How Insurers Invest

How do insurers invest the premium allocated to an indexed strategy?

An insurance company often buys options so that they can credit interest based on possible index gains. As you may be aware, an option can allow one to buy (a call) or sell (a put) an asset at a specific price within a specific time period.

For example, let’s assume that you can buy a stock for $10. However, instead of buying that stock for $10.00, let’s assume you buy an option that will allow you to buy that stock for $10.00 anytime during the next year. And, let’s assume you paid $1.00 for that option and that the stock never, never exceeds $10. At the end of year, naturally, you do not exercise your option to buy that stock for $10 since it is $10 or less.

Your cost is the $1.00 you paid for the “luxury” to buy that stock for $10 within one year. On the other hand, let’s assume that stock went up to $20.00. You could have purchased a $20 stock for only $10 (plus the $1.00 it cost you to buy the option).

You can buy options on indexes, government obligations, stocks and even currencies. Let’s assume an insurer, conceptually, receives a premium of $10,000 from a new contract owner. Conceptually, they get $1,000 from that $10,000 dollars and buy a one year option on an index and invest the remaining $9,000 in bonds.

The bonds help make the insurer’s minimum guarantee surrender value possible and the index option can help the insurer credit interest if the index increases.