J. K. Dietrich - FBE Fall, 2005 Non-Bank Financial Institutions Week 3 – September 14, 2005

J. K. Dietrich - FBE Fall, 2005 Non-Bank Financial Institutions u Insurance-type –Life and property and casualty –Pension funds u Asset management firms and funds u Securities firms u Others –Finance companies –Mortgage bankers –Government-sponsored agencies

J. K. Dietrich - FBE Fall, 2005 Insurance Liabilities u Promise to pay depending on contingency –Life - Pay upon death, or retirement –Property and casualty - Pay on occurrence of accident or loss due to theft or hazard (fire, weather, earthquake, flood) u Differences between life and accident –Life probabilities known with accuracy –Casualty has two risks: incidence and severity

J. K. Dietrich - FBE Fall, 2005 Insurance Services u Life and annuity contract –Probabilities usually not influenced by insured –Cash flows from coverage are predictable –Cancellations, lapses, policy loans u Casualty contract –Period short –Policy-holders influence the incidence and severity of claims

J. K. Dietrich - FBE Fall, 2005 Life Insurance Contracts Age Retirement Death Whole Life ContractLimited Pay Life Premiums, Benefits

J. K. Dietrich - FBE Fall, 2005 Life Insurance Contracts (cont’d) Age Retirement Death Endowment PolicyLife and Annuity Premiums, Benefits

J. K. Dietrich - FBE Fall, 2005 Insurance Distribution u Life insurance –Ordinary –Group –Industrial –Credit u Independent agents u Economics of insurance marketing –Compensation of agents and brokers –Political power in the insurance industry

J. K. Dietrich - FBE Fall, 2005 Insurance Company Income u Revenue: Premium income –Earned premiums Investment income u Expenses: Policy Benefits and Losses –Direct payments to claimants –Loss expenses (evaluation, processing) Marketing expenses Non-interest expense –Labor and related expenses –Communication, fees

J. K. Dietrich - FBE Fall, 2005 Insurance Market

J. K. Dietrich - FBE Fall, 2005 Life Insurance Assets

J. K. Dietrich - FBE Fall, 2005 Role of Insurance Equity u Equity in insurance is sometimes referred to as surplus since it represents premium collections above claims payments u Income is approximately: –Premiums + investment income – claims –Income/loss adds to/subtracts from equity u Equity or surplus absorbs large surges in claims as in catastrophes (e.g. Katrina)

J. K. Dietrich - FBE Fall, 2005 Insurance Balance Sheets u Balance sheet: liabilities are insurance reserves, unearned premiums, and surplus (plus equity capital) u Assets are investments in corporate and municipal bonds, real estate, equities, u Balance sheet management consists of matching asset risks to liability risks –Many liabilities have long tails or durations

J. K. Dietrich - FBE Fall, 2005 Property-Casualty Insurance

J. K. Dietrich - FBE Fall, 2005 Contrast Life/Casualty Insurance u Probabilities of claims in life insurance are well known (vital statistics yield accurate actuarial estimates) u Moral hazard limited in life insurance u Dollar claims in casualty insurance are affected by incidence and severity of damages and may have more are affected by incidence and severity of damages and may have more systematic risk

J. K. Dietrich - FBE Fall, 2005 Pension Funds u Private versus state and local government u Defined benefit versus defined contribution u Self-directed pension plans u Pensions, taxes, and responsibilities –Corporate tax treatment –Personal tax treatment –Corporate responsibilities under ERISA

J. K. Dietrich - FBE Fall, 2005 Pension Fund Assets

J. K. Dietrich - FBE Fall, 2005 Asset Management u Economics of the industry –Performance measurement –Principal-agent problems u A “temporary” disequilibrium –Historical perspective u Services provided by asset managers u Issues in asset management

J. K. Dietrich - FBE Fall, 2005 Asset Management Firms u Revenue: Management Fees –Based on assets under management u Expenses: Research Costs –Analysts (labor expense) –Data and computer expenses Marketing expenses Non-interest expense –Overhead labor and related expenses –Communication, fees

J. K. Dietrich - FBE Fall, 2005 Securities Firms u Brokers –Find buyers for sellers –Organize markets u Dealers –Provide liquidity to market –Hold inventories and take price risk u Securities originators –Design and place financial instruments for primary market issuers

J. K. Dietrich - FBE Fall, 2005 Brokers and Investment Banking u Full-line firms offer retail and institutional trading, securities origination and financial advisory services, and market-making services u Clearing brokers (e.g. Bear Stearns) present securities for settlement u Wire houses transmit orders to other firms for execution

J. K. Dietrich - FBE Fall, 2005 Investment Banking u Bulge bracket firms (e.g. Morgan Stanley) are largest investment banking firms u Regional firms (e.g. Wedbush Morgan) operate in local markets u Boutique firms specialize in certain types of transactions (e.g high tech or health care) u Terms are not mutually exclusive

J. K. Dietrich - FBE Fall, 2005 Securities Firm Income u Revenue: Commissions Fees - Advisory, investment banking, asset management Gains (and losses) and interest u Expenses: Labor costs Communications and space Clearing fees Borrowing costs

J. K. Dietrich - FBE Fall, 2005 Finance Companies u Three basic types –Captive finance companies (owned by manufacturer, e.g. GMAC) –Commercial finance companies and financial firm affiliates (owned by banks or other financial firms, e.g. Foothill Group) –Consumer or personal finance companies (specialized in high-risk finance, like Household Finance) u Funding sources - Bank credit, commercial paper, affiliate company financing

J. K. Dietrich - FBE Fall, 2005 Finance Company Investments

J. K. Dietrich - FBE Fall, 2005 Asset-Pools u Origination –Government-sponsored agencies (GSEs) »Federal National Mortgage Association (FNMA or Fannie May) »Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) »Student Loan Marketing Corporation (SLMC or Sallie May) –Private originators u Servicing –Servicing fees and costs –Transactions in servicing portfolios

J. K. Dietrich - FBE Fall, 2005 Other Financial Firms u Mortgage banks u Information and advisory firms u Clearing firms and depositories u Exchanges and communication networks u Clear differences between types are eroding, but traditionally were due to –Regulation, taxation, and charters –Specialization and expertise –Historical evolution

J. K. Dietrich - FBE Fall, 2005 Next week: Sept. 21, 2005 u Read Chapters 4 and 17 of Money and Capital Markets u Read selections from trade press selected by students and download handouts before class u Form a group of three or four students for the group project and provide a tentative choice for the group project from the list provided or as discussed with me u Bring a Wall Street Journal to class every Wednesday