insurance companies

Copyright © 2012 Pearson Prentice Hall.All rights reserved.

CHAPTER 21

Insurance Companies and Pension Funds

© 2012 Pearson Prentice Hall. All rights reserved. 21-2

Insurance Companies

Insurance companies assume the risk of their clients in return for a fee, called the premium.

Most people purchase insurance because they are risk-averse—they would rather pay a certainty equivalent (the premium) than accept a gamble


Insurance Companies: Major Employer


Fundamentals of Insurance

Although there are many types of insurance and insurance companies, there are seven basic principles all insurance companies are subject to:

1.There must be a relationship between the insured and the beneficiary. Further, the beneficiary must be someone who would suffer if it weren’t for the insurance.



2. The insured must provide full and accurate information to the insurance company.

3. The insured is not to profit as a result of insurance coverage.

4. If a third party compensates the insured for the loss, the insurance company’s obligation is reduced by the amount of the compensation.



5. The insurance company must have a large number of insured so that the risk can be spread out among many different policies.

6. The loss must be quantifiable. For example, an oil company could not buy a policy on an unexplored oil field.

7. The insurance company must be able to compute the probability of the loss’s occurring.


Adverse Selection and Moral Hazard in Insurance

As we have seen in previous chapters, asymmetric information plays a large role in the design of insurance products. As with other industries, the presence of adverse selection and moral hazard impacts the industry, but is fairly well understood the insurance companies.


Adverse Selection in Insurance

The adverse selection problem raises the issue of which policies an insurance company should accept:

Those most likely to suffer loss are most likely to apply for insurance.

In the extreme, insurance companies should turn anyone who applies for an insurance policy.


Adverse Selection in Insurance

However, insurance companies have found reasonable solutions to deal with this problem:

Health insurance policies require a physical exam.

Preexisting conditions may be excluded from the policy.


Moral Hazard in Insurance

Moral hazard occurs in the insurance industry when the insured fails to take proper precautions (or takes on more risk) to avoid losses because losses are covered by the insurance policy.

Insurance companies use deductibles to help control this problem.


Selling Insurance

Another problem is that most people don’t purchase enough insurance. Insurance companies use a strong sales force to combat this.─ Independent agents may sell the insurance products

of a number of different insurance companies.─ Exclusive agents only sell the products of

one company.─ An underwriter reviews each policy prior to its

acceptance to determine if the risk is acceptable.


Growth and Organization of Insurance Companies

The number of insurance companies grew steadily until 1988, and since then the number has fallen steadily.

This can be seen in the next slide.



The previous slide also shows that insurance companies may be organized in two difference ways:─ A stock company is owned by shareholders and has

a profit motive─ A mutual insurance company is owned by the

policyholders and attempts to provide the lowest cost insurance

At the end of 2005, only 135 of 1119 insurance companies were mutual insurance companies.


Types of Insurance

Insurance is classified by which type of undesirable event is covered:

Life Insurance

Health Insurance

Property and Casualty Insurance


Life Insurance

Life insurance policies come in many forms. Some of the typical policies include:

Term Life: the insured is covered while the policy is in effect, usually 10–20 years.

Whole Life: similar to term life, but allows the policyholder to borrow against the policies cash value. When the term of policy expires, the insured can get the cash value of the policy.


Life Insurance

Life insurance policies come in many forms. Some of the typical policies include:

Universal Life: includes both a term life portion and a savings portion.

Annuities: pays a benefit to the insured until death, to cover retirement years.


Expected Life of Persons at Various Ages


Sample Annual Premiums


Life Insurance: Company Assets and Liabilities

Life insurance companies derive funds from two sources:─ They receive premiums that must be used to

payout future claims when the insured dies─ They receive premiums paid into pension funds

managed by the life insurance company

The next figures shows the distribution of the typical life insurance company’s assets, as well as assets invested in mortgages.



Life insurance companies have two primary liabilities:─ Life insurance payouts─ Pension fund payouts


Health Insurance

Health insurance policies are highly vulnerable to the adverse selection problem. Those with known or expected health problems are more likely to seek coverage.

This is why most health insurance is offered through group policies. Individual policies must be priced assuming adverse selection.


Health Insurance

Health insurance is a hot topic in the political environment, focusing on increased costs and availability of coverage.

Insurance programs are attempting to shift costs to the employers.

Health Maintenance Organizations are another attempt to keep costs down.



Property Insurance: protects businesses and owners from the risk associated with ownership. ─ Named-peril policies: insures against any losses only

from perils specifically named in the policy─ Open-peril policies: insures against any losses except

from perils specifically named in the policy

Casualty Insurance

Reinsurance



Casualty Insurance: also known as liability insurance, it protects against financial losses because of a claim of negligence.

Reinsurance: allocates a portion of the risk to another company in exchange for a portion of the premium.



Terrorism Risk Insurance Act of 2002: based on the 9-11 attacks in NYC, new legislation was passed in 2002 limiting the amount insurance firms would be required to pay out in the event of future attacks

Government will pay 90% of losses, up to $100 billion.


Insurance Regulation

The McCarran-Ferguson Act of 1945 explicitly exempts insurance companies from any type of federal regulation.

Most insurance regulations is at the state level

Regulation is typically designed to protect policyholders from losses, or expand insurance coverage in the state.


Conflict of Interest Violations

In 2004, NY Attorney General E. Spitzer charged Marsh and McLennan with insurance fraud.

Indictment cited bid-rigging and bribery. Some of the pay-for-play fees amounted to $800 million per year.

Many top execs left the firm in the wake of the incident.


The Practicing Manager: Insurance Management

Screening

Risk-Based Premium

Restrictive Provisions

Prevention of Fraud

Cancellations of Insurance

Deductibles

Coinsurance

Limits on the Amount of Insurance


Credit Default Swaps

A CDS is insurance against default on a financial instrument, usually some kind of securitized bond.

Market essentially non-existent before 1995. By 2008, there were about $62 trillion of CDS outstanding!

The CDS market allowed speculators to bet on the health of a company, a usual no-no in insurance.


Credit Default Swaps: The AIG Blowup

AIG’s Financial Products division insured over $400 billion of CDS securities, of which $57 billion were debt securities backed by subprime mortgages.

Creditors quickly realized the losses may bankrupt AIG – AIG could not raise any capital

The Fed organized a bailout, but took a big stake in AIG as payment. Insurance companies nationwide will now fall under federal scrutiny.


Monoline Insurance

Monoline insurance companies specialize in credit insurance and are the only insurance companies that are allowed to provide insurance that guarantees the timely repayment of bond principal and interest when a debt issuer defaults. All other insurance companies are prohibited from doing this.

Help lower required interest by providing a credit enhancement. The crisis affected them as well.


The Subprime Crisis and the Monoline Insurers

Monoline insurers did insure debt backed by subprime mortgages.

Defaults on these mortgages resulted in credit downgrades for the insurers.

This weakened the value of their insurance guarantees, which spilled over into their municipal securities insurance.

Investors reduced the value of the insurance—municipalities started seeing higher interest costs. This, in turn, resulted in lower spending on roads, schools, etc.


Pensions

Definition: A pension plan is an asset pool that accumulates over an individual’s working years and is paid out during the nonworking years.

Developed as Americans began relying less on children for care during their later years.

Also became popular as life expectancy increased.


Types of Pensions

Defined-Benefit Pension Plans: a plan where the sponsor promises the employee a specific benefit when they retire.

For example, Annual Retirement Payment 2% average of final 3 years’ income years of service


Types of Pensions

Defined-Benefit Pension Plans place a burden on the employer to properly fund the expected retirement benefit payouts.─ Fully funded: sufficient funds are available to meet

payouts─ Overfunded: funds exceed the

expected payout─ Underfunded: funds are not expected to meet the

required benefit payouts


Types of Pensions

Defined-Contribution Pension Plan: a plan where a set amount is invested for retirement, but the benefit payout is uncertain.

Private Pension Plans: any pension plan set up by employers, groups, or individuals

Public Pension Plan: any pension plan set up by a government body for the general public (e.g., Social Security)


Private Pension Plan Assets


Social Security

Pay as you go system, where current funding is used (partially) to pay current benefits.

Projected number of workers is falling while projected number of retirees is increasing, which will cause problems in years to come if not corrected.


Social Security Assets


Social Security

It’s difficult to measure the health of the social security system. Many factors are hard to predict, such as birth rates and the rate of immigration. Although it may not fail, it’d be wise for you plan other sources for your retirement cash flows.


Participants and Beneficiaries Receiving PBGC Payments


The Future of Pension Funds

We can expect their growth and popularity as the average population continues to grow.

Variety of pension fund offerings may increase as well.

Pension funds may gain significant control of corporations as their stock holdings increase.

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