FNCE 4000 Financial Institutions Management Chapter 2 Part 2 Institutions Other Than Depository Institutions

1-2 Financial Institutions Vs General Business For most businesses: Gross margin = sales less cost of goods Gross margin less operating expenses = operating income For depository institutions: Net Interest Margin = Interest income less interest expense Net Interest margin less operating expenses = operating income BUT, financial institutions differ from most business because of the long-term commitments on both the income and expense side

Keys To Success  Distribution Capabilities –Funding/Liabilities –Assets/Fund deployment (including investment)  Compliance  Product Pricing  Risk Control  Operational Efficiency

Life Insurance Companies  Distribution –Funding – insurance policy issuance –Assets - investments  Compliance  Product pricing –Underwriting of policies  Product offered  Loss & cost analysis  Risk control –All risks faced by banks (less liquidity risk) –Additional risk: uncertainty of liabilities  Operational efficiency –Over 8000 companies –Largest change: Brokered to captive agents –Deal with state regulation

Life Insurance Balance Sheet Abbreviated Life Insurance Balance Sheet Assets: Investments62.9 Separate Account Assets33.0 Other Assets4.1 Total Assets100.0 Liabilities and Capital: Policy Reserves52.9 Deposit-type accounts & Other14.4 Separate Accounts32.9 Capital & Surplus5.6 Total100.0

Life Insurance Balance Sheet

Health Insurance  Mostly part of life companies  Very different business  Most important: –Operational efficiency  This is a processing business –Pricing of products –Compliance/regulatory relationships  Investment performance is far less important –Vast majority of funds in/out in one year

P&C Insurance vs. Life Ins.  Reduced spread of risk –Natural disasters  Shorter-term policies (liabilities) –Less investments, so performance not as significant –While P&C industry premiums > life industry premiums, less than half the investments –Much more volatile short-term earnings

P&C Abbreviated Balance Sheet Abbreviated P&C Insurance Balance Sheet Assets: Investments78.0 Receivables8.3 Other Assets13.7 Total Assets100.0 Liabilities and Capital: Policy Reserves72.0 Other Liabilities14.5 Capital & Surplus13.5 Total100.0

P&C Balance Sheet

Simple Insurance Income Statement Abbreviated Insurance Company Income Statement Premium Income100.0 Losses on policies75.0 Loss Ratio = 75.0 Policy administration expenses15.0 Selling and General Admin11.0 Combined ratio = Investment Income8.0 Policy dividends paid0.6 Pretax Income7.4

Finance Companies  Like banks, but not really –Borrow and lend  No insured deposits –Must issue bonds/commercial paper for funding –Higher capital ratios –Less regulation –Lower-quality borrowers  Independent finance companies – R.I.P. –Squeezed between banks and securitization  Only captive finance companies still around –GE Capital. GMAC, FMC –Product expertise & sales support

Mutual Funds  Only marginally “Institutions”  Each fund is a corporation  Investment results flow directly to investors (less expenses)  Keys to success: –Investment results –Distribution  “Sponsored” by investment advisor

 Captive customers  Important factors: –Investment performance –Risk control –Efficiency  Extremely long-term liabilities  Sponsored by corporation or government Pension Plans