1. Chapter Fifteen
Insurance Companies
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2. 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 for coverage or for a policy
Insurance is broadly classified into two groups
life insurance provides protection against untimely death, illness, and retirement
property-casualty insurance protects against personal injury and liability
Insurance companies also sell a variety of investment products similar to other FIs
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3. Life Insurance Companies
Approximately 1,300 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 $4.8 trillion at the beginning of 2007
compares to $1.1 trillion in 1988
Life insurance companies can be either stock or mutually owned (where the policyholders are the owners)
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4. 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 saving funds on their own
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
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5. Life Insurance Companies
Insurance companies accept or underwrite risk that a prespecified 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
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6. Life Insurance Companies
Moral hazard occurs when, after an insurer and a customer enter into an insurance contract, the insured takes an action not taken into account in the contract that changes the value of the insurance
Actuaries reduce the risks of underwriting insurance
with life insurance, actuaries analyze mortality, produce life tables, and apply the time-value-of-money to produce life insurance annuities and endowment policies
with health insurance, actuaries analyze the rates of disability, morbidity, mortality, fertility, etc.
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7. 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
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8. 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
combines features of variable and universal life insurance
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9. 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
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10. Life Insurance Companies
Other life insurance activities
annuities are investment vehicles that liquidate a fund over a long period of time
private pension funds compete with other financial service companies
accident and health insurance accounted for more than $142 billion of premiums written in 2007
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11. Life Insurance Company Balance Sheets (2007)
Corporate bonds and stocks represent 73.4% of total assets
matches the long-term nature of their liabilities
Government securities represent 10.4% of total assets
Policy loans represent 7.5% of total assets
policy loans are loans made by an insurance company to its policyholders using the policy as collateral
Mortgages (mortgage backed securities) represent 6.4% of total assets
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12. Life Insurance Company Balance Sheets (2007)
Policy reserves represent 43.9% of total liabilities and capital
policy reserves reflect expected payment commitments on existing policy contracts
Separate account business represents 35.8% of total liabilities and capital
Deposit type contracts (includes GICs) represents 7.0% of total liabilities and capital
Capital and surplus reserves represent 5.4% of total liabilities and capital
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13. 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)
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14. Property-Casualty (P&C) Insurance Companies
Currently 2,700 companies sell property-casualty (P&C) insurance
top 10 firms have a 48% 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
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15. 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
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16. Balance Sheets of Property-Casualty (P&C) Insurance Companies (2007)
Bonds and stocks represent 69.6% of total assets
Losses and loss adjustment expenses represent 37.1% of total liabilities and capital
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 represent 13.7% of total liabilities and capital
includes premiums that have been paid before insurance coverage has been provided
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17. 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
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18. 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
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19. 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
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20. Property-Casualty (P&C) Insurance
Much of the 1987 to 2007 period was characterized by catastrophes of historically high severity
9/11/2001 terrorist attacks
2004 Florida hurricanes
2005 hurricane Katrina
An underwriting cycle is a pattern that the profits in the P&C industry tend to follow
The federal government has increasingly increased their role of providing compensation and reconstruction assistance following natural disasters
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21. 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)
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