In the previous blog Social Security: What is it? Insurance or Investment?, we determined that Social Security from its beginning was and is an insurance program that blends the personal needs of each participant with the collective needs of society.
Given that it operates like private insurance, the logical question is: “How does an insurance company work?”
In this two part blog, we will first answer that question. In part two, we will look at Social Security investment returns.
Insurance is all about managing risk. Insurance companies are a special type of financial institution that deals in the business of managing risk.
Without getting too technical, all insurance companies operate on the Law of Large Numbers and need predictable income.
Law of Large Numbers
An insurance company pools the risks of a large number of individuals and uses statistical analysis and probabilities to project what the future claims or payouts will be for the pool.
Insurers do this by collecting premiums, which helps to lower the total cost of risk management for everyone in the pool.
Life insurance companies sell products (i.e., life insurance and annuities) where claims and withdrawals occur years and decades after the initial purchase of the products. This means life insurers have long-term liabilities on their financial books that may exceed 40 or 50 years or more into the future. And, liabilities for annuities may extend even longer the longer we live.
As such, life insurers face the challenge of investing customer premiums to ensure they will have sufficient funds available to satisfy claims and withdrawals in the distant future. This makes insurance companies inherently conservative and generally leads them to invest heavily in long-term “predictable” assets.
Bonds are generally more predictable than stocks, but generate lower returns. Therefore, bonds allow insurance companies to match their statistically predictable liabilities (i.e., future insurance claims and payments) against more predictable cash flows (i.e., principal and interest).
According to the National Association of Insurance Commissioners (NAIC), bonds represent the majority of the insurance industry’s investments. NAIC reports that for life insurers, bonds represent at least 80% of invested assets across companies of all sizes. Ninety-four (94) percent of those bonds are high-quality, investment grade bonds that are rated BBB or higher by Standard & Poor's and Baa3 or higher by Moody's.*
Insurance Company Performance
If an insurer invested heavily in stocks, a substantial fall in stock prices would severely threaten its survival. In contrast, a similar or greater decline in its bond portfolio does not threaten the insurers survival. No matter the current price of bonds, as long as the bonds don’t have to be sold, they will be worth face value at maturity, which means predictable cash flow.
This helps explain why life insurance companies performed particularly well during the 2008-09 credit crisis. In fact, there were just eight insolvencies between 2008 and 2012. Those failed life insurers combined liabilities total $900 million, which pales in comparison to the $619 billion Lehman Brothers bankruptcy. (As an aside, most policyholders of those eight failures recovered all or nearly all benefits under their contracts.)
We will continue this blog in Part 2 by looking at Social Security investment returns.
* Zacks Investment Research, How Do Insurance Companies Invest Money?