Kenneth R. Szulczyk
Insurance companies are financial intermediaries because they link the funds from the
policyholders to the financial markets. Policyholders make periodical payments to the insurance
company called premiums. Insurance company will invest the premiums in the financial
markets. For the insurance company to earn a profit, the amount of interest earned in the
financial markets plus the total amount of premiums must exceed the amount paid for claims.
Largest insurance companies include Allstate, Aetna, and Prudential. Most states established
commissions that regulate insurance companies. Commissions may limit premiums, minimize
fraud, and prevent the insurance companies from investing in risky securities.
Insurance companies use the law of large numbers as they insure a large number of people.
On average, statisticians can predict an insurance company’s pay out in claims because they, on
average, accurately predict the rates of death, illness, injury, and property damage for an entire
country. Statisticians do not know which specific individuals will experience hardship, but they
can predict how often it occurs. Unfortunately, insurance companies have two problems, when
selling insurance policies: Adverse selection and moral hazard. Adverse selection means a
person buying insurance has more information than the insurance company. For example, a
person knows he has a heart problem and decides to buy a very large life insurance policy, and
he hides this information. Moral hazard means people buying insurance becomes more careless
than when they did not have insurance. For instance, a person buys theft insurance for his home,
and this person stops locking his windows and doors when he leaves, increasing the risk a
burglar will break into his home.
Insurance companies use two strategies to combat moral hazard and adverse selection. First,
insurance companies gather information about the policyholders, such as driving records,
medical records, and credit histories. Consequently, the insurance company charges a higher
premium to a person who is likely to file a claim, which we call a risk-based premium. Second,
insurance companies use a deductible. When a person makes a claim, the person must pay the
first portion. For example, a person buys health insurance with a $500 deductible. After this
person has paid the first $500 to a doctor, then the insurance company pays the remainder of the
claim. This passes some of the responsibility to the person holding the insurance policy. Finally,
a person could buy insurance with smaller premiums but with a greater deductible.
First type of insurance company is a life insurance company. These companies purchase
long-term corporate bonds and commercial mortgages because they can predict future payments
with high accuracy. Furthermore, the insurance companies are organized in two ways: Mutual
company or stock company. Insurance policyholders own a mutual company because the
insurance policy functions as corporate stock, while a stock company is a corporation that issues
stock. Thus, the shareholders own the company, while the insurance policyholders do not. Stock
company is more common because a stock company has more funding sources. They receive
funding by selling stock to shareholders, and receive revenue by selling insurance policies. Most
policies issued are called term life policies. Person buying the life insurance must pay the
premium for the rest of his life. These policies are popular because the policyholder can borrow
against the value of the life insurance policy, when he retires. Borrowing against insurance is an
annuity. An annuity pays a retired person a specific amount of money each year.