Insurers as providers of fixed income investments
So far we've taken a look at the safe and stable world of fixed income investing, namely bank deposits and money market mutual funds. However, before we enter the wilder world of bond investing, let's consider fixed income investments offered by insurance companies.
Many people only think of insurance companies as places to file a claim, but insurance companies are large financial intermediaries that lend money like banks and make investments like mutual funds.
In fact, life insurance companies make a lot of money by first collecting insurance premiums, and then investing the premiums so that the investment returns are higher than the return promised to the policy holder.
Insurers act as an investment intermediary for not only cash value life insurance, but also for financial products which have little or nothing to do with insurance.
Guaranteed investment contracts, otherwise called GICs, are a good example of these products. These are large-scale financial products offered by life insurers. It's doubtful that you can invest in a GIC by yourself, but there's a good chance that your employer will allow you to invest in GICs through the company's 401(k) or other retirement plan. In this case, the guaranteed investment contract may be called the "Stable Income Fund" or something similar.
If you invest in a GIC, you give the insurer some money, and the insurer promises to give your money back plus a guaranteed rate of return.
This is where the "guaranteed" part of GICs comes from. Note that the insurer only guarantees the rate of return. Your investment is not guaranteed by a federal agency, although many states provide some kind of insurance to bail out insurers if they go under.
So a guaranteed investment contract is like investing in a bond or a bank certificate of deposit, and GIC yields are roughly equal to bank CD rates. Also, like bank CDs, most GICs restrict your ability to withdraw money before the end of the contract.
The GIC should be safer than investing in a single bond issued by, for example, General Motors. The insurer takes your money and invests it in a variety of bonds and other securities, so a GIC reduces risks by diversifying its investments.
But GICs are not risk free, in spite of the nice sounding name of "guaranteed investment contract". The thing to watch out for with a GIC is the solvency of the insurer. As investors found out in the late 1980s with the insolvency of two large insurers that invested heavily in junk bonds, insurers can and do go bankrupt.
Eventually, investors got a good portion of their money back, but their money was tied up for years in bankruptcy courts. Before you invest in a GIC, make sure you check out the financial stability of the underlying insurer.
There are a number of insurance rating services, including AM Best and Weiss Research that provide credit ratings for insurers. Check with your library for more information about these insurance rating services.
Fixed annuities are another investment offered by insurance companies. Annuities come in two flavors, fixed and variable.
Fixed annuities generally invest in bonds and offer a guaranteed rate of return for the life of the contracted annuity. Variable annuities normally invest in stocks. If the underlying stocks go up, you could do better than if you had used a fixed annuity. But if stocks go down, the fixed annuity would have been better.
Characteristics of annuities
Annuities are retirement investment vehicles offered by insurance companies. Annuities offer tax-deferred growth of your investment, but you can't remove funds from the annuity without facing a tax penalty until you reach age 59.5.
Insurance agents chat up the tax-deferred savings aspects of annuities, but they don't stress that the annuity uses after-tax dollars. Because of this, a deductible retirement account like an IRA or 401(k) account is better than an annuity.
Fixed annuities usually are expensive investments because you have to pay commissions to the agent who sells the annuity to you, and you have to pay insurance premiums for a small amount of insurance offered by the annuity.
You also have to pay hefty surrender charges to the insurance company if you withdraw your money early. This is on top of any tax penalties you may face. In the early 1980s annuities offered other tax advantages, but these largely disappeared with the 1986 Tax Reform Act.
Fixed annuities can be another tool you may want to use for your retirement planning, but there are better vehicles like your 401(k) or IRA that should be used first.
Copyright 1997 by David Luhman