- The final type of financial institution
we want to talk about is insurance companies.
The social value of insurance
is that it shifts risk from ordinary people such as you
and me to a large insurance company.
We pay insurance companies to take risk away from us,
healthcare cost risk, house fire risk,
automobile damage risk, early death risk, and so forth.
Insurance companies earn their money in two ways.
First, they are very good
at estimating what their losses are
and then pricing their premiums to cover those losses.
That's the most common way
we think about insurance companies.
They charge a premium and the losses
they have to pay for are less
than the premiums that they collect.
Now, what type of insurance companies are there?
Well, we are familiar with all of these.
There are property casualty insurance companies.
They cover losses from flood,
fire, earthquake, and automobile losses.
Examples include State Farm, Allstate, and Geico.
Another type of insurance is health insurance.
These insurance companies cover
traditional health insurance,
catastrophic health insurance,
disability insurance, and long-term healthcare insurance.
A well-known health insurance company
is Blue Cross Blue Shield.
There are also life insurance companies.
You can buy life insurance policies
from companies such as Prudential,
MetLife and New York Life.
We pay premiums and the insurance company guarantees
that they will pay money to our family if and when we die.
Another type of insurance is business insurance.
Doctors pay insurance companies
to help them with medical malpractice.
Other companies buy business interruption insurance
in case some outside event hinders
or stops their business operations.
Companies that insure businesses include Zurich Insurance,
Travelers Insurance, and AIG.
Now, in addition to balancing the cost
of claims against the amount of premiums collected,
insurance companies also make money
in another way, through investments.
Think about the timing of the cash flows
in the insurance business.
I pay my premiums to the insurance company now
and they pay losses on my behalf later.
The insurance company has the use
of that money from the moment I give it
to them to the moment they have to pay out the claims.
Now, what can they do with that float,
the money that's available to them?
Well, they can invest in other companies.
They can invest in stocks, bonds, and mutual funds.
They can invest in real estate development projects.
Insurance companies make a great deal
of money on their investments while they are waiting
to pay for the insurance claims that come in.
Because insurance companies are
able to make profits from these investments,
they can lower the cost that they charge us for insurance.
Thus, we see that insurance companies are another form
of financial institution.
To review, if we were all financially sophisticated
and had infinite time and perfect communication
with everyone else in the world,
we would arrange borrowing,
investing, and savings
transactions personally among ourselves.
We would also manage risk ourselves.
We wouldn't need special insurance companies,
but we don't have infinite time,
and we don't have perfect information.
And we are not all financially sophisticated.
Financial institutions provide us
with financial sophistication for a price.
They gather savings from lots of investors
like you and me and channel those savings
to entrepreneurs on our behalf.