Nondepository Financial Institutions Chapter 10

Life Insurance Companies Oldest type of intermediary in the U.S in Philadelphia (now called Presbyterian Ministers’ Fund) Invest funds obtained through the sale of policies. Primary investments: Long term taxable, not highly marketable securities: corporate bonds and commercial mortgages. Income paid to policy holders is tax exempt - return on the policy holders investment Insure against dying too soon and living too long.

Life Insurance Companies Regulation of life insurance companies includes: Sales practices Premium rates Allowable investments Usually overseen by a state insurance commissioner, who might also be the state banking commissioner

Types of Life Insurance Policies Whole Life Insurance Constant premium that is paid through entire life of policy Build up cash reserves or savings which can be withdrawn as borrowing or outright by canceling the policy Savings component pays a money market rate of interest that changes with market conditions

Types of Life Insurance Policies Term Life Insurance Pure insurance with no cash reserve or savings element Premiums are relatively low at first but increase with the age of the insured individual Universal (variable) Life Variation on whole life policy “Unbundle” the term insurance and tax-deferred savings component Owner can elect how to allocate the savings component among a menu of investment options, thereby potentially earning above money market rates

Life Insurance Companies Based on actuarial tables, life insurance companies have ability to predict cash flow Typically insurance companies use excess funds to buy long-term corporate bonds and commercial mortgages Higher yields Unlikely of having to sell prior to maturity However, lately they have branched out into riskier ventures such as common stock and real estate

Life Insurance Basics Public makes payments in exchange for protection Companies lend out the funds collected. Companies use the interest and dividend income received to pay benefits to policyholders Insurance companies have a reasonably predictable stream of payments to policy holders distributed over time.

Dealing with Asymmetric- Information Problems in Insurance Limiting adverse selection Restricting the availability and quantity of insurance. Limiting moral hazard in insurance Deductible: A fixed amount of an insured loss that a policyholder must pay before the insurer is obliged to make payments. Coinsurance: A policy feature that requires a policyholder to pay a fixed percentage of a loss above a deductible.

Pension Funds Program established by an employer to provide retirement benefits to employees. History established at the end of the 19th century by railroads American Express Company who was closely associated with railroading. Many failed during the depression - led to increased regulation.

Pension Funds Individuals need pension plans to supplement Social Security benefits Most pension fund assets are in employer-sponsored plans Defined Benefit Plan Defined Contribution Plan

Defined Benefit Plan Retirement benefits are defined by the plan Employer contributions are adjusted to meet the benefits and insure the plan is fully funded—enough funds to meet future obligations Vesting Retirement benefits remain with the employee if they leave the firm and is based on length of employment Employee Retirement Income Security Act (ERISA) Establishes minimum reporting, disclosure, vesting, funding and investment standards to safeguard employee pension rights Pension Benefit Guaranty Corporation— Guarantees some benefits in defined benefit plans if company is unable to meet its accrued pension liabilities

Defined Contribution Plan Contributions are defined by the plan Contribution may be made by employees or employers or a combination of the two Employee contributions are tax deferred—taxes payable when funds are withdrawn Benefits depend on the performance of the assets in the plan Avoids the problems of vesting and funding Individual employee has the ability to choose the assets in which to invest Most common are 403(b) and 401(k)

Pension Funds Defined contribution plans are the type favored by most employers, although some employers offer both plans In addition to employer-sponsored plans, some individuals are given tax incentives to set up their own pension plans Keogh Plans—self-employed individuals Individual Retirement Accounts (IRAs)— working people who are not covered by company- sponsored pension plans

Pension Fund Basics Tax-exempt institutions set up to provide participants with retirement income that will supplement other sources of income. The number of people likely to retire each year is quite predictable. As a result they invest about 80% of their funds in corporate equities.

Property and Casualty Insurance Companies Insure against casualties such as automobile accidents, fire, theft, personal negligence, malpractice, etc. Losses can be unexpected and highly variable. Invest in tax-free municipal bonds and short-term securities.

Property and Casualty Insurance Companies (Cont.) State insurance commissions set ranges for rates, enforce operating standards, and exercise overall supervision over company policies Little federal involvement in regulating these companies

Most Costly Natural Disasters Since 1992 Hurricane Andrew caused $30 billion in damages in 1992 Midwest floods caused $20 billion in damages in 1993 The Northridge earthquake in California caused $42 billion in damages in 1994; Severe weather and floods in Texas, Oklahoma, Louisiana, and Mississippi caused $5.5 billion in damages in 1995 Hurricane Marilyn caused $2.1 billion in damages in 1995 Hurricane Mitch caused an estimated $2.1 billion in damages in Central America and the United states in 1998 The southern plains drought caused $4 billion in damages in 1996 Hurricane Fran caused $5 billion in damages in 1996 The winter blizzard of 1996 caused $500 million in damages Red River floods in North Dakota and Minnesota caused $4 billion in damages in 1997 Preliminary figures from 1998's Hurricane Georges show it killed 350 people and total insured losses could end up reaching $2 billion

Cost to insurers ACE and XL Capital: $1bn-1.1bn AIG: $500m Allianz: $930m AXA: $ m Berkshire Hathaway: $2.2bn ay.com ay.com CNA Financial: $200m-350m Chubb: $ m Employers' Re: $600m GE: $600m Hannover Re: $365m Munich Re: $1.95bn Partner Re: $ m Royal & Sun Alliance: $220m Scor: $150m-200m Swiss Re: $1.25bn Zurich Financial: $400m

Mutual Funds Money Market Mutual funds have been prominent on the American financial scene since the 1970s However, stock market mutual funds (Mutual Funds) have been in existence since the 1950s. A mutual fund pools the funds of many people and managers invest the money in a diversified portfolio of securities to achieve some stated objective

Open-end Mutual Fund Sell redeemable shares in the fund to the general public Shares represent a proportionate ownership in a portfolio held by the fund Shareholder can go directly to fund and buy additional shares or redeem shares at their net asset value (NAV) No-load Funds--Sold directly to public at the current NAV Load Funds—Sold through brokers and buyer pays a sales commission

Open-End Mutual Funds Net Asset Value (NAV) Fund calculates the total market value of its portfolio and divides this figure by the number of outstanding shares. Redeem outstanding shares or issue new ones at the NAV. Number of shares is not fixed but increases as more money is invested. Commonly known as Mutual Funds.

Closed-End Investment Company Issues a fixed number of shares. Invests the proceeds in a portfolio of assets. No load but brokerage fee. Shares are transferable. Price of the share is determined by supply and demand.

Mutual Funds Mutual funds are regulated by the Securities and Exchange Commission (SEC) Primary objective of regulation is the enforcement of reporting and disclosure requirements to protect the investor Many investors are attracted to families of mutual funds Number of mutual funds operated under one management umbrella Investors can easily transfer money among funds within the family

Net Asset Value Example A fund has 10 million shares and is worth $100 million. NAV = $10.00 Investors invest $20 million more. At $10/share → 2 million shares → $120 million in assets with 12 million shares. You can buy fractional shares.

Low-load Funds Load is ≤ 3% and goes to the fund. Front end load Charged when shares are purchased. Back end load Charged when shares are sold.

Full Load Funds Sold by salespeople who earn a commission. Load is split between the salesperson and the fund. Max load allowed by the SEC is 9.589%

12b-1 Plans Charge for advertising and selling expenses, including sales commissions to brokers. All shareholders in the fund bear the burden, not just new investors. Funds that use 12b-1 plans call themselves “no-load”.

Mutual Fund Information Mutual Fund Education Alliance Morningstar.com Valueline.com Vanguard.com Wall Street Journal Bloomberg.com

Finance Companies Consumer Finance Companies Make consumer loans Specialty Finance Companies—specialize in credit card financing Commercial finance Companies Make commercial loans usually on a secured (collateralized) basis Loans not as risky as consumer loans Since lending is short-term, these companies borrow substantial amounts in commercial paper market

Finance Companies Historically finance companies have played an important role in financing growing undercapitalized companies Commercial finance companies originated the concept of leveraged buyout (LBOs) which relies heavily on debt to pay for acquisition of a company Captive Finance Companies—Finance purchase of commercial and retail oriented businesses such as General Motors products (GMAC)

Securities Brokers and Dealers and Investment Banks These financial institutions play a crucial role in the distribution and trading of huge amounts of securities

Investment Banks Sell and distribute new stocks and bonds directly from issuing corporations to original purchasers League Tables rank investment banks by the volume of securities they underwrite Underwriting is typically conducted through a syndicate which includes many investment banks and brokerage firms Investment banks derive a substantial amount of income from offering advice to firms involved in mergers and acquisitions What price one firm should pay for another How the transaction should be structured Provide strategic advice in hostile takeovers—when one firm seeks to acquire another against the other’s wishes

Brokers and Dealers Involved in the secondary market, trading “used” or already outstanding securities Brokers match buyers and sellers and earn a commission Dealers commit their own capital in the buying and selling of securities and hope to make profit on the transaction

Brokers and Dealers Many of the nationwide stock exchange firms act as investment bankers, dealers, and brokers A number of large stock exchange firms have branched out to provide new types of financial services previously out of their operating charter Commercial banks, investment banks, and broker dealers have now combined under single holding company umbrellas

Venture Capital Funds, Mezzanine Debt Funds, and Hedge Funds Venture capital funds, mezzanine debt funds, and hedge funds are usually not available to public investors and not registered with SEC Funding comes from wealthy individuals or other financial institutions, possibly sponsored by brokerage firms and banks Both venture capital funds and mezzanine debt funds provide an important source of funding to small and midsize companies Financing by both venture and mezzanine funds is non-traded and held until maturity

Venture Capital Funds Invest funds in start-up companies Traditional bank financing for these firms in the early stage of growth would be very limited The Venture Capital Fund receives a substantial equity stake in the firm Although many start-up companies will fail, significant profit on those that are successful Receives profits when it takes the successful company public in an initial public offering (IPO).

Mezzanine Debt Funds Provide debt funds to small and midsize companies Issue convertible debt and subordinated debt Sometimes simply invest in a combination of high-yielding debt and equity issued by the same company Used to provide long-term funds, sometimes part of a management-buyout financing package

Hedge Funds Hedge funds: Limited partnerships that, like mutual funds, manage portfolios of assets on behalf of savers, but with very limited governmental oversight as compared with mutual funds.

Long Term Capital Management Founded by John Meriwether in 1993 LTCM had more credibility than the average broker/dealer on Wall St. Two Nobel laureates: Robert Merton and Myron Scholes Former Vice Chair of the Board of Governors of the Federal Reserve: David Mullins

Biggest losers LTCM partners $1.1 billion UBS $690 million Dresdner Bank $100 million Sumitomo Bank $100 million Bank of Italy $100 million Credit Suisse $55 million

Banks Versus Nondepository Institutions Many nondepository institutions offer services that compete directly with banks Traditionally many of the different markets were segmented, however, today they often compete for the same business The Gramm-Leach-Bliley Act of 1999 allowed the creation of financial holding companies (FHCs) that can own commercial banks, investment banks, and insurance underwriters

Banks Versus Nondepository Institutions (Cont.) The creation of FHCs brings the United States much closer to the universal banking regulatory model adopted by the European Union