Insurance premiums aren’t used just to pay claims
Insurance companies play a crucial role in our society, providing individuals and businesses with financial protection against unexpected losses. To do this, insurance companies collect premiums from policyholders. But what happens to your premium once it is paid to the insurance company?
Insurance companies don’t just store your premiums in a giant safe until they’re needed to pay claims. Instead, they put these funds to work by investing them. This practice is vital to insurance companies for several reasons.
Let’s break it down. When you pay a premium for an insurance policy, the insurance company pools your premium together with those paid by other policyholders. The pooling of premiums is the first step that allows the insurance company to spread out the risk of potential claims among many policyholders.
Now, these pooled premiums form a large amount of money known as a reserve. This reserve is there to ensure that the insurance company has enough money to pay out if a policyholder files a claim. But while this money is sitting in the reserve, the insurance company doesn’t just let it idle. They invest this money to generate income and to increase the value of the reserve.
Investment income helps to keep the insurance premiums lower than they would be otherwise. Without the income from investments, insurance companies would need to charge much higher premiums to maintain their financial stability and be able to pay claims.
So, how does an insurance company invest your premiums? They typically follow a conservative investment strategy because it’s essential to maintain the ability to pay claims even in unfavorable market conditions.
The investments of insurance companies are usually in the form of bonds, especially government and high-quality corporate bonds. Bonds are chosen because they are relatively safe compared to other types of investments and provide a steady income in the form of interest. Some part of their investments might also be in real estate, mortgages, and stocks, but these usually represent a smaller portion of the investment portfolio because they come with higher risk.
The specific rules and regulations about how insurance companies can invest their funds vary from state to state and are overseen by the state’s department of insurance in which the company is domiciled. These regulations are in place to ensure that insurance companies are not taking excessive risks with the premiums they have collected.
Insurance premiums are not just used to pay claims. Instead, they are carefully invested to earn income, helping the insurance company to remain financially stable and to keep premiums affordable. This prudent financial management is essential to ensure that the insurance company can honor its commitment to policyholders even in the face of large or unexpected claims.
Brad Pistole of Ozark, Mo., is farmer and a Certified Financial Fiduciary®, Certified Annuity Specialist®, and CEO of Trinity Insurance & Financial Services, INC.
