Chapter Fifteen Insurance Companies

Insurance Companies (ICs) The primary function of insurance companies is to compensate policyholders if a prespecified event occurs, in exchange for premiums paid insurance underwriters assess and price risk insurance brokers sell insurance contracts Insurance is broadly classified into two groups life insurance policies provide protection against untimely death or illness, and/or transfer wealth through time to retirement property-casualty insurance protects against personal injury and liability associated with specific events Insurance companies also sell a variety of investment products similar to other FIs 2

Life Insurance Companies Approximately 2,000 life insurance companies exist in the U.S. in the mid-2000s compares to 2,300 in 1988 the industry has seen consolidation to take advantage of scale and scope economies Aggregate industry assets were $4.94 trillion at the beginning of 2010 compares to $1.1 trillion in 1988 3

Life Insurance Companies Life insurers pool the risks of individuals to diversify away some of the customer-specific risk Thus, they are able to offer insurance services at a cost lower than any individual could achieve on his/her own This allows the transfer of income related uncertainties from the individual to the group Other activities of life insurance companies: sell annuities, which are savings contracts that involve the liquidation of those funds saved over a period of time manage pension plans (e.g., tax-deferred savings plans) provide accident and health insurance 4

Life Insurance Companies Insurance companies accept or underwrite risk that a pre-specified event will occur in return for insurance premiums underwriting decisions determine which risks are accepted and which are not underwriting decisions determine how much to charge (in the form of premiums) for accepted risk The adverse selection problem is the problem that customers who apply for insurance policies are more likely to be those in need of coverage 5

Life Insurance Companies Moral hazard occurs when, after an insurer and a customer enter into an insurance contract, the insured engages in risky behavior because the risk is covered Actuaries reduce the risks of underwriting insurance With life insurance, actuaries analyze mortality, produce life tables, and apply time-value-of-money tools to price life insurance annuities and endowment policies With health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc. 6

Life Insurance Companies Ordinary life insurance is marketed to individuals—policyholders make periodic premium payments in exchange for coverage Term life beneficiary receives payout at time of death if insured lives beyond the term of the contract, no benefits are paid Whole life policy protects over entire lifetime beneficiary receives face value of contract upon death 7

Life Insurance Companies Endowment life beneficiary receives payment at time of death if insured lives beyond the term of the contract, insured receives face value of the contract Variable life premiums are invested in market securities value of policy depends on the value of the securities Universal life allows the insured to change both the premiums and the maturity of the contract Variable universal life a universal policy where the premiums are invested in variable rate earning assets Because of the costs and fees on insurance policies with a savings feature many investors are better off buying term insurance and investing for retirement on their own in some other tax advantaged vehicle as long as they are disciplined enough to save on their own for retirement. 8

Life Insurance Companies Group life insurance covers a large number of persons under a single policy contributory—both the employer and the employee cover a share of the premiums noncontributory—the costs are borne entirely by the employer Credit life insurance protects lenders against borrower death 9

Life Insurance Companies Other life insurance activities Annuities are investment vehicles that liquidate a fund (pay investors) over a long period of time Annuity sales were $303 billion in 2009 Private pension funds compete with other financial service companies. In 2010 insurers administered more than $2.3 trillion of pension fund assets Guaranteed investment contracts (GICs) are instrumental in many of these plans 10

Life Insurance Companies Other life insurance activities Accident and health insurance accounted for more than $171 billion of premiums written in 2009 Life insurers write over 50% of all health premiums 11

Life Insurance Lines 12

Annuities Example You have a policy with a cash value of $250,000 which you wish to annuitize. You are currently 62 years old and your spouse is 58. Interest rates are 5% per year, and you are considering receiving monthly payments under three options. In option 1 you will receive 10 years of monthly payments. With option 2 you will receive a monthly payment until you die, which is expected to be in 14 years. With option 3 you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years. How much will you receive per month with each option (ignoring administrative costs and fees)? 13

Annuities, Monthly Payments In option 1 you will receive 10 years of monthly payments. With option 2 you will receive a monthly payment until you die, which is expected to be in 14 years. With option 3 you will receive a monthly payment until both you and your spouse die. Your spouse is expected to outlive you by 8 years. 14

Life Insurance Company Balance Sheet Policy loans are loans made by an insurance company to its policyholders using the policy as collateral Note: long term nature of assets matches liabilities 15

Life Insurance Company Balance Sheet Policy reserves reflect expected payment commitments on existing policy contracts Funds in separate account business are monies for which the insurer maintains separate accounting (annuities and certain insurance policies) 16

Insurers and the Financial Crisis of 2008-2009 The life insurance industry performed well during the mid-2000s while the stock markets and the economy were performing well As the crisis began, insurers experienced losses on mortgage-backed securities, commercial loans, particularly commercial real estate, and on corporate bonds The result was very large profit declines in 2008 (over 50% declines from 2007) and continuing poor conditions in 2009 on more losses on investments With dropping equity markets, insurers also collected lower fees on their variable annuity products which are largely equity based. This means that insurers with large amounts of separate account activity had more extensive losses than other insurers. The very low interest rate environment meant that insurers could not lower crediting rates on new policies. This encouraged existing policyholders to surrender their policies if they were already at the minimum crediting rate. There were also large losses on common and preferred stock holdings in their own investments. Industry conditions improved in 2010 and should be better in 2011 unless the economy slips back into another recession. The worst of the profit problems seems to be over but giving the expected lackluster growth of the economy the profit outlook is not strong. 17

Life Insurance Regulation McCarren-Ferguson Act of 1945 confirmed primacy of states over federal regulation of ICs state insurance commissions charter and examine ICs the National Association of Insurance Commissioners (NAIC) has developed a coordinated examination system States promote insurance guarantee funds funds are run by the insurance companies themselves contributions are paid only when an IC fails (except in NY) The Financial Services Modernization Act (FSMA) of 1999 allowed CBs, IBs, and ICs to exist as subsidiaries under one Financial Holding Company (FHC) 18

Life Insurance Regulation During the financial crisis Congress considered adding a federal regulator of the insurance industry, but left regulation to the states Dodd-Frank bill created the Federal Insurance Office (FIO) that reports to Congress and the President on the insurance industry The FIO is supposed to identify systemic risks arising from insurers, monitor international insurance events, eliminate state regulatory gaps and encourage the offering of insurance products to underserved segments 19

Property-Casualty (P&C) Insurance Companies Currently about 2,600 companies sell property-casualty (P&C) insurance top 10 firms have a 49% market share top 200 firms have a 94% market share Property insurance involves coverage related to the loss of real and personal property Casualty insurance offers protection against legal liability exposure 20

Property-Casualty (P&C) Insurance 21

Property-Casualty (P&C) Insurance Fire insurance and allied lines 4.3% of premiums written in 2006 vs. 16.6% in 1960 Homeowners multiple peril (MP) 12.5% of premiums written in 2006 vs. 5.2% in 1960 Common multiple peril 4.3% of premiums written in 2006 vs. 0.4% in 1960 Auto liability and physical damage (PD) 39.3% of premiums written in 2006 vs. 43.0% in 1960 Liability insurance (other than auto) 14.7% of premiums written in 2006 vs. 6.6% in 1960 22

Balance Sheets of Property-Casualty (P&C) Insurance Companies Reinsurance: Insurance companies can attempt to share risks by buying insurance from other insurance companies 23

Balance Sheets of Property-Casualty (P&C) Insurance Companies Policyholder surplus is equity 24

Balance Sheets of Property-Casualty (P&C) Insurance Companies Loss reserves and loss adjustment expenses loss reserves are set aside to meet losses from underwriting loss adjustment expenses represent the administrative and adjusting costs associated with settling claims Unearned premiums includes premiums that have been paid before insurance coverage has been provided 25

Property-Casualty (P&C) Insurance Underwriting risk is the risk that premiums are insufficient to cover losses and administrative expenses after taking into account investment income Underwriting risk may result from: unexpected increases in loss rates unexpected increases in expenses unexpected decreases in investment yields 26

Property-Casualty (P&C) Insurance Loss risk is a function of actuarial predictability property vs. liability severity vs. frequency long-tail vs. short tail product inflation vs. social inflation Loss risk is a measure of pure losses incurred to premiums earned premiums earned are premiums received and earned on insurance contracts because time has passed with no claim filed Expense risk occurs from two major sources: loss adjustment expenses (LAE) commissions and other expenses 27

Property-Casualty (P&C) Insurance The combined ratio is a measure of overall profitability equals the loss ratio plus LAE to premiums written plus commissions and other expenses to premiums written Investment yield is measured as net interest income divided by premiums earned The operating ratio is also a measure of overall profitability equals the combined ratio minus the investment yield 28

P&C Insurance Profitability *First six months of 2010, Source Text, from AM Best, www.ambest.com Loss Ratio: Losses and adjustment expenses to premiums earned Expense Ratio: Expenses incurred to premiums written Dividends: Dividends to policyholders to premiums earned Combined Ratio = Loss Ratio + Expense Ratio Combined Ratio after Dividends = Combined Ratio plus dividends 29

Property-Casualty (P&C) Insurance Many catastrophes of historically high severity have occurred recently 9/11/2001 terrorist attacks 2004 Florida hurricanes, 2005 hurricane Katrina, 2008 hurricane Ike An underwriting cycle is a pattern that the profits in the P&C industry tend to follow The federal government has consistently increased their role of providing compensation and reconstruction assistance following natural disasters 30

Property-Casualty (P&C) Insurance Regulation P&C insurers are chartered at the state level P&C insurers are regulated by state commissioners State guarantee funds provide (some) protection to policyholders The NAIC provides services to state regulatory commissions such as the Insurance Regulatory Information System (IRIS) 31

Global Issues About 55% of total global life insurance premiums written are generated by four countries: the U.S., Japan, the United Kingdom, and France The world’s largest life insurer by revenue in 2010 was Japan Post Holdings with revenue of $202.2 billion The largest P&C insurer was the German firm Allianz with $126.0 billion of revenue 32