CHAPTER 17 INSURANCE COMPANIES AND PENSION FUNDS Copyright© 2012 John Wiley & Sons, Inc.

2 The Insurance Service Indemnify another against risk of economic loss. Requires pooling of a large number of similar, but independent risks - law of large numbers. Insurance is the last step after other pure risk control and reduction techniques of risk management. Pure risk, the chance of loss, differs from speculative or investment risk which is related to the variability of returns where one can have a gain or a loss. Insurance reduces society's cost of bearing risk. Copyright© 2012 John Wiley & Sons, Inc.

3 The Insurance Mechanism An insurer assumes objective risk which is the deviation of actual losses from expected losses. It is part of the operating risk of an insurance company. Insurance companies reduce objective risk through underwriting, deductibles, coinsurance, and reinsurance. Copyright© 2012 John Wiley & Sons, Inc.

4 Insurable Risks Certain conditions must be present before a private company can insure a risk: homogeneous or similar exposures losses should be random or occurring by chance circumstances of loss can be identifiable a probability of loss can be estimated the losses occur independent of each other-not all at once, such as a flood, wiping out the insurer premiums must be economically feasible for the insured Copyright© 2012 John Wiley & Sons, Inc.

5 Objective risk control methods include: use of loss prevention techniques such as "safety" programs accept "average" risks as customers require deductibles or shared losses with the insured Copyright© 2012 John Wiley & Sons, Inc.

6 Insurance premiums represent the sum of: expected losses, plus operating costs, plus target profit, less premium investment income with adjustment as necessary for competitive conditions Copyright© 2012 John Wiley & Sons, Inc.

7 Interest rate risk affects insurance companies Insurance contracts are long-term contracts: interest rates vary providing incentives for cancellations and revision of intentions. Because of long-term nature of liabilities, portfolios are heavily invested in bonds. Copyright© 2012 John Wiley & Sons, Inc.

Organizational Forms Stock companies: A stock insurance company is a corporation owned by its shareholders. Mutual companies: A mutual insurance company is an insurer that is owned by its policy owners - there are no stockholders. Reciprocals: These organizations operate like unincorporated mutuals, and their objective is to minimize the cost of the insurance. Lloyd’s associations: These are organizations that do not directly write insurance, but instead provide a marketplace and services to members of an association who write insurance as individuals. 8 Copyright© 2012 John Wiley & Sons, Inc.

Regulation of the Insurance Industry Insurance companies are regulated by the states in which they do business. McCarran- Ferguson Act (1945). State insurance commissioners are members of the National Association of Insurance Commissioners (NAIC). 9 Copyright© 2012 John Wiley & Sons, Inc.

Life and Health Insurance Industry 10 Copyright© 2012 John Wiley & Sons, Inc.

11 Term Life Insurance: Basic Model Payment for death only Coverage for specified term Lower premium Large amount of protection per premium dollar No “investment” features Copyright© 2012 John Wiley & Sons, Inc.

12 Term Life Insurance: Variations Straight - coverage for specific time period with premiums increasing with age. Decreasing - pay level premiums over a period of years while level of coverage declines. Increasing – coverage that increases monthly or yearly. Renewable - option to continue after expiration date, independent of health changes. Convertible - policyholder may convert to a whole life policy for an added premium fee. Copyright© 2012 John Wiley & Sons, Inc.

13 Whole Life Insurance Level premiums for constant level of protection. Premium includes cost of insurance (decreasing term) and savings contribution. Cash values (savings accumulated by insured) increase with time. Death benefit includes decreasing term amount and "return" of savings. Copyright© 2012 John Wiley & Sons, Inc.

14 Whole Life Insurance, cont. Provides "living" benefits in form of accumulated savings. Combines life insurance and savings (at a relatively low but contractual rate). Interest or dividends on cash values accumulate free of income taxes-important tax shelter. Copyright© 2012 John Wiley & Sons, Inc.

15 Universal Life Insurance The most popular interest-sensitive life insurance. Flexible premium policy with varying death benefit and premium amounts. Pays market rate on savings. Copyright© 2012 John Wiley & Sons, Inc.

16 Variable Life Insurance Popular recently with rapid growth in equity values Fixed-premium life insurance Insured direct investment of cash values Guaranteed death benefit No guaranteed cash value Copyright© 2012 John Wiley & Sons, Inc.

17 Annuities Superannuation - risk of living beyond one’s means A life annuity, for a given payment, pays a life long stream of payments The period of time and survivorship terms vary The longer the "certainty," the less the payments Copyright© 2012 John Wiley & Sons, Inc.

18 Balance Sheet of Life Insurers Liabilities and net worth Life insurance reserves - funds owed for life insurance policies, including cash values and losses owed, not yet paid Pension fund reserves - accumulated commitments to pay future pensions Surplus and net worth Copyright© 2012 John Wiley & Sons, Inc.

19 Balance Sheet of Life Insurers, cont. Assets - long-term matching liabilities Corporate bonds - largest financial investment Corporate equities Mortgages U.S. government securities Policy loans Copyright© 2012 John Wiley & Sons, Inc.

Life Insurance Companies’ Balance Sheet, Copyright© 2012 John Wiley & Sons, Inc.

21 Health Insurance Covers medical, disability, and dental expenses. Insurance companies write about sixty percent of health insurance premiums. Blues, HMOs, PPOs. Patient Protection and Affordable Care Act of Copyright© 2012 John Wiley & Sons, Inc.

22 Copyright© 2012 John Wiley & Sons, Inc.

23 Property/Casualty Insurers Property insurance - protection from financial loss of property from perils such as fire and theft Casualty insurance - liability, worker's compensation, auto, aircraft, marine Copyright© 2012 John Wiley & Sons, Inc.

24 Life versus P/C operations P/C policies shorter term than life P/C loss payments less predictable P/C balance sheet must be more liquid P/C loss payments increase with inflation Both life and P/L firms generate revenue from premiums and investment income Copyright© 2012 John Wiley & Sons, Inc.

25 Types of P/C Policies Property - insurance against losses associated with physical damage. “Named perils” : Coverage limited to specific losses listed in policy. “All-risk coverage” or “open perils”: Any loss covered unless specifically excluded. Liability - insurance against financial responsibility for harm to another person or property. Copyright© 2012 John Wiley & Sons, Inc.

26 Types of P/C Policies, cont. Marine insurance - covers losses related to transportation. Ocean marine - ocean transportation Inland marine - inland transportation and some special personal property such as furs and jewelry Multi-peril or multi-line combines property and liability insurance. Copyright© 2012 John Wiley & Sons, Inc.

27 Balance Sheet of P/C Insurers Assets - selected for income, inflation hedge, liquidity, and tax sheltering State and municipal bonds (tax free) and corporate bonds Corporate stock (inflation hedge and income) Government securities (liquidity and income) Trade credit ($ owed by customers and agents) Liabilities and net worth Policy reserves include: unearned premium reserve; losses incurred, not paid. Surplus and net worth Copyright© 2012 John Wiley & Sons, Inc.

P/L Companies’ Balance Sheet, Copyright© 2012 John Wiley & Sons, Inc.

29 Types of Pension Plans Private Pension Plans Insured – managed by life insurer Non-insured Trustee managed by a third party Non-trustee - managed by firm or labor union Government Sponsored Pension Plans Social Security Federal, state, and local government plans Copyright© 2012 John Wiley & Sons, Inc.

30 Copyright© 2012 John Wiley & Sons, Inc.

31 Pension Plan Vocabulary Fully funded: contributing funds sufficient to cover future obligations versus paying benefits from current revenue Contributory: employee and employer contribute Fully contributory: only employee contributes Noncontributory: only employer contributes Defined benefit: benefits set by formula based on years of service and average salary; responsibility is fully on employer to provide promised benefits Copyright© 2012 John Wiley & Sons, Inc.

32 Pension Vocabulary, cont. Defined contribution: employee and employer each make contributions of some set percentage of salary; employee chooses how funds are invested; ultimate benefits depend on employee’s investing; 401k most popular example today Vesting: employee assured of retirement benefits after a set period of time Portability: ability to transfer vested benefits to another plan Copyright© 2012 John Wiley & Sons, Inc.

33 Pension Management Factors Little need for liquidity “Qualified” plans not taxed The higher the earning rate, the lower the contribution to support a given benefit Pension funds face risk/return trade-off decisions for their beneficiaries Regulation focuses on fiduciary duty, full funding, and prudent investing Copyright© 2012 John Wiley & Sons, Inc.