Insurance is often described as banking without money given it engages in a risk management business model using other people’s money. In normal times, insurance companies are stodgy widow and orphan stocks returning a modest return but with a level of safety. For example, using the period of 1993-2003 (i.e. pre-bubble), the S & P Life and Health Insurance Index returned only 3.6% on an annual basis.

But, with the cheap lure of money and every CEO suddenly thinking they were high-flying traders, insurance companies got sucked into the vortex of unreasonable risk taking in the recent past. The most notable example was Manulife Financial (NYSE: ) who invested insurance premiums heavily into equities, and failed to hedge against such trading, found itself in financial trouble.

Assuming that the world gets back to normal and risk management companies actually begin to manage risk responsibly again, what should one look for when investing in insurance companies?

Insurance companies- what is its business model?

Insurance is the transfer of risk from one party to another in exchange for the payment of a premium. The premium, in turn, is invested and used to pay out future claims and to operate the insurance company.

In essence, insurance companies are engaged in two primary revenue streams: the assumption of other people’s risk in exchange for money/premiums and the management of such premiums (asset management). An insurance company makes money by making more in revenue (insurance premium sales + investment income) than expenses (premiums paid out + general operating expenses).

Here’s where things get a bit bizarre. Insurance companies are guessing (albeit with some sophisticated financial modeling) whether it will make money on each policy sold. The insurance premium could be too low (i.e. the insured is riskier than they thought), the return on the premiums invested could be under its assumptions on ROI or the insured could cancel their policies too early (which, with a return of premium rider, is bad news for the insurer).  Insurance, on some preserve level,  is like taking a stab into future events.

Thus, a critical piece of an insurance company’s operations is to ensure that it always has enough capital to manage all the risk it has assumed.