Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Fifteen Insurance Companies

15-2 McGraw-Hill/Irwin Insurance Companies (ICs) The primary function of insurance companies is to compensate policyholders if a prespecified event occurs, in exchange for premiums paid insurance underwriters assess and price risk insurance brokers sell insurance contracts Insurance is broadly classified into two groups life insurance policies provide protection against untimely death or illness, and/or transfer wealth through time to retirement property-casualty insurance protects against property damage, personal injury and liability associated with specific events Insurance companies also sell a variety of investment products similar to other FIs The primary function of insurance companies is to compensate policyholders if a prespecified event occurs, in exchange for premiums paid insurance underwriters assess and price risk insurance brokers sell insurance contracts Insurance is broadly classified into two groups life insurance policies provide protection against untimely death or illness, and/or transfer wealth through time to retirement property-casualty insurance protects against property damage, personal injury and liability associated with specific events Insurance companies also sell a variety of investment products similar to other FIs

15-3 McGraw-Hill/Irwin Life Insurance Companies Approximately 1,000 life insurance companies exist in the U.S. in the 2010s compares to 2,300 in 1988 the industry has seen consolidation to take advantage of scale and scope economies Aggregate industry assets were $5.73 trillion at the beginning of 2013 compares to $1.1 trillion in 1988 Approximately 1,000 life insurance companies exist in the U.S. in the 2010s compares to 2,300 in 1988 the industry has seen consolidation to take advantage of scale and scope economies Aggregate industry assets were $5.73 trillion at the beginning of 2013 compares to $1.1 trillion in 1988

15-4 McGraw-Hill/Irwin Life Insurance Companies Life insurers pool the risks of individuals to diversify away some of the customer-specific risk Thus, they are able to offer insurance services at a cost lower than any individual could achieve on his/her own This allows the transfer of income related uncertainties from the individual to the group Other activities of life insurance companies: sell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of time manage pension plans (e.g., tax-deferred savings plans) provide accident and health insurance Life insurers pool the risks of individuals to diversify away some of the customer-specific risk Thus, they are able to offer insurance services at a cost lower than any individual could achieve on his/her own This allows the transfer of income related uncertainties from the individual to the group Other activities of life insurance companies: sell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of time manage pension plans (e.g., tax-deferred savings plans) provide accident and health insurance

15-5 McGraw-Hill/Irwin Life Insurance Companies Insurance companies accept or underwrite risk that a pre- specified event will occur in return for insurance premiums underwriting decisions determine which risks are accepted and which are not underwriting decisions determine how much to charge (in the form of premiums) for accepted risk The adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage Insurance companies accept or underwrite risk that a pre- specified event will occur in return for insurance premiums underwriting decisions determine which risks are accepted and which are not underwriting decisions determine how much to charge (in the form of premiums) for accepted risk The adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage

15-6 McGraw-Hill/Irwin Life Insurance Companies Moral hazard occurs when, after an insurer and a customer enter into an insurance contract, the insured engages in risky behavior because the risk is covered Actuaries reduce the risks of underwriting insurance With life insurance, actuaries analyze mortality, produce life tables, and apply time-value-of-money tools to price life insurance annuities and endowment policies With health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc. Moral hazard occurs when, after an insurer and a customer enter into an insurance contract, the insured engages in risky behavior because the risk is covered Actuaries reduce the risks of underwriting insurance With life insurance, actuaries analyze mortality, produce life tables, and apply time-value-of-money tools to price life insurance annuities and endowment policies With health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc.

15-7 McGraw-Hill/Irwin Life Insurance Companies Ordinary life insurance is marketed to individuals— policyholders make periodic premium payments in exchange for coverage Term life beneficiary receives payout at time of death if insured lives beyond the term of the contract, no benefits are paid Whole life policy protects over entire lifetime beneficiary receives face value of contract upon death Ordinary life insurance is marketed to individuals— policyholders make periodic premium payments in exchange for coverage Term life beneficiary receives payout at time of death if insured lives beyond the term of the contract, no benefits are paid Whole life policy protects over entire lifetime beneficiary receives face value of contract upon death

15-8 McGraw-Hill/Irwin Life Insurance Companies Endowment life beneficiary receives payment at time of death if insured lives beyond the term of the contract, insured receives face value of the contract Variable life premiums are invested in market securities value of policy depends on the value of the securities Universal life allows the insured to change both the premiums and the maturity of the contract Variable universal life a universal policy where the premiums are invested in variable rate earning assets Endowment life beneficiary receives payment at time of death if insured lives beyond the term of the contract, insured receives face value of the contract Variable life premiums are invested in market securities value of policy depends on the value of the securities Universal life allows the insured to change both the premiums and the maturity of the contract Variable universal life a universal policy where the premiums are invested in variable rate earning assets

15-9 McGraw-Hill/Irwin Life Insurance Companies Group life insurance covers a large number of persons under a single policy contributory—both the employer and the employee cover a share of the premiums noncontributory—the costs are borne entirely by the employer Credit life insurance protects lenders against borrower death Group life insurance covers a large number of persons under a single policy contributory—both the employer and the employee cover a share of the premiums noncontributory—the costs are borne entirely by the employer Credit life insurance protects lenders against borrower death

15-10 McGraw-Hill/Irwin Life Insurance Companies Other life insurance activities Annuities are investment vehicles that liquidate a fund (pay investors) over a long period of time Annuity sales were $356 billion in 2012 Private pension funds compete with other financial service companies. In 2013 insurers administered more than $2.9 trillion of pension fund assets Guaranteed investment contracts (GICs) are instrumental in many of these plans Other life insurance activities Annuities are investment vehicles that liquidate a fund (pay investors) over a long period of time Annuity sales were $356 billion in 2012 Private pension funds compete with other financial service companies. In 2013 insurers administered more than $2.9 trillion of pension fund assets Guaranteed investment contracts (GICs) are instrumental in many of these plans

15-11 McGraw-Hill/Irwin Life Insurance Companies Other life insurance activities Accident and health insurance accounted for about 25% of premiums written in 2012 Life insurers write over 50% of all health premiums Other life insurance activities Accident and health insurance accounted for about 25% of premiums written in 2012 Life insurers write over 50% of all health premiums

15-12 McGraw-Hill/Irwin Life Insurance Lines

15-13 McGraw-Hill/Irwin Annuities Example You have a policy with a cash value of $250,000 which you wish to annuitize. You are currently 62 years old and your spouse is 58. Interest rates are 5% per year, and you are considering receiving monthly payments under three options. In option 1 you will receive 10 years of monthly payments. With option 2 you will receive a monthly payment until you die, which is expected to be in 14 years. With option 3 you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years. How much will you receive per month with each option (ignoring administrative costs and fees)? You have a policy with a cash value of $250,000 which you wish to annuitize. You are currently 62 years old and your spouse is 58. Interest rates are 5% per year, and you are considering receiving monthly payments under three options. In option 1 you will receive 10 years of monthly payments. With option 2 you will receive a monthly payment until you die, which is expected to be in 14 years. With option 3 you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years. How much will you receive per month with each option (ignoring administrative costs and fees)?

15-14 McGraw-Hill/Irwin Annuities, Monthly Payments In option 1 you will receive 10 years of monthly payments. With option 2 you will receive a monthly payment until you die, which is expected to be in 14 years. With option 3 you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years. In option 1 you will receive 10 years of monthly payments. With option 2 you will receive a monthly payment until you die, which is expected to be in 14 years. With option 3 you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years.

15-15 McGraw-Hill/Irwin Life Insurance Company Balance Sheet Policy loans are loans made by an insurance company to its policyholders using the policy as collateral Note: long term nature of assets matches liabilities

15-16 McGraw-Hill/Irwin Life Insurance Company Balance Sheet Policy reserves reflect expected payment commitments on existing policy contracts Funds in separate account business are monies for which the insurer maintains separate accounting (annuities and certain insurance policies)

15-17 McGraw-Hill/Irwin Insurers and the Financial Crisis of The life insurance industry performed well during the mid- 2000s while the stock markets and the economy were performing well As the crisis began, insurers experienced losses on mortgage-backed securities, commercial loans, particularly commercial real estate, and on corporate bonds The result was very large profit declines in 2008 (over 50% declines from 2007) and continuing poor conditions in 2009 on more losses on investments Industry conditions improved in 2010 through In 2012 premium income stopped falling, net income rose to $40.9 billion, up from $28 billion in The life insurance industry performed well during the mid- 2000s while the stock markets and the economy were performing well As the crisis began, insurers experienced losses on mortgage-backed securities, commercial loans, particularly commercial real estate, and on corporate bonds The result was very large profit declines in 2008 (over 50% declines from 2007) and continuing poor conditions in 2009 on more losses on investments Industry conditions improved in 2010 through In 2012 premium income stopped falling, net income rose to $40.9 billion, up from $28 billion in 2010.

15-18 McGraw-Hill/Irwin Life Insurance Regulation McCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of ICs state insurance commissions charter and examine ICs the National Association of Insurance Commissioners (NAIC) has developed a coordinated examination system States promote insurance guarantee funds funds are run by the insurance companies themselves contributions are paid only when an IC fails (except in NY) The Financial Services Modernization Act (FSMA) of 1999 allowed CBs, IBs, and ICs to exist as subsidiaries under one Financial Holding Company (FHC) McCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of ICs state insurance commissions charter and examine ICs the National Association of Insurance Commissioners (NAIC) has developed a coordinated examination system States promote insurance guarantee funds funds are run by the insurance companies themselves contributions are paid only when an IC fails (except in NY) The Financial Services Modernization Act (FSMA) of 1999 allowed CBs, IBs, and ICs to exist as subsidiaries under one Financial Holding Company (FHC)

15-19 McGraw-Hill/Irwin Life Insurance Regulation During the financial crisis Congress considered adding a federal regulator of the insurance industry, but left regulation to the states Dodd-Frank bill created the Federal Insurance Office (FIO) that reports to Congress and the President on the insurance industry The FIO is supposed to identify systemic risks arising from insurers, monitor international insurance events, eliminate state regulatory gaps and encourage the offering of insurance products to underserved segments In 2013, the Financial Stability Oversight Council (FSOC) designated AIG, Metlife and Prudential as systemically important non-banks During the financial crisis Congress considered adding a federal regulator of the insurance industry, but left regulation to the states Dodd-Frank bill created the Federal Insurance Office (FIO) that reports to Congress and the President on the insurance industry The FIO is supposed to identify systemic risks arising from insurers, monitor international insurance events, eliminate state regulatory gaps and encourage the offering of insurance products to underserved segments In 2013, the Financial Stability Oversight Council (FSOC) designated AIG, Metlife and Prudential as systemically important non-banks

15-20 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Companies Currently about 2,700 companies sell property-casualty (P&C) insurance top 10 firms have a 53% market share top 200 firms have a 94% market share Property insurance involves coverage related to the loss of real and personal property Casualty insurance offers protection against legal liability exposure Currently about 2,700 companies sell property-casualty (P&C) insurance top 10 firms have a 53% market share top 200 firms have a 94% market share Property insurance involves coverage related to the loss of real and personal property Casualty insurance offers protection against legal liability exposure

15-21 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance

15-22 McGraw-Hill/Irwin Balance Sheets of Property-Casualty (P&C) Insurance Companies Reinsurance: Insurance companies can attempt to share risks by buying insurance from other insurance companies Generally shorter term investments than life insurers. Why?

15-23 McGraw-Hill/Irwin Balance Sheets of Property-Casualty (P&C) Insurance Companies Policyholder surplus is equity Why is this percent higher than for Life Insurers?

15-24 McGraw-Hill/Irwin Balance Sheets of Property-Casualty (P&C) Insurance Companies Loss reserves and loss adjustment expenses loss reserves are set aside to meet losses from underwriting loss adjustment expenses represent the administrative and adjusting costs associated with settling claims Unearned premiums includes premiums that have been paid before insurance coverage has been provided Loss reserves and loss adjustment expenses loss reserves are set aside to meet losses from underwriting loss adjustment expenses represent the administrative and adjusting costs associated with settling claims Unearned premiums includes premiums that have been paid before insurance coverage has been provided

15-25 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Underwriting risk is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment income Underwriting risk may result from: unexpected increases in loss rates unexpected increases in expenses unexpected decreases in investment yields Underwriting risk is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment income Underwriting risk may result from: unexpected increases in loss rates unexpected increases in expenses unexpected decreases in investment yields

15-26 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Loss risk is a function of actuarial predictability property vs. liability severity vs. frequency long-tail vs. short tail product inflation vs. social inflation Loss risk is a measure of pure losses incurred to premiums earned premiums earned are premiums received and earned on insurance contracts because time has passed with no claim filed Expense risk occurs from two major sources: loss adjustment expenses (LAE) commissions and other expenses Loss risk is a function of actuarial predictability property vs. liability severity vs. frequency long-tail vs. short tail product inflation vs. social inflation Loss risk is a measure of pure losses incurred to premiums earned premiums earned are premiums received and earned on insurance contracts because time has passed with no claim filed Expense risk occurs from two major sources: loss adjustment expenses (LAE) commissions and other expenses

15-27 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance The combined ratio is a measure of overall profitability equals the loss ratio plus LAE to premiums written plus commissions and other expenses to premiums written Investment yield is measured as net interest income divided by premiums earned The operating ratio is also a measure of overall profitability equals the combined ratio minus the investment yield The combined ratio is a measure of overall profitability equals the loss ratio plus LAE to premiums written plus commissions and other expenses to premiums written Investment yield is measured as net interest income divided by premiums earned The operating ratio is also a measure of overall profitability equals the combined ratio minus the investment yield

15-28 McGraw-Hill/Irwin P&C Insurance Profitability Loss Ratio: Losses and adjustment expenses to premiums earned Expense Ratio: Expenses incurred to premiums written Dividends: Dividends to policyholders to premiums earned Combined Ratio = Loss Ratio + Expense Ratio Combined Ratio after Dividends = Combined Ratio plus dividends YearLoss Ratio Expense Ratio Combined Ratio Dividends to Policyholders Combined Ratio after Dividends

15-29 McGraw-Hill/Irwin P&C Insurance Profitability Premiums $9,455,122 Losses $7,456,789 Expenses $2,578,100 Dividends 4.00%of premiums Loss ratio 78.87% losses to premiums Expense ratio 27.27%expenses & commissions to premiums Combined ratio %(sum of loss, expense and dividend ratios) Example: Calculating ratios for a hypothetical individual line Is the line profitable? What investment yield would be required to make the line profitable?

15-30 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Many catastrophes of historically high severity have occurred recently An underwriting cycle is a pattern that the profits in the P&C industry tend to follow The federal government has consistently increased their role of providing compensation and reconstruction assistance following natural disasters Many catastrophes of historically high severity have occurred recently An underwriting cycle is a pattern that the profits in the P&C industry tend to follow The federal government has consistently increased their role of providing compensation and reconstruction assistance following natural disasters CatastropheYearAmount ($ mill.) Hurricane Sandy2012$25,000 Midwest Drought2012$16,000 Midwest tornadoes2011$14,200 Hurricane Ike2008$12,500 Hurricane Katrina2005$66,000 Florida Hurricanes2004$25,000 9/11 Terrorist Attacks2001$40,000

15-31 McGraw-Hill/Irwin Property-Casualty (P&C) Insurance Regulation P&C insurers are chartered at the state level P&C insurers are regulated by state commissioners State guarantee funds provide (some) protection to policyholders The NAIC provides services to state regulatory commissions such as the Insurance Regulatory Information System (IRIS) P&C insurers are chartered at the state level P&C insurers are regulated by state commissioners State guarantee funds provide (some) protection to policyholders The NAIC provides services to state regulatory commissions such as the Insurance Regulatory Information System (IRIS)

15-32 McGraw-Hill/Irwin Global Issues About 59% of total global life insurance premiums written are generated by five countries: the U.S., Japan, the United Kingdom, France and Germany Globally, 2011 and 2012 were bad years for the insurance industry with insured losses of $111 billion in 2011 and $65 billion in 2012 About 59% of total global life insurance premiums written are generated by five countries: the U.S., Japan, the United Kingdom, France and Germany Globally, 2011 and 2012 were bad years for the insurance industry with insured losses of $111 billion in 2011 and $65 billion in 2012