CHAPTER 26 Insurance Operations

Chapter Objectives n Present the two major areas of insurance: 1) life and health and 2) property and casualty n Describe the different types of insurance policies and their sources of funds n Describe the main uses of insurance company funds n Explain the exposure of insurance companies to various forms of risk n Describe the regulatory environment of insurance companies

Insurance Companies n Provide contractual risk management for: l Risks of insurable asset losses (auto insurance) l Risks of liability claims (product liability) l Risk of large medical costs (health insurance) l Risk of disability (disability insurance) l Risk of premature death (life insurance) l Risk of longevity (annuities)

Insurance Companies, cont. n Major capital market intermediary l Major investor in corporate (life) and state and municipal bonds (property/casualty) l Major long-term commercial mortgage lender (life) n Mutual or stock form of ownership n Premium and investment revenue n Losses and loss adjustment expenses

Insurance Concepts n Pure vs. financial risk n Insure fortuitous, independent risk occurrence n Premium covers losses, administrative expenses and profits n Insured contracts for known loss (premium) in return for protection n Moral hazard and adverse selection

Background n Life insurance companies n Provide risk management contracts for individuals and businesses l Risk areas include premature death, health maintenance costs, and disability l Life insurance provides cash benefits to the beneficiary of a policy on the policyholder’s death l Life insurance premiums reflect u Probability of making payment to the beneficiary u Size and timing of the payment l Have portfolios of policies and use mortality figures and actuarial tables to forecast claims

Cash Value Insurance Group Types of Life Insurance Policies Whole Life Variable Life Universal Life Term Insurance Term Group

Types of Life Insurance Policies n Whole life insurance includes both a death benefit (term insurance) and a savings component that l Builds a tax sheltered cash value amount for the future for the owner of the policy l Generates periodic cash flow payments over the life of the policy for the insurance company to reinvest l Pays fixed death benefit at death

Types of Life Insurance Policies n Term life insurance characteristics l Temporary, providing death benefits only over a specified term l Premiums paid represent insurance only with no saving component l Considerably lower cost for the insured than whole life—able to buy more insurance protection for any amount of premium l Term is for those who would rather invest their savings in other contracts or securities

Types of Life Insurance Policies n Variable life insurance l Whole life with variable cash value amounts l Cash values invested in equities and will vary with the investment performance l Flexible premium option since 1984 n Universal life insurance l Combines the features of term and whole life l Variable premiums over time—buys terms and invests difference in a variety of investments l Builds a varying cash value based on contributions and investment performance

Types of Life Insurance Policies n Group plans l Employees of a corporation offered life insurance or life insurance purchased on life of employee l Cash value or term insurance l Low cost (term) because of its high volume l Can cover group members and dependents

Health Care Insurance Health Care Insurance n Health maintenance organizations or HMOs l Intermediaries between purchasers and providers of health care l Annual fee or premium u Covers all medical expenses u Medical staff is designated by the HMO l Losses in recent years for HMOs

Sources of Life Insurance Company Funds n Cash value reserves—accumulated cash values owed insureds (liability) n Pension reserves—accumulated “insured” pension commitments (liability) n Annuity reserves—accumulated annuity commitments (liability) n Unearned premium income—premiums received; not yet earned (liability) n Loss reserves--losses incurred, not yet paid n Capital funds

Uses of Life Insurance Company Funds n Major investor in corporate bonds n Government securities n Common stock n Commercial mortgage n Real Estate n Policy loans to insured

Uses of Funds—Policy Loans n Policy loans are loans to policyholders l Whole life policies l Borrow up to the cash value of the policy l Guaranteed interest rate is stated in the policy l Usually used by borrowers during periods of rising rates to lock in the lower rate associated with their policy

Insurance Company Capital n Capital l Build capital by issuing new stock (stock companies) or retaining earnings l Used to finance investments in fixed assets l Cushion against operating losses l Capital requirements vary depending on asset risk l Credibility with customers is also enhanced by adequate capital l Mutual companies owned by policyholders— includes earnings retained over time

Regulation n Insurance companies are highly regulated by state insurance agencies n The National Association of Insurance Commissioners (NAIC) l Provides coordination among states in regulatory matters l Adopted uniform regulatory reporting standards n State Regulators l Make sure insurance companies provide adequate service l States approve/review rates l Agent licensure l Forms are approved to avoid misleading wording

Regulation n Insurance Regulatory Information System l Compiles financial information and lists of insurers l Calculates 11 ratios to assess and monitor financial health n Assessment system l Ability of the company to absorb either losses or a decline in the market value of its investments l Return on investment l Relative size of operating expenses l Liquidity of the the asset portfolio

Regulation n Regulation of capital l In 1994 companies were required to report risk- based capital ratios to insurance regulators l Goals of requirements are to u Discourage insurance companies from excessive exposure u Back higher risks with higher capital u Reduce failures in the industry

Risks of Life Insurance Companies Pure Risk of Life Insurance Policies Pension Commitments and Annuities Contracts Financial Risk includes Interest Rate Risk Credit Risk Market Risk Liquidity Risk

Exposure to Financial Risks n Interest rate risk l Fixed rate assets in company portfolios have market values sensitive to interest rate changes l Firm measures and manages risks n Credit risk l Mortgages, corporate bonds and real estate holdings can involve default l Investment-grade securities l Diversify portfolio among debt issuers

Exposure to Financial Risks n Market risk l Exists because events like significant market value decreases reduce capital l Economic downturn affects real estate investments

Exposure to Financial Risks n Liquidity risk occurs because a high frequency of claims may require the life company to liquidate assets l Life insurance companies have high cash flow from premiums to offset normal cash needs l In case of large disaster (9/11) may be forced to sell assets to generate cash even if market value is low l Companies try to balance the age distribution of their customer base l As interest rates rise, voluntary terminations of policies occur

Asset Management n Performance is significantly affected by the performance of the assets l Companies get premiums for several years before paying out benefits l Companies try to manage the risk of losses with offsetting investment gains or diversity of assets they hold l Diversify into other businesses to offer a wide variety of financial products

Property and Casualty Insurance n Property insurance (fire insurance) n Casualty insurance (liability) n Performance and financial bonding

PC Versus Life Insurance Companies n PC have shorter contracts n PC have more varied risk areas n Life companies larger due to long-term savings and pension contracts n PC has wider distribution of Occurrences l PC’s need liquid, marketable assets l PC’s earnings more volatile

Property Casualty Investment Needs n Tax sheltering--major municipal/state bond investor n Liquid, marketable assets l Marketable corporate and government bonds l Listed common stock n Inflation hedge--common stock n Reinsurance contracts--manage pure risks

Valuation of an Insurance Company n Value of an insurance company depends on its expected cash flows and required rate of return  V = f [  E(CF),  k]  V = Change in value of the insurance company  k = Change in required rate or return Where:  E(CF) = Change in expected cash flows +

Valuation of an Insurance Company n Factors that affect cash flows E(CF) = Expected cash flow R f = Risk free interest rate INDUS = Prevailing industry conditions for the company Where:  E(CF)= f (  ECON,  R f,  INDUS,  MANAB) ECON = Economic growth MANAB = Management ability of company ++?

Valuation of an Insurance Company n Investors required rate of return  k = f(  R f,  RP) ++ R f = Risk free interest rate Where: RP = Risk premium

Performance Evaluation n Common indicators of company performance are available l Statistical analysis of performance l Ratio analysis u Trends over time u Compare to industry average

Performance Evaluation n The higher the liquidity ratio, the more liquid the company Liquidity Ratio = Invested Assets Loss Reserves and Unearned Premium Reserves

Performance Evaluation n Return on net worth or policyholders’ surplus is a profitability measure Return on Equity= Net Profits Policyholders’ Surplus

Performance Evaluation n Underwriting gains and losses or underwriting profitability measured by the net underwriting margin l Profits include investment income, underwriting profits and realized capital gains l Ratios can be calculated to focus on various sources of profits Net Underwriting = Premium Income - Policy Expenses Total AssetsMargin

Other Issues n Insurance companies interact in a variety of ways with other financial institutions n Insurance companies participate in a full range of financial markets n Multinational insurance companies l Insurance companies operate in many countries l Some countries lack developed markets for insurance n Multinational investments