How Insurance Companies Work: Understanding Their Role, Benefits and Risks

Insurance companies date back to the ancient world. Essentially, these organizations act as financial intermediaries or “middlemen.” They usually offer both insurance products and annuities, which provide guaranteed income for life or a set period of time. Below, we’ll take a closer look at what insurance companies are and how they work from an annuities standpoint.

History of Insurance Companies

• Ancient Roots: The concept of insurance began in ancient Babylon and expanded to Greece and Rome for trade and shipping protection.
• U.S. Emergence: Benjamin Franklin founded the Philadelphia Contributionship in 1752 to protect homes from fires.
• 19th Century Growth: The Industrial Revolution increased the demand for liability insurance.
• Modern-Day Industry: Today, the insurance sector employs 2.8 million people in the U.S. and generates $1.4 trillion in net premiums.

Types of Insurance Companies

There are three main types of insurance companies on the market, including:

• Life & annuity insurance companies: These companies offer life insurance to protect your loved ones financially in the event you pass away unexpectedly as well as annuities, which are investment vehicles that can provide a steady income stream in retirement.
• Property & casualty insurance companies: Property & casualty insurance companies sell products that protect you from property you own. Auto, homeowners, renters, and business insurance all fall under the property & casualty umbrella. 
• Health insurance companies: Health insurance companies sell private health insurance for those who would like coverage for a variety of healthcare expenses, such as doctor’s visits, medications, diagnostic exams, treatments, and surgeries. 

The Inception of Annuities

Just like insurance companies, annuities have been around for quite some time. Their history traces back to the ancient Roman Empire. In exchange for their service, retired soldiers and their families collected annual payments called “annuas,” which is the Latin word for annual stipends. 

During the 17th century, investors contributed to a large pool of money and enjoyed annual lifetime payments. Once an investor passed away, the remainder of the funds was redistributed among the group. In the U.S., annuities made their debut when they were used by the Presbyterian Ministers Association to provide retirement income for older ministers.  

Over the years, annuities have become increasingly more sophisticated to appeal to a variety of individuals with different risk tolerances and goals. Today, you’ll find a number of annuity products, including fixed annuities, indexed annuities, and variable annuities from many insurance companies. 

How Annuities Work

Put simply, annuities convert your premiums into regular retirement payments. Here’s a brief rundown of how the process works: You purchase an annuity from an insurance company. Next, you pay premiums that are kept in a reserve, which is the money the insurer sets aside in order to pay their policyholders. 

Then, the insurance company invests these funds in bonds, mutual funds and other safe vehicles to generate a yield. Depending on your contract, you’ll receive payments and a steady income stream a set period of time or for the rest of your life. Your payments will come from your original investment and sometimes interest, minus fees. Note that whether you’ll receive interest will depend on the annuity you’ve chosen.

Step-by-Step Process

1. Purchase an annuity from an insurance company.
2. Pay premiums that the insurer reserves to fund future payouts.
3. The insurance company invests funds in bonds, mutual funds and other assets.
4. Based on your contract, you receive regular payments for a set period or for life.
5. Your payments come from your original investment and possibly earned interest.

Fees, Charges, & Risks

As with most financial products, you can expect to pay fees when you purchase an annuity. These vary by insurer and product but may include surrender charges, mortality & expense fees, administrative fees, and commissions. Additionally, while many annuities are comprehensive, they do come with exclusions and policy limits. Lastly, economic downturns and interest rates can have a negative impact on some of these products.

Financial Strength and Customer Reviews

Since there are countless insurance companies on the market today, do your due diligence and research an insurer’s financial strength and customer reviews before you move forward with one of their annuities. Reputable, third-party agencies, such as A.M. Best, Moody’s, and Standard & Poor rate most insurers to give you an idea of their stability and how likely they are to follow through on their annuity contracts. Reviews from sites like TrustPilot, Google, and the Better Business Bureau (BBB) may also help you gauge an insurance company’s reputation and customer satisfaction. 

Is An Annuity Right for You?

Annuities may be worthwhile for individuals from all walks of life. To determine the ideal options for your unique situation, shop around. Compare various annuity contracts from different insurance companies. You may also collaborate with an insurance agent or a financial advisor who can make recommendations based on your particular circumstances and goals.