since the insurance industry in North America is heavily taxed, they pay about 16% of the premium received in the form of taxes. As a result, after deducting all the expenses, insurance companies are left with a measly 8% which they can retain in the form of profit.

This is not a sustainable situation since insurance companies are taking far too many risks and therefore 8% is not a fair rate of return. However, this 8% is only the difference between premium collected and money paid out.

As explained above, insurance companies also have a second source of income, i.e. investment income. In many insurance companies, investment income contributes about 50% to the total profit earned by insurance companies. The bottom line is that investment income is critical and can make or break the financials of any insurance company.

Volatility and Investment Income

The funds held by insurance companies are very tightly regulated. These companies are not at liberty to invest the funds as and when they like. Instead, there are strict guidelines which explain the various sub-limits which have to be followed while investing this money. For instance, most of the money has to be kept in ultra-liquid debt funds since it may have to be retrieved quickly. A relatively small amount of funds can be invested in long term equities. Also, insurance companies may not be permitted to trade in low end penny stocks. Their investments have to be restricted to blue chip stocks only.

• Market volatility affects short term funds in a negative manner. This is because most of the times, market volatility is the result of rising interest rates in the market. The problem is that a large chunk of insurance money is held in debt securities.

  Since the value of debt securities is inversely related to interest rates, insurance companies lose money. This has a negative impact on the reserves, i.e. the claim paying ability of the insurance companies. Companies tend to predict these events and invest more money than required. However, at the end of the day, even the most sophisticated insurance company is making a guess. Sometimes these guesses do not work out as intended and have a negative impact on the solvency of the company.

• Also, when interest rates rise, the value of stocks also takes a beating. Stocks are where insurance companies tend to make most of their investment income from. A fall in the value of the stocks reduces the surplus available with insurance companies. Since the reserves fall short of the amount required for making claim payments, many times, surplus amount is divested in order to make good on the promise to pay claims.

Hence the bottom line is that insurance companies are affected by market volatility in two ways.

1. Firstly, they witness a fall in the reserves that they have held.

2. Secondly, they also see a drastic fall in the surplus amount that they hold.

Insurance companies are built to handle up to moderate shocks in the stock market and still remain solvent. However, when black swan events occur, and markets lose a large percentage of their market capitalization overnight, insurance companies may end up being one of the first casualties.