Insurance Companies Chapter 3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. K. R. Stanton

McGraw-Hill/Irwin 3-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview  In this segment... Insurance Companies: Two major groups:  Life, Property & Casualty Size, structure and composition Balance sheets and recent trends Regulation of insurance companies Global competition and trends

McGraw-Hill/Irwin 3-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Insurance Companies  Differences in services provided by: Life Insurance Companies Property and Casualty Insurance

McGraw-Hill/Irwin 3-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Life Insurance Companies  Size, Structure and Composition of the Industry: In 1988: 2,300 life insurance companies with aggregate assets of $1.12 trillion In early 2000s: 1,500 companies / $3.4 trillion  4 largest wrote 19% of new premium business Increasing involvement of commercial banks in insurance policy sales  Large scale mergers

McGraw-Hill/Irwin 3-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Biggest Life Insurers

McGraw-Hill/Irwin 3-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Life Insurance: Issues  Demutualization  Adverse selection Insured have higher risk than general population Alleviated by grouping of policyholders into risk pools

McGraw-Hill/Irwin 3-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Life Insurance Companies  Life Insurance Products: Ordinary life  Term life, Whole life, Endowment life.  Variable life, Universal life, Variable universal life. Group life Industrial life Credit life

McGraw-Hill/Irwin 3-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Distribution of Premiums

McGraw-Hill/Irwin 3-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Life Insurer Activities Annuities  Reverse of life insurance activities. Private pension funds  Compete with other financial service companies. Accident and health insurance  Morbidity insurance  Effects of growth in HMO enrollment

McGraw-Hill/Irwin 3-10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Balance Sheet Long-term liabilities  Net policy reserves to meet policyholders’ claims Long-term assets  Need to generate competitive returns on savings components of life insurance policies  Bonds, equities, government securities  Policy loans

McGraw-Hill/Irwin 3-11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation of Life Insurance Companies  McCarran-Ferguson Act of 1945  Confirms primacy of state over federal regulation.  State insurance commissions  Coordinated examination system developed by the National Association of Insurance Commissioners (NAIC).  States promote life insurance guaranty funds  Not permanent funds (like FDIC)  Required contributions from surviving within-state firms.  Financial Services Modernization Act, 1999

McGraw-Hill/Irwin 3-12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Current Regulatory Proposals  Proposals to create council of federal and state officials to oversee insurance  Complaints of costly and cumbersome state regulation  Possibility of a dual (State and Federal) system similar to bank regulatory system.

McGraw-Hill/Irwin 3-13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Blending of Insurance and Banking  Major insurers applying for savings bank charters  Examples: State Farm Mutual Auto Insurance / State Farm Bank FSB TIAA / TIAA-CREF Trust Co. Allstate Insurance Co. / Allstate FSB Metropolitan Life Insurance Co. / Metlife Bank & Trust Co. FSB

McGraw-Hill/Irwin 3-14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For more detailed information on insurance regulation, visit:

McGraw-Hill/Irwin 3-15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Property and Casualty Insurance  Size and Structure Currently about 3,200 companies. Highly concentrated. Top 10 firms have 45% of market in terms of premiums written.  Top 200: over 95%  Balance sheet Similar to life insurance cos. (Smaller asset base) Major liabilities: loss reserves, loss adjustment expense and unearned premiums.

McGraw-Hill/Irwin 3-16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Property-Casualty  Changing composition of net premiums written (2002 versus 1960): decline in fire insurance and allied lines since 1960: 3.5% in 2002 vs. 16.6% in 1960 Homeowners MP: 10.5% vs. 5.2% in 1960 Commercial MP: 7.2% vs. 0.4% in 1960 Auto L&PD: 42.0% vs. 43% in 1960 Other liability: 22.7% in 2002 vs. 6.6% in 1960

McGraw-Hill/Irwin 3-17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Loss Risk  Underwriting risk may result from Unexpected increases in loss rates Unexpected increases in expenses Unexpected decreases in investment yields or returns.  Property versus liability: Losses from liability insurance less predictable. Example: claims due to asbestos damage to workers’ health.

McGraw-Hill/Irwin 3-18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Loss Rates  Severity versus frequency: Loss rates more predictable on low-severity, high-frequency lines (such as fire, auto, homeowners peril) than on high-severity, low- frequency lines (such as earthquake, hurricane, financial guaranty). Claims in high-severity, low-frequency lines may not be independent. Higher uncertainty forces PC firms to invest in more short-term assets and hold larger capital and reserves than life insurance firms.

McGraw-Hill/Irwin 3-19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Insurance Risks Post 9/11  Crisis generated by terrorist attacks forced creation of federal terrorism insurance program in 2002  Federal government provides backstop coverage under Terrorism Risk Insurance Act of 2002 (TRIA) Caps losses for insurance companies Key provisions extended in 2004

McGraw-Hill/Irwin 3-20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Long Tail Versus Short Tail  Long-tail risk exposure: Arises where peril occurs during coverage period but claim is made many years later. Examples: Asbestos cases and Dalkon shield case.

McGraw-Hill/Irwin 3-21 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Insurance Costs: Social Inflation  Product inflation versus social inflation Unexpected inflation may be systematic or line- specific. Social inflation: unexpected changes in awards by juries.

McGraw-Hill/Irwin 3-22 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Trends Loss ratios have generally increased. Expense ratios have generally decreased. Trend toward selling directly through their own brokers rather than independent brokers.  Combined ratio: Includes both loss and expense experience. If greater than 100 then premiums are insufficient to cover losses and expenses.

McGraw-Hill/Irwin 3-23 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Investment Yield / Return Risk  Operating ratio = Combined ratio after dividends minus investment yield.  Importance of investment income: Causes PC managers to place importance on measuring and managing credit risk and interest rate risk.

McGraw-Hill/Irwin 3-24 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Recent Trends  PC industry was not very profitable during  Succession of catastrophes Hurricane Hugo 1989, San Francisco Earthquake 1991, Oakland fires 1991, Hurricane Andrew 1991 Hurricanes Charley, Frances, Ivan, Jeanne in rapid succession generated claims comparable to Andrew. Effect on Florida PC companies yet to be discerned  Trough of underwriting cycle. More recently, September 11, 2001 terrorist attacks created an insurance crisis (and heightened demand).

McGraw-Hill/Irwin 3-25 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation  PC insurers chartered and regulated by state commissions.  State guaranty funds  National Association of Insurance Commissioners (NAIC) provides various services to state regulatory commissions. Includes Insurance Regulatory Information System (IRIS).  Some lines face rate regulation.

McGraw-Hill/Irwin 3-26 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Global Issues  Insurance industry becoming more global  Regulatory and tax effects in Cayman Islands and Bahamas  Introduction and acceleration of insurance market reforms cross-country mergers (insurance companies as well as universal banks)

McGraw-Hill/Irwin 3-27 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. World’s Largest Life Insurers Revenues ($millions)Country ING Group 88,102Netherlands AXA Group 62,051France Nippon Life Insurance 61,175Japan Assicurazioni Generali 55,105Italy Aviva 53,723UK

McGraw-Hill/Irwin 3-28 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. World’s Largest P & C Insurers Revenues ($millions)Country Allianz 74,178Germany American Int’l Group 44,637US Munich Re Group 41,974Germany State Farm Insurance 40,656US Berkshire Hathaway 39,962US

McGraw-Hill/Irwin 3-29 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites A.M. Best: Federal Reserve: Insurance Information Institute: Insurance Services Offices: National Association of Insurance Commissioners: State of NY Insurance Guarantee Fund: