The insurance sector is made up of companies that offer risk management in the form of insurance contracts. The basic concept of insurance is that one party, the insurer, will guarantee payment for an uncertain future event. Meanwhile, another party, the insured or the policyholder, pays a smaller premium to the insurer in exchange for that protection on that uncertain future occurrence.
As an industry, insurance is regarded as a slow-growing, safe sector for investors. This perception is not as strong as it was in the 1970s and 1980s, but it is still generally true when compared to other financial sectors.
The insurance industry is made up of different types of players operating in different spaces.
Life insurance companies focus on legacy planning and replacing human capital value, health insurers cover medical costs, and property, casualty, or accident insurance is aimed at replacing the value of homes, cars, or valuables.
Insurance companies can be structured either as a traditional stock company with outside investors, or mutual companies where policyholders are the owners.
Types of Insurance Companies
Not all insurance companies offer the same products or cater to the same customer base. Among the largest categories of insurance companies are accident and health insurers; property and casualty insurers; and financial guarantors. The most common types of personal insurance policies are auto, health, homeowners, and life. Most individuals in the United States have at least one of these types of insurance, and car insurance is required by law.
Accident and health companies are probably the most well-known. These include companies such as UnitedHealth Group, Anthem, Aetna and AFLAC, which are designed to help people who have been physically harmed.
Life insurance companies mainly issue policies that pay a death benefit as a lump sum upon the death of the insured to their beneficiaries. Life insurance policies may be sold as term life, which is less expensive and expires at the end of the term or permanent (typically whole life or universal life), which is more expensive but lasts a lifetime and carries a cash accumulation component. Life insurers may also sell long-term disability policies that replace the insured’s income if they become sick or disabled. Well-known life insurers include Northwestern Mutual, Guardian, Prudential, and William Penn.
Property and casualty companies insure against accidents of non-physical harm. This can include lawsuits, damage to personal assets, car crashes and more. Large property and casualty insurers include State Farm, Nationwide and Allstate.
Businesses require special types of insurance policies that insure against specific types of risks faced by a particular business. For example, a fast-food restaurant needs a policy that covers damage or injury that occurs as a result of cooking with a deep fryer. An auto dealer is not subject to this type of risk but does require coverage for damage or injury that could occur during test drives.
There are also insurance policies available for very specific needs, such as kidnap and ransom (K&R), medical malpractice, and professional liability insurance, also known as errors and omissions insurance.
Some companies engage in reinsurance to reduce risk. Reinsurance is insurance that insurance companies buy to protect themselves from excessive losses due to high exposure. Reinsurance is an integral component of insurance companies’ efforts to keep themselves solvent and to avoid default due to payouts, and regulators mandate it for companies of a certain size and type.
For example, an insurance company may write too much hurricane insurance, based on models that show low chances of a hurricane inflicting a geographic area. If the inconceivable did happen with a hurricane hitting that region, considerable losses for the insurance company could ensue. Without reinsurance taking some of the risks off the table, insurance companies could go out of business whenever a natural disaster hits.
Mutual vs. Stock Insurance Companies
Insurance companies are classified as either stock or mutual depending on the ownership structure of the organization. There are also some exceptions, such as Blue Cross Blue Shield and fraternal groups which have yet a different structure. Still, stock and mutual companies are by far the most prevalent ways that insurance companies organize themselves.
Worldwide, mutual insurance companies accounted for 26.7% of the market share in 2017. In the U.S., 39.9% of the market belonged to mutual insurers.
A stock insurance company is a corporation owned by its stockholders or shareholders, and its objective is to make a profit for them. Policyholders do not directly share in the profits or losses of the company. To operate as a stock corporation, an insurer must have a minimum of capital and surplus on hand before receiving approval from state regulators. Other requirements must also be met if the company’s shares are publicly traded. Some well-known American stock insurers include Allstate, MetLife, and Prudential.
A mutual insurance company is a corporation owned exclusively by the policyholders who are “contractual creditors” with a right to vote on the board of directors. Generally, companies are managed and assets (insurance reserves, surplus, contingency funds, dividends) are held for the benefit and protection of the policyholders and their beneficiaries.
Management and the board of directors determine what amount of operating income is paid out each year as a dividend to the policyholders. While not guaranteed, there are companies that have paid a dividend every year, even in difficult economic times. Large mutual insurers in the U.S. include Northwestern Mutual, Guardian, Penn Mutual, and Mutual of Omaha.
What Is Insurance Float?
One of the more interesting features of insurance companies is that they are essentially allowed to use their customers’ money to invest for themselves. This makes them similar to banks, but investing happens to an even greater extent. This is sometimes referred to as “the float.”
Float occurs when one party extends money to another party and does not expect repayment until after a circumstantial event. This mechanism essentially means insurance companies have a positive cost of capital. This distinguishes them from private equity funds, banks, and mutual funds. For investors in stock insurance companies (or policyholders in mutual companies), this means the potential for lower-risk, stable returns.
Insurance and Selling Financial Products
Insurance plans are the principal product of the sector. However, recent decades have brought a number of corporate pension plans to businesses and annuities to retirees.
This places insurance companies in direct competition with other financial asset providers on these types of products. Indeed, many insurance agents are now branded as full-service financial advisors offering both protection products as well as investments, financial planning, and retirement planning. Many insurance companies now have their own broker-dealer either in-house or in partnership.