The fundamental purpose of insurance is to provide the purchaser with a greater sense of financial security, protecting assets and income from accidental loss and misfortune. So insurance is a financial market. Considering the current state of the economy, you might want to know just how secure your coverage is.
While insurance investments—the places where premiums and policyholders’ surplus are parked while waiting to pay out claims, expenses and dividends—have taken a beating over the past year, they’re in much better shape than most retirement accounts. By their own nature and as imposed by state regulation, insurance-company investments are generally very conservative. Typically, two-thirds of an insurer’s investments are in high-rated bonds. Less than 20 percent may be tied up in common and preferred stocks, and typically less than 2 percent in mortgage loans or real estate, the sectors of the financial market most affected by the recent downturn.
The bond markets did not turn in a profitable performance over the past year, with bonds of even high ratings posting high single- or double-digit losses. Still, these losses seem a blessing compared to the slide in equity markets, with the Dow Jones Industrial Average down more than 35 percent over the last 12 months and the S&P 500 down more than 40 percent.
Some of you are thinking, “Wait, I’m a taxpayer, and I now own a portion of the federal government’s substantial equity stake in an insurance company called American International Group. AIG is obviously in serious trouble.” Let’s be clear: The problems of AIG are due to the failure of a financial unit regulated by federal agencies, not its more traditional insurance products, which are regulated by state insurance departments. Financial problems from such risky investments as credit default swaps are not shared by companies who focus and restrict operations to traditional insurance products.
While I just painted a picture of the insurance industry designed to reduce your stress level, I would be remiss in leading you to believe all is rosy. The combined ratio—incurred losses plus expenses divided by net earned premiums—was 105.6 percent for the first six months of 2008. In other words, insurance companies paid out about 5.5 cents for every dollar they took in.
Catastrophe losses accounted for higher than average annual losses for the property and casualty industry in 2008, with hurricanes Ike and Gustav contributing to $14.3 billion in losses. Ike was the fourth most expensive storm on record. While year-end results for 2008 were not published at the time this article was written, the projected loss to the property and casualty insurance industry surplus for the year is about $80 billion, or about 20 percent of policyholders’ surplus.
Policyholders’ surplus is a financial cushion that protects a company’s policyholders in the event of unexpected or catastrophic losses. A certain margin of that cushion is required for every policy based on line of business and state regulatory requirements. What this means for companies that have seen a decline in their policyholders’ surplus is they must write less insurance or raise more capital during the next year. Raising new capital is not a simple task in today’s market.